How to Play It Safe in Biotech

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Biotech is notoriously risky. The odds of a drug getting FDA approval are staggeringly low, and even then, companies aren't in the clear. Investors might just think biotech is just way too risky to bother with, but it doesn't have to be.

In this week's episode of Industry Focus: Healthcare, host Shannon Jones and Motley Fool contributor Brian Feroldi share three methods that can get you exposure to biotech-style gains without taking on so much of that going-to-zero-overnight risk. Listen in to hear the pros and cons to investing in sectorwide ETFs, contract research organizations, and picks-and-shovels plays -- plus, of course, some companies to add to your watchlist in each of those categories.

A full transcript follows the video.

This video was recorded on Jan. 23, 2019.

Shannon Jones: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. Today is Wednesday, January the 23rd, and we're talking Healthcare. I'm your host, Shannon Jones and I am joined via Skype by a special guest, Fool.com contributor Brian Feroldi. Brian, finally, we get to do a show together! I'm so excited!

Brian Feroldi: This is exciting! Dylan has pulled in for the Tech episodes a couple of times, but I've been looking forward to getting in on Healthcare. 

Jones: For our listeners out there, I highly encourage you to read Brian's coverage of the healthcare space. One of the things I love about Brian, he comes with a background of about 10 years in the medical device industry, and he has an eye for under-the-radar ideas. Our show today, I'm excited to have him on because something we don't talk about enough is how to invest in biotech in safer ways. For today's show, we're actually going to be covering three ways in particular that are safer -- I won't say completely low-risk -- but maybe a little bit safer than the biotech industry, one of the most volatile sectors in the stock market today. 

Brian, I think it's safe to say, when it comes to biotech, you and I love it. It's probably one of the more exciting industries. You have a constant churn of news and headlines. Oftentimes, these are huge, market-moving headlines that come out, whether it be a new trial read-out, a drug finally [crossed] the finish line for approval, no matter what, there's always a plethora of news. But, in addition to all the good news, there's also a lot of bad news. The land mines are aplenty when it comes to biotech. The risks don't just go through clinical development, but they even extend into commercialization, as well. Brian, what is it about the biotech industry that's so exciting, but also so scary at the same time?

Feroldi: Biotech is certainly not for the faint of heart. But if you just zoom out and think about it from a 10,000-foot level, there's so much happening in the biotechnology world for investors to get excited about. I mean, CRISPR, immunotherapies, CAR-Ts, RNAi -- there are a number of different segments within biotech that have so much promise, and can really go on to not only treat but cure basically hundreds or even thousands of diseases as they develop. That's a very exciting prospect for investors to get behind. 

If you combine that with the global population trends -- the age of the average person that's alive is getting older, which is a general push toward more and more spending on healthcare. When you combine those two things, the future of the biotechnology industry in general is looking incredibly bright. 

Jones: Absolutely! But, that comes with a lot of risk. Part of that is just getting a drug through the very long clinical development timeline. You're talking about Phase I all the way through Phase III, and then even Phase IV, monitoring it after it comes to market. Brian, what can you tell us about some of the approval rates as you go through that entire timeline? 

Feroldi: I think most investors know that it's very hard to get a drug from the lab actually into the market, but to throw some stats behind it, about 70% of drugs that enter Phase I will make it on to Phase II. That's a pretty good batting average right there. But of those drugs, only about 33% of them will make it through Phase II. And then, of those survivors, only about 30% of those will make it through Phase III. When you take it through those steps, that means that less than 10% of the drugs that enter Phase III will even find their way onto the market. So, the odds are heavily stacked against any particular compound making it through. 

Jones: That's an excellent point. Actually, BIO, the Biotech Industry Organization, the trade group, basically, they did a multiyear study -- I believe it was nine or 10 years -- where they looked at the likelihood of approval across specific indications. You mentioned 10% being the benchmark; it's even lower for some of the hottest areas in biotech right now. Thinking about neurology, which is really hot, starting to become even hotter again, you're looking at an 8.4% likelihood of approval; cardiovascular, you're looking at 6.6%; and all the way at the bottom of the barrel is one of the indications I love the most, probably has dominated most of the headlines, and that's oncology. The oncology indication, 5.1% likelihood of approval. So, you hit the nail right on the head, Brian. The odds truly are stacked against many of these companies and many of these drugs that are making their way through the pipeline.

