How to Invest in Pharmaceutical Stocks: A Beginner's Guide

Person in white lab coat holding a tablet with pharmaceutical icons on the screen

Growth. Value. Dividends. The pharmaceutical industry is one of the few Wall Street sectors that caters to nearly any investing style or strategy.

Whether you're looking for the relative safety of established dividend stalwarts like Johnson and Johnson (NYSE: JNJ) or the potential for explosive returns with early-stage, high-growth-oriented biotechnology companies like bluebird bio (NASDAQ: BLUE) , there are hundreds of pharmaceutical stocks, ETFs, and mutual funds to choose from.

But determining what makes one stock or fund a good investment over another can be tricky. How should an investor evaluate the inherent risks -- and avoid the potential pitfalls -- in an industry that can be anything but predictable? With an estimated $180 billion expected to be poured into pharmaceutical research and development through 2022, how do you know when you've found the next big thing?

Though investing in this space can be intimidating, the key is understanding the basics. We'll dive into these essential concepts everyone should know before investing in pharmaceutical stocks:

Person in white lab coat holding a tablet with pharmaceutical icons on the screen

Image source: Getty Images.

What is the pharmaceutical industry?

The pharmaceutical industry comprises companies that develop, produce, and market medications designed to treat, prevent, or cure a medical condition. The industry can be divided up into two main classes of therapeutics: pharmaceuticals and biologics.

Pharmaceutical drugs are made up of plant-based and synthetic chemicals fused together in tablet or pill form. For example, Pfizer 's (NYSE: PFE) Lipitor, an oral pill for the treatment of high cholesterol, is a pharmaceutical drug made from a byproduct of fungus along with a host of synthetic ingredients. Given their small size, manufacturing hundreds of thousands of pharmaceutical tablets and pills is relatively straightforward on an industrial-level scale.

But the simplicity of manufacturing these small-molecule drugs also means they can be easy targets for competition -- especially if they reach blockbuster status, meaning they generate over $1 billion in annual sales. As a drug reaches the end of its patent life or market exclusivity (more on this later), generic drugs , which are chemical copies of an approved drug, can easily steal market share. As branded drugs reach this patent cliff , the drop in sales can be dramatic as doctors and patients opt for cheaper alternatives. After losing patent protection in 2011, Lipitor, which once hit over $13 billion in annual revenue, saw sales plummet nearly 20% in the year following; by 2017, the drug only brought in $1.9 billion in annual sales.

Biologics , on the other hand, are large, protein-based molecules made from living cells. With a more complex structure comes a more extensive manufacturing and approval process. Products like vaccines, medications for blood disorders such as hemophilia, and gene therapies are considered biologics. Unsurprisingly, biologic treatments like AbbVie 's (NYSE: ABBV) Humira, for the treatment of rheumatoid arthritis and psoriasis, tend to be more much expensive than chemically derived drugs; it's not unheard-of for biologics to command six-figure price tags. Additionally, these drugs generally require restricted distribution by specialty pharmacies.

The higher costs and complexity associated with biologic manufacturing keep the barriers to entry high, and biosimilar competition relatively at bay. Biosimilars are products considered close but not identical copies of branded biologics. Additionally, to have its drug considered a biosimilar, a competitor must demonstrate there's no clinically meaningful difference between the two products.

The path to approval for biosimilars is fairly new. The process was laid out in the Affordable Care Act, passed in 2010, and it took another five years for the U.S. Food and Drug Administration (FDA) to approve its first biosimilar. Since then, only nine biosimilar drugs have successfully gained marketing approval.

Even though these drugs are similar to their biologic counterparts, they are not true copies. Therefore, biosimilars can't be considered interchangeable equivalents in the same way that generics are, which limits switching. This means the patent-cliff risk for branded biologics is lessened, albeit not completely. Add it all up, and biosimilar producers have not had an easy path.

Largest pharmaceutical stocks by market cap

Data source: Yahoo! Finance.

Why should you invest in the pharmaceutical industry?

Every minute, seven American baby boomers will turn 65. That means over 10,000 men and women every day, and over 3.65 million people every year, are reaching retirement age in the U.S. And this rate isn't expected to slow down until at least 2029.

