I am drawn to biotech stocks like a moth to a flame because I love the field's cutting-edge technological advances. I'm a science guy, and I enjoy digging into the intricacies of drug development in my biotech work for the Rule Breakers newsletter service, but I realize that many investors may not share my exuberance for the technical side of the industry. In fact, it might scare some people away.
But I don't want anyone interested in investing in fast-growing companies to shy away from biotech because they fear the complicated technology.
Baseball legend Yogi Berra once said, "baseball is 90 percent mental -- the other half is physical." The same, er, wisdom holds true for investing in biotech. Ninety percent of what you need to know has nothing to do with understanding the science. If you accept that statement, then fear of the technology shouldn't keep you away from reaping the rewards available in this sector.
Just a widget
All companies, the good ones anyway, are in business to sell products and make a profit. If we break down what businesses do, that is as simple as it gets. Whether it is Pfizer (NSYE: PFE) selling Viagra, Johnson and Johnson (NYSE: JNJ ) selling Band-Aids, or Coke (NYSE: KO ) selling, well, Coke, what companies do is sell stuff to make money.
Drug companies are no different. Drugs are products that are sold by pharma and biotech companies. Let's keep it simple and leave it at that. For now we don't need to know what they do or how they work, just that they are sold for a profit and, in many cases, eye-popping profits over which investors salivate.
If we want to keep it really simple, think of drugs as widgets. Investors here have to figure out whether to put their investment dollars into these particular widget factories. See, I told you there was no knowledge of technology required.
Exploring widget companies
Now that we are examining unintimidating and unscary widget companies, what criteria can we look for to see whether a particular widget company is better than another? Here's a short list:
- Market opportunity. Is there an existing need for our widget? Does it fill a niche? How big is the niche?
- Competitive advantages. Value investors love to talk about wide and deep moats that provide lasting competitive advantages. Does our widget company have any?
- Profitability. How profitable is this widget company?
- Valuation. Is the valuation reasonable for the future prospects of the widget business?
- Management. Is there a history of good management performance? Do they underpromise and overdeliver? Or do they repeatedly make bold predictions and fall short on execution?
- Financials. How do the financial statements look? Is the balance sheet clean, or is the company laden with debt? Has the company been abusive to shareholders with excessive stock option grants?
That's just a short list, and I'm sure everyone can come up with additional factors they like to look at. But the point is that you can run any company in any industry -- even a drug company -- through these paces without consulting with Bill Nye "The Science Guy." Even without understanding the science, these steps go a long way to telling you whether a company is a good investment. If you have developed these skills, you have all it takes to hit the ball down the middle of the biotech fairway instead of slicing into the rough.
Back to biotech
Now I'm going to run an actual biotech company through the above checklist to show how easy it is. I will use Genentech (NYSE: DNA ) as an example since it recently had the good fortune of winning another drug approval -- Tarceva for the treatment of lung cancer.
- Market opportunity: From the company's website, we can see many familiar diseases such as cancer, multiple sclerosis, and arthritis. While not all of the diseases are readily recognizable, many of them are well-known as areas where most people know that better drugs are needed. Thus, it is safe to conclude the company has good markets in which to launch new products.
- Competitive advantages: If someone didn't know anything about this company, a little bit of research would turn up that Genentech is one of the world's leading companies in the development of cancer drugs. The products Avastin, Herceptin, and Rituxan all enjoy first-mover status and are entrenched in their respective markets.
- Profitability: In general, drug companies are very profitable, and Genentech is no exception. Through the first nine months of this year, the company had $3.3 billion in sales and nearly $600 million in net income (GAAP). Profits coming in at 18% of sales is a sign of a healthy business.
- Valuation: GAAP earnings for the trailing four quarters are $705 million, with a current market cap of $51 billion that gives a trailing P/E ratio of 73. Normally that's a red flag, but with such robust earnings growth, let's call it a yellow flag.
- Management: A review of the company's history shows that management has a pretty good track record. Over the last seven years, the company has received seven FDA approvals and increased earnings six-fold. That's a track record few companies can match. That grades an "A."
- Financials: There is a strong history of revenue and earnings growth. The balance sheet looks good with $3.1 billion cash and $1.3 billion long-term liabilities, though stock options are a concern.
After applying some basic business analysis and investment fundamentals, we can conclude that Genentech is a strong company with a valuation that is arguably steep depending on the projections for future growth. Even better, these conclusions can be reached without any knowledge of the science behind the company's products. This is what I mean when I say that 90 percent of what you need to know to invest in biotech has nothing to do with the technology.
Now, if you are comfortable running companies through the paces but are still apprehensive about the science, the Rule Breakers service can help. One of the best features of the service is what David Gardner calls "distributed intelligence." That is a reference to the extensive amount of shared knowledge amongst everyone on the discussion boards, including myself. That way, when technical questions do pop up, it is very likely that someone is there with an answer. So there's really no reason to be scared of biotech.
For additional articles on the drug industry, see:
Fool contributor Charly Travers does not own shares of any company mentioned in this article.