But that's just the beginning. Even if you get a drug through all of those phases, get it onto the market, Brian, you're still looking at hurdles when it comes to commercialization. Talk to us a little bit about that.

Feroldi: There are several of them. Some people automatically assume, "If you get it through the FDA, it's nothing but smooth sailing from there." But that's the start of a whole [other] set of problems. Once you get a drug onto the market, the FDA gives it the thumbs up, you still have to get through payers. Payers have to be willing to cover the drug, to offer it to their members and be willing to pay for it. Then, you have to convince healthcare providers to actually be willing to prescribe the drug. There's an expense with educating them and getting them on board. And then, even after the fact, a lot of drugs require follow-on safety studies, that's called Phase IV. There are ongoing clinical trials to make sure that the drug is safe and effective, as it was shown in earlier trials. If a study comes up that shows that maybe it's not, maybe there's an additional risk that wasn't uncovered earlier, there's a chance that drug can come off the market.

When you compile those onto the low, low odds of just getting a drug through in the first place, you can understand why, for a drug to truly become a success in the market, it's incredibly rare. 

Jones: Yeah. The odds are definitely stacked against the average biopharma company. But let's talk about us as Average Joe investors, Brian. For people like you and me who want to play in the biotech space, but don't necessarily want to take on all of that risk by investing and chasing some of these one-hit-wonder biotech companies, what's a good way to actually jump into it that's also safe?

Feroldi: There are a couple of strategies that individual investors could take to lower their individual risk. The first and probably the easiest for them to do is to get their biotech exposure by using exchange-traded funds, more commonly known as ETFs. These are funds that individual investors can buy, and when they do so, they can gain instant access to dozens, or even hundreds of individual biotech stocks. What that does is, it spreads their money out across dozens or hundreds of holdings, basically in an instant. That greatly increases the odds that those few huge winners that will emerge in the biotech sector will be in your portfolio. 

Jones: With ETFs, you're getting a basket of securities. You can buy and sell them through your brokerage, much like an individual stock. It gives you the flexibility and also helps minimize some of the risk. Brian, you've got two ETFs, two that we actually talk about a lot on Industry Focus, especially when we're benchmarking returns for a particular company, or even just trying to gauge investor sentiment and how people are feeling about biotech. Let's start with the first one, the NASDAQ Biotech ETF, also known as the IBB.

Feroldi: This is the biggest and the most popular ETF that's focused on biotechnology on the market. It holds more than 200 companies in it. It actually has a focus on the biggest stocks in biotechnology -- Biogen, Celgene, Amgen and Gilead are the four biggest ones, and this fund has a heavy concentration in the big names. Because of that concentration, it actually comes with a dividend yield of 0.2%. Admittedly, that isn't much. But, considering you're talking about the biotechnology industry, it's actually pretty remarkable. 

Even though it has a concentration on the biggest names, this is a fund that has performed very well for investors. Over the last decade, the IBB is up 370%. For comparison, the S&P 500 is up 286%. This a single fund that has a decade-long history of outperforming.

Jones: Just to give our listeners some idea in terms of exposure, you've got, of course, the big biotechs that you mentioned -- Biogen, Celgene, Amgen and Gilead -- but you've also got exposure to pharmaceuticals. Just looking at the fund itself as of today, in terms of exposure, you've got 80% in biotech, you've got about 9% in pharmaceuticals, and looks like about 8% in the life sciences, tools, and services. So, in terms of spreading out that exposure across multiple sectors, in terms of diversification, this one is probably the most popular for that reason.

Let's turn our attention, because the other ETF that you mentioned is one that is not as widespread, but for those that are looking for more concentrated biotech exposure, this could actually be one that is a good idea to invest in. It's the SPDR S&P Biotech ETF, also known as the XBI.