As this cohort of baby boomers hits retirement, the impact of the aging baby boomer population will likely drive national healthcare expenditures -- and company revenues -- higher. According to the Centers for Medicare and Medicaid Services, in 2016, U.S. healthcare expenditures topped $3.4 trillion; this is $10,348 per person, and the figure is expected to grow 5.5% annually through 2026. Healthcare spending is even expected to outpace gross domestic product (GDP) by one percentage point, boosting the healthcare share of GDP from 17.9% to nearly 20% by 2026.

Unsurprisingly, the prescription drug market is the fastest-growing segment of the healthcare industry, making up over 10% of U.S. healthcare spending in 2016. This figure is expected to grow at an annual average rate of 6.3% through 2025.

But it's not just the growth opportunities that attract investors. The safety in economic downturns draws investors as well. Prescription drugs are routine necessities for nearly 70% of Americans, and even during economic slowdowns, medication expenses tend to remain relatively stable. During the 2008 recession, spending decreased in every consumer spending category except for healthcare.

With such expenses often being the last budget category to get nixed in tough times, this makes the healthcare sector itself largely recession-proof, particularly for established companies like Amgen (NASDAQ: AMGN) . The company boasted an impressive 24.3% return in 2008, outperforming the S&P 500 (SNPINDEX: ^GSPC) by nearly 63 percentage points. This was on just 3% annual revenue growth from the prior year. Combining this with a well-timed share buyback program and positive clinical trial results for a pipeline drug, the stock was one of the best-performing large-cap biopharmas.

So whether you're looking for long-term growth or simply a recession-proof strategy for your portfolio, investing in the pharmaceutical industry could be one of the best places to park your cash in both good times and bad. Here are several other industry tailwinds poised to drive growth in the long term:

  • Increased government funding for healthcare research
  • Longer lifespans for patients with chronic diseases, meaning ongoing treatment for longer periods
  • International growth opportunities, particularly in China
  • Innovative (and expensive) approaches, such as gene therapy, to diagnose, prevent, and treat disease

How should you evaluate pharmaceutical stocks?

Before diving into how to evaluate pharmaceutical stocks, it's important to note that all the same basic investing rules apply. Learning how to assess a company's financial position , valuation , and future growth opportunities is essential for every investor.

To start, here are the most common metrics to use when evaluating profitable pharmaceutical companies:

  • Price-to-earnings ratio (P/E): A company's current earnings in relation to its price. Also known as the earnings multiple, the P/E ratio is a way of valuing a stock to see how cheap (or expensive) it's trading relative to the earnings it generates. The lower the ratio, the cheaper the stock. As one of the most widely used relative valuation metrics, it serves as an easy reference point to compare stocks within an industry.

  • Price-to-earnings-growth ratio (PEG) : Pharmaceutical investors often buy stocks based on the growth opportunities ahead. While the P/E ratio measures a company's current earnings in relation to its price, the PEG ratio takes into account a company's future growth potential. PEG can be calculated by dividing the P/E ratio by the estimated earnings growth rate, usually five years forward.

    A PEG ratio below 1 means a stock is trading below its expected growth rate, and is generally considered undervalued. A PEG ratio above 2, however, would signal that the price of the stock has exceeded the future growth rate; it may indicate an investor should wait on the sidelines.

  • Profit margin : A measure of profitability, a profit margin measures how much net income a company produces for every dollar spent generating that revenue; to calculate it, divide net income by revenue. Generally, the higher the margin, the more profitable the company. The average profit margin for the largest 25 drug companies is between 15% and 20%.

But wait...what if the company is not yet profitable?

On the long road of drug development, it may take decades for a company to become profitable. P/E and PEG ratios simply won't cut it when a company has yet to post any earnings at all.

