Our spotlight today is the pharmaceutical industry. This is the fourth part of this series which talks about the different characteristics of each industry and what investors should look out for. You can refer to the previous article on the retail industry here. Note that the major pharmaceutical companies are located in three main countries — the U.S., Switzerland, and Japan — and some of the players are so huge that they are collectively known as “big pharma.” Pharmaceutical companies form the bedrock of medical research as well as therapies that treat many dreaded diseases and illnesses such as…
Our spotlight today is the pharmaceutical industry. This is the fourth part of this series which talks about the different characteristics of each industry and what investors should look out for. You can refer to the previous article on the retail industry here.
Note that the major pharmaceutical companies are located in three main countries — the U.S., Switzerland, and Japan — and some of the players are so huge that they are collectively known as “big pharma.”
Pharmaceutical companies form the bedrock of medical research as well as therapies that treat many dreaded diseases and illnesses such as diabetes, cancer, and tuberculosis, to name just a few. Without these companies and their large research and development (R&D) budgets, human beings would not be able to enjoy the quality of healthcare we enjoy now. But does this automatically make pharmaceutical companies good investments? Let’s take a dive into the industry.
R&D is a long, expensive, and laborious process
Investors need to understand that the R&D and drug approval process can be a long and laborious slog. There are four phases for clinical trials in order to not only test the efficacy of a drug but also gauge its side effects in a sampled population. Blind testing is done in phase 3 and may last several years, involving several hundred to several thousand people.
Assuming all trials are cleared and the drug still shows good promise, it still needs to be submitted to the U.S. Food and Drug Administration (FDA) for approval. The entire process from the start of phase 1 to FDA approval may take many years and cost millions of dollars.
Drug efficacy and sales potential are tough to model
For an investor who is thinking of projecting the revenue a successful drug can bring in, note that the efficacy of a drug when released to the general public and its sales potential are very tough variables to predict. There have been cases of drugs being approved that then led to adverse side effects in patients, resulting in lawsuits and the recall of said drug. The pharmaceutical company would, of course, have to write off millions of dollars of R&D spending if this were to happen.
A drug’s revenue potential may only be known a few years after it has been released, and it would depend on its acceptance by major healthcare institutions, pharmacies, and distribution channels. It would also depend on whether competitors are releasing a similar drug or compound that may divert sales away from the newly-launched drug.
Watch out for the (patent) cliff!
Investors in pharmaceutical companies have to constantly keep track of the company’s drug pipeline, which is usually disclosed clearly in the annual report. These drugs are what drive revenue for the company, and every drug has a patent life granted by the FDA. Most patents are granted for a period of time between 10 and 20 years, and the patent protects the company from competition during this period.
The patent cliff refers to the steep drop in sales for a drug once its patent period ends, as this means many generic drug companies (mostly in emerging markets) can now manufacture the drug much more cheaply and plentifully. This obviously benefits the patient as it brings the cost of their medication down, but it usually results in a big hit to the pharmaceutical company’s revenue.
The Foolish bottom line
Investing in pharmaceutical companies may be rewarding, but investors need to be aware of the above traits of such companies in order to analyze them properly. Many pharmaceutical companies are also trading at very high valuations due to their dominance and pricing power, and investors should be wary of this as well.
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