3 Things Beginning Investors Should Know About the Healthcare Sector

Source: Food and Drug Administration via Facebook. 

The healthcare sector can be an intimidating place to put your money for beginning investors. Few other sectors offer greater risks or rewards than healthcare stocks, and even the way healthcare stocks are valued is markedly different from any other sector. 

With that in mind, we asked three of our top analysts to list one thing beginning investors in healthcare need to know before investing their hard-earned money in the sector. Here's what they had to say. 

Todd Campbell 
If there's any one thing that new healthcare investors should remember is that there's absolutely no guarantee that a drug in human clinical trials will make it to the market.

Source: National Cancer Institute via Facebook

Roughly 90% of all therapies that enter phase 1 human trials end up in the dust bin and a whopping 30% to 40% of drugs in late-stage phase 3 trials similarly come up short.

That means that the odds are heavily stacked against biopharma to develop the next billion dollar blockbuster. It also means that investors should be cautious in awarding premium valuations to clinical stage biotech stocks, even if early- and mid-stage research data is intriguing.

Instead of chasing stocks higher following the latest clinical trial news, a better approach is to maintain an actively updated watch list of companies that are intriguing and then monitor them regularly for opportunities to own them at the price you want to pay.

Dan Caplinger
One key thing to understand when following stocks in the healthcare sector is that you can't necessarily rely on the past results that a company has produced. There's one very good reason for this: Intellectual property law gives companies an exclusive period during which to profit from patented discoveries and innovations in drugs and other treatments. Once that period ends, however, competitors are generally free to come in and try to make generic versions of that company's products.

Source: Food and Drug Administration

The inevitable result is that drug companies, biotechs, and other treatment-dependent businesses in healthcare see huge swings in sales after patents expire. In the worst case, competing generic drugs almost entirely replace sales of the original brand-name drug, and that leaves the original developer with little or no future revenue from that product. Sometimes, companies are successful in marketing their drug even in light of generic competition, but even then, they typically have to reduce prices dramatically in order to compete effectively.

In particular, investors should look beyond simple metrics like price-to-earnings ratios in evaluating share prices for pharma stocks and biotechs with well-established product lines. All too often, the earnings behind low P/E ratios can disappear when patent protection goes away.

Sean Williams
Healthcare stocks are unique from other sectors in that most companies tend to lose money. Of healthcare companies with a market value above $50 million, two-thirds were losing money over the trailing 12-month period, per www.Finviz.com, a free online stock screener. Furthermore, even among those that were making a profit, some had earned a one-time milestone payment, divested a business or product, or even revalued warrants, resulting in profits that are unlikely to be sustainable.

Thus, if there's one thing beginning investors need to know about the healthcare sector, it's that these companies tend to lose money more often than not.

Source: Flickr user Mike Poresky 

The upside to this is Wall Street tends look far into the future when valuing healthcare companies. Biotech and pharmaceutical stocks are valued based on the peak sales potential of approved drugs and pipeline products, while insurers are priced based on the expected enrollment under the Affordable Care Act. This means that fundamentals can sometimes take a back seat to clinical data and other possible catalysts.

But for you as the investor it means you'll need to keep an extra close eye on a company's cash and cash equivalent balance. It's pretty uncommon for a healthcare company to go bankrupt, but raising cash is quite common for earlier stage biotech and pharma stocks. This can mean dilutive common stock offerings that directly impact the value of your stock. Make it a habit to familiarize yourself with a healthcare company's cash position and understand what its cash needs might be like over the next couple of quarters and even next three-to-five years.