The emerging coronavirus pandemic highlights the world's dependence on pharmaceutical and biotech companies to produce drugs and vaccines to help overcome all types of illness. This outbreak may bring new appreciation for the industry. Here we explore four reasons that investors should consider drug stocks currently in the spotlight. 

Capsule opened with gold dollar signs spilling out.

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1. Diseases ignore the economy

In good times and bad, people fall ill or get injured and require medication. Individuals with chronic diseases like diabetes or rare genetic disorders such as Gaucher disease require ongoing therapy. Big pharmaceutical companies, smaller specialty pharma, and biotech companies will continue to deliver medicines to the extent that's possible.

In the current environment of social distancing and avoiding unnecessary exposure, we could witness a shift in the delivery of treatment. This includes virtual doctor visits or telemedicine. In disease areas with multiple treatment options, patients may transition to oral medicines (traditional pills and capsules) that can be taken at home rather than going to a clinic to receive an infusion or shot. These kinds of decisions will be made on a patient-by-patient basis. From an investment perspective, it could mark an uptick in self-administered treatment.

2. Beaten-down valuations

Healthcare did not evade the current market downturn. The stocks of big pharmaceutical companies like AbbVie (ABBV 1.26%), Bristol Myers Squibb (BMY -0.18%), Novartis (NVS -0.12%), and Pfizer (PFE -0.97%) are down 20% to 30% from peak prices in the past year. These global pharmas range in value from $100 billion to $200 billion even with the current haircut in price.

Biotech companies were not immune to the recent market sell-off. The iShares Nasdaq Biotechnology ETF (IBB -0.44%), the largest biotech ETF by assets, skews toward larger companies. In fact, its top ten holdings, including Gilead Sciences (GILD -0.21%), Vertex Pharmaceuticals (VRTX 1.04%), Amgen (AMGN -0.71%), and Biogen (BIIB 0.23%), make up 53% of the portfolio. The IBB was down over 20% but has since climbed back to post only a 12% loss so far this year.

The SPDR S&P Biotech ETF (XBI -1.52%) comprises a larger cross-section of smaller drug developers than the IBB. The index fell more than 30% this year. Like the IBB, it has recaptured some of its losses in the second half of March. It is down approximately 20% year to date.

3. Financial stability

Big pharma companies sell boatloads of drugs and spend small fortunes on research and development (R&D). While sales may be impacted by COVID-19, the expense side is affected as well. Most big pharmas halted any new clinical trials and paused most that were ongoing. This will lower R&D expenses in the near term.

Six of the largest big pharma companies spent over $31 billion in 2019 to repurchase stock. Since buyback programs are discretionary and can be stopped or started at any time, the money can be diverted to fund operations through a business slowdown.

Along with paying dividends, buybacks of company stock represent a way to return value to stockholders. I would expect the companies to protect their dividend first. Then, as business begins to regain traction, the stock repurchases can restart again.

4. Binary bets drive performance

R&D-stage drug development companies enjoy what I'll call the luxury of unprofitability. By this, I mean that investors in these companies want to see advancements in the R&D pipeline. New scientific data, clinical trial results, and updates from regulators, like the Food and Drug Administration (FDA), can cause the stocks of these companies to spike or drop. Valuation is based on the potential of the drugs in development. This event-driven reality is in contrast to commercial entities that need to manage quarter-to-quarter and year-to-year revenue and profit expectations.

Drug developers burning through capital on the hopes of future success saw stock prices take a hit. Smaller companies often took a greater beating than their larger counterparts. Why? One big consideration is cash.

In contrast to big pharma and large biotechs with substantial cash war chests to ride out the downturn, smaller companies, with less cash on hand, become riskier in this environment. In some cases, stocks traded down to cash value or even below. This effectively wipes out any value for such companies' R&D pipeline.

While many drugs will fail, some will succeed. Drug developers can deliver huge home runs to investors if binary events are positive. Just look at the 2019 performance of Axsome Therapeutics, Kodiak Sciences, or ArQule as examples. Patient, bargain-hunting healthcare investors can find cheap stocks among smaller R&D-stage companies.

The world is looking to drug developers as the cavalry riding in to win the war against COVID-19. More people may seek to invest in these promising companies and realize the value they provide to both shareholders and society at large. In the meantime, focus on cash-rich companies that can fund operations until the world returns to "normal" and the economy starts chugging forward again.