Feroldi: This is a fund that I personally happen to like a lot. Like the IBB, it's spread out. This one has 120 individual holdings in it. It's very well-diversified. However, what differentiates this fund is that it takes an equal-weight approach to its indexing, as opposed to the NASDAQ Biotech ETF, which takes a market-weight. What that means is, the 120 holdings that are in this fund, the percentage of the fund that is in each individual holding is exactly the same across the board. And this rebalances itself. What that does is gives stockholders much more exposure to the small stocks. A couple of them that are in there, for example, are Portola Pharmaceuticals, Neurocrine Biosciences, bluebird bio. You have the exact same exposure to those small ones as you would to the larger ones. If you're the type of investor that's looking for a little bit more upside potential, and you want to have a bigger concentration in the small stocks, which can put up huge percentage gains if they work out, the XPI gives you a little bit more exposure to that. 

Jones: For the brand-new investor, Brian, who's thinking, "This sounds like a very compelling investment opportunity," what's the downside? What am I not getting when I invest in ETFs that I could be getting from stocks? 

Feroldi: Like anything, you do give up a little something when you invest in ETFs. With ETFs in particular, you do have an expense ratio that you have to pay that you wouldn't have to pay if you owned individual stocks. To put some numbers on that, the IBB has an expense ratio of 0.47%. The XPI is a little bit lower, at 0.35%. So, you have a small fee that you have to hold these exchange-traded funds over the course of a year. I think that's a pretty modest thing that you have to give up in exchange for the broad exposure. 

The bigger disadvantage is that diversification cuts both ways. Because you're owning so many stocks, you're guaranteed to hold a lot of companies that are probably going to lose, and they're going to lose badly. Whereas if you were picking individual stocks, and you were really good at it, you might be able to get a higher concentration of the winners. You're trading risk, in this case, for that reward. And because these funds have both done so well over the last decade, they've both outperformed the S&P 500, I think that's a trade-off that's worth making. 

Jones: Very well said, Brian! Let's talk about another safer way to invest in biotech and biopharma. That way is interesting because in an effort to curb costs and expedite R&D, many biotechs are now starting to outsource many of their clinical functions. This goes to a class of providers better-known as the contract research organizations, or CROs, as they're called. Brian, what makes CROs so attractive as investment opportunities right now? 

Feroldi: As I'm sure many biotech investors know, getting a drug through the regulatory approval process and conducting those clinical trials not only takes a long time, but it's extremely expensive. That means they're going to be spending heavily on clinical trials. The advantage of buying a CRO is that they're the ones that are directly benefiting from that spending. They're also directly benefiting from that long lead time.

CROs partner with biotech companies, pharma companies, and they handle all facets of the clinical trial process. They can literally design the trial, get in contact with clinics to actually perform the trial, they can run the tests, they can analyze the data, they can help with the regulatory submission. If a company wants to outsource that work, or even just partner to get consulting advice, CROs are a natural go-to partner for them. 

The great thing for investors is that the CRO makes money on the drug basically no matter what the outcome is. If a drug fails to live up to its expectations, the CRO still gets paid for conducting a trial. Another nice benefit is, when a drug enters Phase I, by the time it gets through Phase III, that process can take many years. If you partner with a CRO on Phase I, and you have to take it through all the way to Phase III, well, those trials have to be conducted over a course of years. You typically sign contract agreements with the CRO that last multiple years and multiple phases. If a CRO wins a compound early in its life cycle, they get a lot of revenue visibility as the drug develops. That's very attractive. 

Jones: Yeah. Interestingly enough, right now, only about 40% of clinical development is currently outsourced. Some analysts are saying this could rise above 50% over the next few years. A couple of reasons why, a couple of drivers, one is just the cost of running these expensive, massive trials. Those are going to continue to grow, especially as many biopharma companies are continuing to expand and run trials on a global basis. You've also got very complex regulations. In some cases, the FDA is starting to back off in some ways and make it less complex, but in other ways, in other areas, like gene therapies, those are going to be the more complex routes that many of these biopharmas will have to tackle. They'll need a partner like a CRO to help get them through. 

In addition, another huge driver is insurance reimbursement. We've seen and will continue to see, especially as we get through the next election cycle, continued pressure on drug pricing. You're seeing payers push back, you're seeing politicians get more involved in the mix. Maybe, maybe not, we'll actually see something happen when it comes to drug pricing. Either way, all of this amounts to continued downward pressure on margins for many of these large biopharma companies. 

Biotechs, especially the smaller ones, need the expertise, they need the cost efficiencies, and really, they need the global reach that many of the CROs offer. Brian, are there any names in particular that stand out to you in the CRO space? 

