What sets the best biotech stocks apart from the rest? There are several good answers to that question. Strong research and development comes to mind, for example. So does smart financial management, particularly during the clinical development stage.
Ultimately, though, the key to success in biotech is the same basic key that exists in other industries. I can't think of any competitive advantage more important than one emphasized by Warren Buffett: an economic moat. Buffett once stated that he looks for "economic castles protected by unbreachable moats". In other words, he likes companies with products that don't face tough competition. So how do biotechs build these moats?
Several years ago, the term "blue ocean" became popular in business circles thanks to the best-selling book Blue Ocean Strategy. "Blue ocean" referred to new markets in which there were no competitors. Few industries have as many obvious blue oceans as biotech, primarily because of the opportunities to develop drugs for orphan diseases -- rare conditions that affect relatively few people and usually have few (if any) effective treatments.
Alexion Pharmaceuticals (NASDAQ:ALXN) stands out as an example of a biotech that focused on treating an orphan disease to create a wide moat. The company's drug Soliris received approval from the FDA and European Medicines Agency in 2007 as a treatment for paroxysmal nocturnal hemoglobinuria, or PNH. PNH is a rare blood disease that affects only one to two people in a million.
In 2011, Alexion won regulatory approval for Soliris to treat another orphan disease -- atypical hemolytic uremic syndrome, or aHUS. Although not as rare as PNH, aHUS affects around one in 500,000 Americans each year.
Because of the lack of competition, Soliris was able to command a premium price. Despite low numbers of patients using the drug, Alexion raked in revenue and profits. This made the biotech's stock one of the best in recent years. Alexion's shares have skyrocketed roughly 1,650% since 2007.
While several biotechs have pursued the orphan disease route, others have built moats by developing drugs that address relatively prevalent diseases more effectively than rivals. Gilead Sciences (NASDAQ:GILD) could serve as the poster child for this "build-a-better-mousetrap" approach.
Gilead bought a company called Pharmasset back in 2011 for $11 billion. At the time, some observers scoffed at the big biotech paying such a hefty price. But Gilead and its shareholders had the last laugh. That acquisition landed Gilead the hepatitis C program that Pharmasset had developed, which ultimately spawned blockbuster drugs Sovaldi and Harvoni.
Other treatments for hepatitis C were already on the market, but none achieved the near-100% cure rates that Sovaldi and Harvoni offer. Other biotechs raced to get to market first with similar drugs, but Gilead beat them to the punch.
Even when rival hepatitis C treatment Viekira Pak scored a big win by securing an exclusive formulary position with the nation's top pharmacy benefits manager, Gilead managed to quickly respond with its own exclusivity deals. It definitely helped that Sovaldi and Harvoni are taken just once per day, improving the likelihood of adherence to the medication regime.
Gilead built the better mousetrap -- and it paid off. Sovaldi and Harvoni combined for more than $12 billion in revenue last year, and Gilead's shares have more than tripled in value since the beginning of 2013.
While Warren Buffett says that he likes companies with moats that are unbreachable, I suspect that he knows any moat can be breached given enough time. At some point, a treatment for PNH and aHUS could emerge that's more effective than Soliris (or even nearly as effective but less expensive). Sovaldi, Harvoni, and their rivals could cure enough patients that revenues plummet, or an even better treatment could come out and render these obsolete.
That's why the best approach for investors looking for biotechs with moats is to jump aboard when a moat is still filling up with water. Find companies that are in good shape to win regulatory approval soon for a drug treating a rare disease with no effective treatments. Or find companies with drugs that should dramatically improve the level of treatment for a disease that affects a relatively larger number of patients.
BioMarin is one potential candidate for the "blue ocean" moat strategy. The biotech has several drugs targeting orphan diseases in mid-stage and late-stage clinical trials. Meanwhile, Celldex Therapeutics is a possible pick for the "better mousetrap" approach. The company's Rintega could soon provide improved treatment for brain cancer.
The good news for investors is that there are plenty of other potential biotech winners like Biomarin and Celldex working hard to dig their moats. And there are still biotechs like Alexion and Gilead with castles that should stay safe for a while.