Here are a few important metrics to use when assessing a company before it reaches profitability:

  • Price-to-sales ratio : The price-to-sales (P/S) ratio is a better metric than P/E for early-stage companies, as it measures the stock's price only in relation to its sales, not its earnings. To calculate P/S, simply divide a company's market capitalization -- the total shares outstanding times its share price -- by its revenue. For very-early-stage companies, you can even use future expected sales in the calculation:

    Size of total addressable patient population * expected market share * price of drug = future sales

    Generally, early-stage biopharmaceutical companies are valued at between 3 and 5 times the expected peak annual sales of each company's lead drug candidate. If you find a company trading for less than 3 times future sales, and the prospects for gaining approval and market share look favorable, you may have hit the jackpot.

  • Cash burn and cash runway : Bringing a drug successfully to market is no easy -- or cheap -- feat. And for a company with no approved products on the market, the stakes are even higher, with little to no recurring revenue stream to keep the lights on. That's why a company's cash balance is one of the most important balance-sheet items a pharmaceutical investor should know.

    Cash burn is simply how much cash a company is using every quarter. Cash runway is a measure of how long the company will be able to keep that spending up before it runs out of money; it can be calculated by taking a company's total cash balance and dividing it by quarterly cash burn. A company with $50 billion in cash that spends $10 billion per quarter has a cash runway of five quarters, or 15 months, before it will need to raise more capital -- either by issuing more equity or debt. The longer the cash runway, the better for pharmaceutical investors.

It's important to view multiple data points in context when considering whether a stock is priced favorably. For example, a company with a significantly higher debt load may have trouble making interest payments and, therefore, may be a riskier bet than a company with no debt on its balance sheet. All other things being equal, you'd expect a company with no debt to trade at a premium to the company with higher leverage.

What qualitative measures should pharmaceutical investors look for?

While quantitative financial data points are helpful, often qualitative factors, like the quality of management, can be just as important in assessing whether or not to buy a stock in the pharmaceutical industry.

Here are a few qualitative points every pharmaceutical investor should consider:

  • Management: A good place to start when evaluating a company's management is to consider the experience of the executive team and the board of directors. Do they have experience developing pharmaceutical products? Have they successfully navigated regulatory authorities to bring a biologic to market? In such a heavily regulated industry, where mistakes are constantly made, there's really no substitute for experience.

    It's also important to consider how transparent the management team is. Do they regularly provide updates on the company's pipeline? Do they explain changes in clinical trial protocols? When clinical trial updates are released, do executives fully disclose and explain the results -- both good and bad -- or do they just tend to focus on the positive?

  • Pipeline quality: Growth in a pharmaceutical company comes by the way of its pipeline, or the set of drug candidates currently in discovery or development phases. While having a large quantity of drugs in the pipeline is ideal, it's more important to assess the quality of those drugs, and what stage of development they're in. Late-stage drug candidates (those in phase 3, or under regulatory review for approval) are significantly more de-risked than those in early-stage phase 1 trials.

  • Patents: Issued by the U.S. Patent and Trademark Office, these protect a drug company's intellectual property (IP) for 20 years after an application is filed. Generally, the higher the number of patents a company has been issued, and the longer amount of time they cover, the better.

Another way a company can protect its IP is to obtain marketing exclusivity , which delays competitors from obtaining marketing approval for a set amount of time. Marketing exclusivity, granted by the FDA once a drug gets approved, is intended to encourage biopharmaceutical companies to pursue patient populations with high unmet needs, and to reward innovation. It's important to note, however, that market exclusivity and patent protection can run concurrently or independent of one another, and a company can even have patent protection without exclusivity.

Here are the most common market exclusivity periods a biopharmaceutical company can obtain:

Data source: U.S. Food and Drug Administration.

What are the risks when investing in pharmaceutical stocks?

Investing in pharmaceutical stocks is not for the faint of heart. And understanding the drug development process is the first step every healthcare investor should take.

Regulatory risk: The drug development process

Successfully obtaining approval to market a drug from the FDA can take 10 to 15 years and cost over $2.6 billion.

  • Preclinical testing: Before a drug can even begin human testing, a company (also known as a sponsor) must demonstrate in preclinical testing that its drug is reasonably safe in animals. Assuming the drug passes this first hurdle, the company can then submit an investigational new drug application (IND) to the FDA. This filing signifies that a sponsoring company is ready to take the drug candidate into the clinic with human testing.