Feroldi: There's a handful of them that are publicly traded. My personal favorite is the largest one in the sector, which is called IQVIA Holdings (IQV 3.15%). This is a company with 55,000 employees. It literally services 8,000 different customers. They handle soup to nuts, from basically discovery all the way through commercialization. If a biotech needs help with anything, they can get that basically from IQVIA. So, not only do they have resources, a huge army of researchers and regulatory experts in multiple countries that they can use, but IQVIA actually owns a database that has 530 million patient records in it, and they can use that to analyze prescribing habits, that can help sales reps with doctor targeting after a drug gets approval to make the commercialization process as easy as possible. 

To give some scale, this company currently has a backlog of future projects worth $60.4 billion. These guys are absolutely enormous.

Jones: I love their focus and their push on the data end. You can see that playing out in so many different ways. You have access to clinical trial data once a drug is on the market. They also have a database that's looking at prescribing trends. I really think it equips the salesforce with better data to go after markets to drive top line for this company. Also, they're expanding globally. I know they've recently been expanding into the Asia Pacific markets. Really interesting there.

There are some other companies in this space, as well. Any others come to mind?

Feroldi: There [are] a couple of smaller ones. IQVIA is definitely the big dog in the area, but there are a handful of other CROs that take more niche focuses. Because they're smaller, they tend to be growing quicker. A couple for investors to put on their radar, one's called PRA Health Sciences. Their ticker symbol is PRAH. Then, there's Syneos Health, which is the sponsor of the show. Their ticker is SYNH. Then, there's another one called ICON plc (ICLR 2.86%). Their ticker is ICLR. All these companies have their own niches within the industry. Since they're smaller, if you want to ride the wave, perhaps they could be more interesting to look at because they could post faster growth on a percentage basis.

Jones: Yeah. That's a great point on the smaller companies. What we've seen over the past few years in the CRO space is a lot of M&A action. I think that's set to continue. If you think about it strategically, it makes a lot of sense. Obviously, together, not only can they combine and leverage a much wider network of clinical trial sites, they can also now expand their clinical trial participant pools and start to utilize the big data and the AI tools that many of them are going after. So, it wouldn't surprise me to see more M&A heading in the next few years in this space, as well. 

Let's talk about our third and final way to play it safe when it comes to biotechs, Brian, and that's with picks-and-shovels providers. Brian, what in the world is a pick and shovel?

Feroldi: That's a that's a fun investor way of saying, if you want to play a trend, one of the safer ways to do it is to buy the suppliers to that industry. Let me give you an example. There's a company called West Pharmaceutical Services. What they do is, they're a leading provider of components and systems that make drugs injectable. They provide vials, syringes, pens, stoppers, safety devices on the actual drugs themselves. If you have a thesis that the number of drugs that are available are going to grow, and the number of people using them is going to grow, that naturally leads to more demand for the injectable products, the actual things that get the drug into your body -- the vials themselves, the packaging. All of those things are actually handled by West Pharmaceutical. These guys are one of the top-tier suppliers to the industry. In fact, about the top 75 biotech injectable products on the market actually come from West. This is a company that has no risk of any particular drug not going well. They're a steady-eddy business, and they've produced fantastic returns for shareholders over the last 10 years. They're actually up about 520%. That's a return that just smashes the index. 

Jones: That's incredible returns for a company you don't hear a lot about. I did some research, this company has actually been around since the 1920s, which is very surprising to me. When you're in the position of being a biopharma company, you want that long-term expertise, that experience on the regulatory front, and even more so when it comes to the delivery components. Sometimes, getting that right -- both from a manufacturing and a compliance and regulatory perspective -- is just as important as getting the drug itself through to approval. So, this company in particular, don't see it going away anytime soon. They supply pharmaceutical companies, they supply the biotech companies, even generic medical device companies, as well. They're massive. They've got over 50 locations, 28 facilities across the globe. This is one I'm certainly going to be watching, Brian.

Let's talk about the second picks-and-shovels play on your list, a company that I pretty much consider a good Fool favorite around here. 

