Peter Lynch once said, "Never invest in any idea you can't illustrate with a crayon." Can investors still follow that classic advice in the highly scientific biopharma sector? Find out in this special edition of Industry Focus: Healthcare, with Motley Fool healthcare analysts Kristine Harjes and Max Macaluso.

A full transcript follows the video.

This podcast was recorded on March 10, 2016, and released on May 18, 2016. 

Kristine Harjes: Doing our best to illustrate biotech with a crayon, on this healthcare episode of Industry Focus.

Hi, everyone! Welcome to Industry Focus: Healthcare. I'm your host, Kristine Harjes, and I have special guest Max Macaluso on Skype from our Denver, Colo., office. Welcome to the show, Max!

Max Macaluso: Thanks, Kristine.

Harjes: So, Max wears many hats here at the Fool, but he was trained as a scientist. So we wanted to do a deeper dive, but also kind of a 10,000-feet look at a lot of the science behind some of these different drug classes that we hear about. Peter Lynch, famous investor, says, "Never invest in any idea you can't illustrate with a crayon." So, at the risk of getting too weeds-y, we wanted to take some of our concepts that we talk about in the drug-developing world and see if we can make them a little bit more draw-with-a-crayon-able.

So, first off, I wanted to ask you, Max, is your approach, due to your science background, different when you're looking at biotech or pharma stocks? Or do you think it's the same sort of financials, nitty-gritty as somebody without a scientific background?

Macaluso: Well, it's a good question. The first thing I need to be cautious of, typically, is not to be drawn in by the scientific story. In order to avoid that, I've developed a very simple framework that I'm sure people have heard me talk about before. I just refer to it as the 3 Ps. That also helps you distinguish between some of the big pharmas and the smaller biotechs. The 3 Ps stand for portfolio, patents, and pipeline. So we can look at each one in a little bit more detail. 

The portfolio, Kristine, as you know, is just the drugs that a company currently has on the market. As an investor, it'll help you identify what the sales drivers are. It'll also let you know whether or not they have any products on the market. A lot of smaller biotechs are still pre-commercial stage, and the valuation is driven by what's in the pipeline, which we'll get to in a little bit. So the portfolio is the first P. 

The second P is patents. So that answers the question, "How long will the company have patent protection on the drugs in its portfolio?" We know that once drugs go off-patent, generic competition enters the market. And typically, those drugs lose about 90% of their sales, which can be devastating if a company doesn't have another drug coming up through to replace that dropped revenue.

And that brings us to the third part -- the last P is pipeline. So, when drugs come off patent, looking a few years ahead, does the company have anything in its pipeline that has a good chance of FDA approval that is potentially in a big market that can close that gap?

So, typically, three Ps -- portfolio, patents, and pipeline -- is where I start. That gives you a clue as to whether this is a big pharma which already has drugs on the market, or a small biotech that's still pre-commercial stage. And then, after I look at those, just to get my feet wet when I'm looking at a new stock, then I dig into the financials.

Harjes: OK, so, in looking at, particularly portfolio and pipeline -- maybe not as much patent -- it seems like it would be really helpful to understand some of the science of what's going on. As you mentioned, you don't want to be fooled by a good scientific story, and of course, this is "fool" with the lowercase "f" here. But it's still very helpful to know exactly what makes a certain class of drugs competitive, or maybe vulnerable to risks of a new and maybe even better class coming up. So, with that, we want to focus today on just a couple of types of drugs and getting a better understanding of how they work.

The first class that we wanted to talk about, I don't know if we've ever actually mentioned these by names on the show, but we've talked about examples of them in abundance, and these are GPCRs. Max, can you take over from here? What exactly are these?

Macaluso: Sure. GPCR stands for G-protein-coupled receptor. They're also called serpentine receptors. It's kind of a neat name, only because they're composed of seven helices that kind of line up and down in the cell membrane.

Harjes: So, like a snake?

Macaluso: Like a snake, exactly.

Harjes: Nice.

Macaluso: I mean, they don't really look like that [laughs], but all of the images that are based on the crystal structures kind of look like that, hence the name.

Harjes: So if you have your crayon box out, start drawing a snake.

Macaluso: Exactly. But they're used for signalling. Essentially, something will bind to the outside of that receptor, outside of the cell, and that causes a reaction within the cell. So it's kind of like a telegram. Someone knocks on the door, hands a telegram to the person, the person delivers the message. So they're not actually entering through the door. They just relay a message. That's called the signal cascade

GPCRs are very prevalent throughout the body. They modulate a lot of different biological processes. So, Kristine, for instance, did you have a cup of coffee this morning?

Harjes: I did not -- I'm trying to wean myself off of it. But I know plenty of people who did.

Macaluso: [laughs] I certainly did, and I like a little bit of sugar in my coffee, so the sensation of both bitter and sweet tastes are modulated by GPCRs, as well as other senses like sight and smell. There are also cardiovascular functions, and even certain types of mood, like happiness, are modulated by GPCRs, like serotonin receptors. So they're very prevalent for a variety of biological processes.

Harjes: So how exactly are they important to the drug industry?

Macaluso: Well, and it might be surprising, but around 30% of prescription drugs currently on the market target a GPCR. So they've been around for a long time, and it's still a very hot area of research. One example is Heptares. This is a GPCR specialist who was recently acquired for around $400 million. There are a number of companies working in this area. And also, just to put this in context, the first crystal structure of a human GPCR won the Nobel Prize in 2012. And that paper was published in 2007. So, often, with Nobel Prizes, it could take a couple decades, three or four decades, to be recognized for work. In this case, it was only five years.