  • Phase 1: Within thirty days after an IND is successfully filed with the FDA, if the agency gives no feedback or restrictions, a company can begin phase 1 clinical trials. In phase 1 trials, anywhere from 20 to 80 healthy volunteers are given the drug candidate to test for any initial signs of toxicity. The proper dosing and timing are also evaluated in this phase. Phase 1 usually takes a few months to a couple of years to complete, and about 70% of drug candidates successfully move on to the next phase.

  • Phase 2: This phase involves sampling a small subset of actual patients, generally a few hundred, in the intended target demographic, to determine the optimal dosing and identify any early signs of efficacy (how well a drug works). Only about 33% of drug candidates successfully complete phase 2 trials, and warrant moving to the final phase of clinical testing.

  • Phase 3: Also known as late-stage efficacy trials, phase 3 trials aim to see how well a drug candidate would perform in a wider subset of patients -- generally in the thousands -- and over the course of several years. Assuming the drug is both safe and effective, a company can submit a New Drug Application (NDA) or Biologics License Application (BLA) to obtain marketing approval. About 55% of drugs are filed for marketing approval from phase 3, and of those, 80% receive final marketing approval from the agency.

  • Phase 4: Sometimes a drug can be conditionally approved as long as the sponsor conducts post-marketing trials, known as phase 4 clinical trials. The goal of these trials is to study the drug's long-term risk-benefit profile in a real-world setting, and ensure it performs as intended.

It's important for investors to realize that only one in 10 drug candidates ever makes it to market. Even the most promising early-stage drug can turn out to be a flop.

Pricing risk: Who will pay for the drug?

But getting a product to market is only the beginning. The exorbitant price of drugs -- particularly biologic therapies -- leads health insurers to push back by either refusing to cover certain drugs, or restricting use by requiring substantial documentation.

For example, health insurer Anthem refused to cover Sarepta Therapeutics ' (NASDAQ: SRPT) eteplirsen, a $300,000-per-year drug for a rare neuromuscular disease known as Duchenne muscular dystrophy (DMD), citing concerns over the drug's efficacy.

The high cost of drugs has also brought scrutiny from politicians, particularly around campaign cycles. It's not uncommon for many biopharma stocks to take a 1% to 2% tumble after politically charged statements are made about cutting exorbitant drug pricing. And while the political rhetoric has yet to take the shape of tangible drug-pricing reform, the impact on pharmaceutical stock prices (at least in the short term) is still very real.

Investing the easy way: Top pharmaceutical ETFs

Though the rewards for picking the best individual pharmaceutical stocks are attractive, they often come at a cost. It's not unusual for an early-stage company with a limited product portfolio to quickly lose the bulk of its value in an instant after a disappointment like a clinical trial failure.

Given the risks and time required to vet hundreds of healthcare stocks, alternative investment vehicles -- such as exchange-traded funds and mutual funds -- can be an easy way to gain exposure to the industry, all while spreading your risk across dozens or hundreds of stocks representing the entire healthcare sector. But it's important to note that the ease, convenience, and simplicity of fund investing comes at a price. Annual expense ratios, or management fees, can eat away at your returns. If you invest in a fund with 1% in annual fees, a 5% gain in a given year effectively becomes a 4% gain.

Exchange-traded funds (ETFs) allow you to invest in a variety of stocks with the convenience of buying and selling the fund on major exchanges, just as you would with individual stocks.

Here's a chart that compares historical performance (which, of course, is no guarantee of future returns) and costs of several top biopharmaceutical ETFs:

Data sources: Fund providers.

The Health Care Select Sector SPDR ETF tracks the healthcare stocks in the S&P 500, weighted by market cap. This means the fund is heavily weighted toward larger companies, which typically means less overall volatility. The fund's top 10 holdings make up over 50% of the fund's portfolio of 61 stocks.

As the oldest and largest ETF, it broadly reflects the overall U.S. healthcare market with pharmaceutical, healthcare equipment, biotechnology, and even healthcare technology companies. The Health Care Select Sector SPDR ETF has one of the lowest expense ratios, at 0.13%, and offers solid returns for investors looking to broaden exposure across the entire healthcare sector.