Feroldi: Veeva Systems (VEEV 1.02%) should be a name that sounds familiar to a lot of longtime listeners. This a company that provides cloud-based software that's specifically made for the life-sciences industry. Veeva Systems provides software that helps companies to manage their clinical trial data, manage customer relationships before and after the sale, can help with regulatory compliance. This is a company that has taken an extreme niche focus on the life-sciences industry. Because of that, because of their tailored needs, they've really made a name for themselves. In fact, today, they currently boast more than 600 customers, which includes some of the biggest names in the industry, like GlaxoSmithKline, AstraZeneca, Biogen, Lilly, Novartis, etc. All of them rely on Veeva Systems' tools to help them with the clinical trial process. 

Because of their niche focus, and because they've been able to grow so rapidly in the industry, this a company that's put up great returns for investors. They just IPO-ed in 2014, so we don't have an incredible amount of data to look at, but investors who got in at the IPO are already up 177% because this company is growing so rapidly. 

Jones: Another thing I love about the Veeva story is the CEO. He was actually a former executive from Salesforce. He recognized that for the pharmaceutical industry, they didn't have a cloud-based offering that could fit the needs of the industry itself. So, there you have it, here comes Veeva. Veeva has a number of different products. In particular, they started off with a CRM, customer relationship management, tool built for big pharma specifically. But really, the big money-maker has been Veeva Vault. That's helping companies manage all of the data that's needed to track and analyze clinical trials.

What I love about the Veeva platform is that with all these multiple products, they're all connected. As you're a biopharma company, you've got really high switching costs to come off of that one platform to go to another. I love the fact that they've got such a wide moat, here. I think Veeva in and of itself is in a league of its own, and it's even expanding beyond biopharma. It's working now with companies in the consumer goods industry, manufacturing, even the chemical industry. Huge, huge growth ahead for Veeva.

Brian, let's turn our attention to the last picks-and-shovels play, one that I had not followed as much. But after doing some digging, this one certainly piqued my interest.

Feroldi: The final company today is called Repligen (RGEN 8.76%). Its ticker is RGEN. These guys make proteins and filtration technology that enable the drugs themselves to actually be manufactured. When you're making a drug, you need active ingredients. Repligen helps drug companies to actually make the equipment and provides the proteins that go into the drugs themselves. 

These guys have literally a 95% market share in making proteins that are used to make vaccines and are used in gene therapy. They've grown right alongside with the general demand in the biotech market. In fact, this is one of the best-performing stocks over the last decade. Their stock is up 1,320% over the last 10 years. Again, because they don't care specifically about any particular drug making it through, and because they're very well-diversified among a lot of customers, they can ride the general wave of growth in biotech. 

Jones: Absolutely. When you consider that the equipment that they make is needed to purify biologics, and just how crucial that is -- if you think about it, biologics themselves are products that are made from living cells. They're very large, very complex. After they're produced, though, you have to purify the product. This is really where Repligen stands out in terms of lowering the cost. Purification in and of itself is a very cost-intensive step, and one of the riskiest, too, when it comes to biologics manufacturing.

Speaking of biologics, there are currently over 1,000 biologics being studied for development. The growth runway on this stock is tremendous. That's across the globe. Also, interestingly enough, oncology is actually the leading therapeutic area with the maximum number of biologics under development right now. A lot to watch here on this particular company, especially as biologics are expected to hit over $300 billion by next year. It's a massive market. 

All in all, Repligen is a great way for investors to ride the wave safely when it comes to biologics development, both on the development front and post-commercialization.

Brian, we've talked about a number of different ways, given a handful of stocks to play for biotech. If I had to sum up today's show, all in all, investors should know and should be aware of how to structure their portfolios when it comes to playing safely in biotech. Are there any final thoughts that you want our investors to leave today with? 

Feroldi: I would just say there's no need to over-concentrate in any given company. There's a number of steps that you can take to de-risk your portfolio. It's always very exciting to get your hands on a small biotech that promises through-the-moon growth. When you actually look back at the number of failures that are out there, the odds are stacked against you. It can make sense to take a portion of your biotech portfolio and play it a little safer.

Jones: Wise, wise words there, Brian! Thanks so much! And thank you so much for tuning in! That'll do it for this week's Industry Focus: Healthcare show. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Brian Feroldi, I'm Shannon Jones. Thanks for listening and Fool on!