Generic Drugs: Investing Essentials

With healthcare costs rising, physicians and consumers are constantly looking for effective ways to manage medical cost inflation. Generic drugs may offer one piece of the puzzle to that solution.

Because of their attractive costs relative to branded drugs, and considering the world's population is increasing and living longer, we can probably expect an ever-increasing role for generic drugs in healthcare.

But investing in generic drug manufacturers is only prudent if you first understand the ins and outs of the industry -- so let's take a look at the main points.

What are generic drugs?

Perhaps the U.S. Food and Drug Administration says it best: "A generic drug is identical -- or bioequivalent -- to a brand name drug in dosage form, safety, strength, route of administration, quality, performance characteristics, and intended use."

New drugs are protected by patents for a set period of time. Once the patent expires, generic drugmakers are able to swoop in and offer a cheaper version of the drug as long as it meets the laundry list of critical FDA standards mentioned above.

What is the history of generic drugs?

If you've ever picked up a generic drug prescription from your local pharmacy and appreciated the favorable difference in costs between generics and brand-name drugs, then you might want to thank the Drug Price Competition and Patent Term Restoration Act of 1984 for saving you money.

This law, which is better known as the Hatch-Waxman Act, allowed generic drug developers to submit abbreviated new drug applications, or ANDAs, to the FDA in order to request approval for their generic versions of branded drugs. ANDAs allow generic drug developers to avoid costly and time-consuming animal and human clinical testing which can expedite the approval process and also help keep the cost of bringing a generic drug to market down -- leading to savings for consumers.

How many generic drugs are there?

The simple answer is: "A lot!" Using the entire world as a scope, there are thousands of generic drugs available to be prescribed to patients today. And, because patent periods are finite on branded drugs, it means that the pool for new potential generic drugs is always growing.

Because of their high price point, brand-name drugs will always represent a big percentage of total pharmaceutical sales. But the vast majority of all filled prescriptions in the U.S. are for generic drugs.

Why invest in generic drugs?

Now that you have a better understanding of what a generic drug is and how they've come to dominate the number of prescriptions written today, let's consider a few of the advantages associated with investing in generic drugmakers.

Source: U.S. Food and Drug Administration

The first advantage, as mentioned briefly, is that generic drugmakers' pipelines are practically limitless. At some point all branded pharmaceuticals will lose their patent protection, which can expose those innovator companies to generic competition. Having a limitless pipeline means generic drugmakers have many targets and opportunities.

Also, the cost that goes into developing a generic drug is minimal relative to brand-name drugs. By avoiding expensive and time-consuming trials, generic drugmakers can focus almost their entire effort on production and plotting which upcoming patent expiration to tackle next.

And lower costs help generic drugmakers price their therapies at a fraction of branded competitors. Although generic drugmakers' gross margins are much lower than their branded drug counterparts due to the lower price point, generic drug producers make up for their lower margins with impressive sales volume. That lower price point creates a big incentive for consumers and physicians to opt for generic drugs when they're available.

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Sean Williams

A Fool since 2010, and a graduate from UC San Diego with a B.A. in Economics, Sean specializes in the healthcare sector and in investment planning topics. You'll usually find him writing about Obamacare, marijuana, developing drugs, diagnostics, and medical devices, Social Security, taxes, or any number of other macroeconomic issues.

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