Investing the easy way: Top biopharma mutual funds

Mutual funds , on the other hand, are pooled investments that are managed by financial professionals. The amount you invest in a mutual fund is spread out over the portfolio, meaning that you can wind up owning partial shares of a stock. This also means selling your investment, or redeeming those shares, is not as simple as with stocks or ETFs. Because mutual funds do not trade intraday like stocks and ETFs do, the price of the fund is calculated after the market closes each day, and it usually takes until the next business day to get the cash from your sale.

Most mutual funds also require a minimum investment, usually between $500 and $3000, whereas ETFs have no minimum investment.

You'll want to consider funds' turnover ratios, or how often stocks are bought and sold, giving preference to funds with lower turnover ratios in order to minimize fees.

Here's a chart that compares the performance, costs, and turnover of several top biopharmaceutical mutual funds:

Data sources: Fund providers.

The Vanguard Healthcare Fund offers another easy and profitable way to gain exposure across the industry. This fund is composed exclusively of mid- to large-cap healthcare stocks like Bristol-Myers Squibb, Allergan (NYSE: AGN) , and Vertex Pharmaceuticals (NASDAQ: VRTX) -- all companies with established product portfolios.

With a turnover ratio of 11%, this fund has a longer-term buy-and-hold strategy than similar funds in its class. Couple that with a rock-bottom expense ratio of 0.38%, and you've got a relatively cheap basket of mature stocks generating a healthy five-year return of 14.6%. Those are good reasons to consider adding the Vanguard Healthcare Fund to your portfolio.

Disruptive trends to watch

Innovation, scientific breakthroughs, and technological advances are changing healthcare treatment paradigms as we know them. What was originally an industry thought of as simply "treating the sick" is now one of preventative, diagnostic, and holistic patient care.

Personalized medicine, also called precision medicine, involves tailoring medical decisions, practices, interventions, and/or products to an individual patient. For example, physicians are increasingly turning toward targeted treatments, such as Zelboraf, for patients whose skin cancer tests positive for a specific genetic mutation known as BRAF. Around 60% of patients with melanoma have a BRAF mutation, and after treatment with the drug, over half have experienced either a reduction in the size of their skin cancers or complete remission of the disease.

Another revolution in healthcare is gene editing . Scientists pioneering gene editing don't simply want to treat a disease after diagnosis. Rather, they hope gene editing can target the underlying genetic cause of the disease, even before diagnosis. CRISPR , short for "clustered regularly interspaced short palindromic repeats," is a gene-editing tool that could one day cure diseases such as blindness, sickle-cell disease, and even cancer. Companies such as Editas (NASDAQ: EDIT) and CRISPR Therapeutics (NASDAQ: CRSP) are leading the way, with human testing set to begin in 2018.

Advances in technology are also set to dramatically change the healthcare landscape. Harnessing the power of artificial intelligence (AI) could help scientists and physicians better analyze and understand prevention and treatment techniques, leading to better patient outcomes. AI could even one day expedite the clinical trial process by determining which patient subgroups could be more likely to respond to therapy; this could lead to billions of dollars in saved R&D costs, and more importantly, earlier access to potentially life-saving treatments.

Is now the time to buy pharmaceutical stocks?

Pharmaceutical companies are no strangers to share-price volatility. Clinical trial results, regulatory decisions, and political posturing can make it tough to figure out when to buy shares in these stocks. And while long-term investors don't attempt to time the market, they do look for opportune moments to make investments.

With innovative trends set to disrupt the healthcare industry for the long term, this may be the best time to add healthcare stocks to your portfolio.

10 stocks we like better than Health Care SPDR

When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor , has quadrupled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Health Care SPDR wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of June 4, 2018

The Motley Fool owns shares of and recommends Biogen, Bluebird Bio, Celgene, and Gilead Sciences. The Motley Fool owns shares of CRISPR Therapeutics and Johnson & Johnson. The Motley Fool recommends Amgen, Editas Medicine, Novo Nordisk, and Vertex Pharmaceuticals. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

More Related Articles

Info icon

This data feed is not available at this time.

Sign up for the TradeTalks newsletter to receive your weekly dose of trading news, trends and education. Delivered Wednesdays.