So GPCRs are incredibly important to the drug industry. They'll continue to be. And there are a lot of prominent examples of drugs that target this class of proteins. Zyprexa from Eli Lilly, that treats schizophrenia, is an example. You've probably heard of Clarinex as well; that's a popular antihistamine made by Merck, and Zantac, made by Boehringer Ingelheim. Those are three prominent examples.

Harjes: Yeah. To add to that list, because there really are a ton of them, we've got Advair Diskus from GlaxoSmithKline, Abilify, Oxycontin. There are really a ton of these. Do you want to maybe pick one in particular, a company working in the space, and go a little bit deeper?

Macaluso: Sure. Well, I think a lot of listeners are familiar with Arena Pharmaceuticals (NASDAQ:ARNA). It's very active in this field. It has one FDA-approved drug for the treatment of obesity that's called Belviq. Kristine, I don't know if you've talked about it on the show before.

Harjes: I would be surprised if we haven't. The obesity-drug makers have definitely garnered a lot of interest, particularly in the early goings of these drugs. Really, really huge promise. Obesity is something that a lot of people are struggling with, so, you look at that market, and you say, "Oh, man, if somebody could create a good drug to minimize obesity, that should be huge." But ...

Macaluso: Exactly, it should be. If you look at the performance of Arena over the last year, shares have dropped around 65%; over the last 10 years they've dropped around 90%. And a lot of that decline has been driven by the hype around obesity medications, and, unfortunately, the poor sales that have followed the launch. So, like you said, a lot of companies were competing for a piece of this market.

They all found that demand for the drug for this indication just was not as robust as they previously thought. Now, what's interesting about Arena is, even though sales of Belviq have been very slow to ramp up, at the J.P. Morgan conference, they mentioned that they're going to try to de-emphasize its obesity drug and instead focus on its pipeline, which is full of drugs that target GPCRs. I think it's a good move. I think there's a lot of interesting drugs in development there. One targets the S1P1 receptor, GPCR, so that's in that drug class as well. This is a very competitive market. There are drugs from Celgene and Actelion that Arena would have to potentially compete with if it gets FDA approval. But it's also a big market in the autoimmune space.

Arena also has a partnership with Boehringer Ingelheim on CNS drugs that could lead to more than $240 million in milestone payments. But, you know, look at Arena's cash burn. It's around $100 million last year. It does have $150 million in cash, so there's not an immediate cash crunch coming. But as an investor, I would say wait until you see some of the readouts from its phase 2 trials. Don't focus too much on the phase 1 trials in this pipeline; it's still way too early to attribute any value to those. So, you know, I would say, wait for readouts from the phase 2 trials before revisiting it. And, at the same time, there are other companies that we'll talk about later in the show that have even deeper pipelines than Arena.

Harjes: Yeah. I think the concept of "let's wait and see" is pretty directly relevant to the next class of drugs that we wanted to talk about, which is RNAi.

Macaluso: Yeah. RNAi is another incredibly interesting class. It refers to RNA interference. So, to put it all in context, there's a cascade of information that goes from DNA to RNA to the creation of proteins. So RNA helps make proteins like GPCRs and little peptides that bind to GPCRs in the body. And we just talked about how many drugs target GPCRs. So, what RNA interference does is, it moves the process further upstream. Instead of tackling the disease by targeting the protein, you move one step up and interfere with the creation of that protein by attacking messenger RNA that would translate the genetic code into a protein. So it's referred to as gene silencing. And Kristine, it's very complex. It also won a Nobel Prize in 2006, to put that into context, too.

The best analogy I have is very, very crude -- it's a leaky faucet. So the example here is, let's say your sink is broken; the pipe is bursting. One solution is to put a bucket under the sink, and you're going to have to wait for it to fill up, you'll have to dump it out, put it back under the sink. So that's one way you can solve that problem. Or you can turn off the faucet. So in the case of RNA interference, the analogy I like to use is that you turn off the faucet, you go a step further up in the processes and try to solve the disease there.

Harjes: Well, if the analogy holds true, that seems like a much better solution. Are there drugs out there now doing this?

Macaluso: Not yet. Alnylam (NASDAQ:ALNY) is the most prominent example of a company working in this space. It's a leader in this area of research. It has a $5 billion market cap. It's a very exciting biotech to watch, but it doesn't currently have any drugs on the market. It has two programs in phase 3 development; the rest of its assets are in phase 2 or earlier. But it does have a very deep pipeline of therapeutics that could have huge market potential. I think, for investors, the focus at this stage is less about the market opportunity, and more about whether or not they can get a drug approved by the FDA in this drug class. If it's able to do that, it can basically just create a brand-new type of therapeutic that we just haven't seen before.

Harjes: Yeah, and unfortunately, you're going to have to just sit tight on that -- the company's not expected to file its first application until 2017. So we're looking at maybe seeing approval in 2018. The company itself is not expected to be profitable until at least 2020. So definitely a bit of a waiting game right now. But I think you're totally right that if we were to see even a single approval, it would go a long way to validating this entire class of drugs, and the rest of the company's pipeline. What I'm reminded of is Ionis (NASDAQ:IONS). I believe they have a pretty similar drug platform. I guess it's not exactly the same, since there aren't any RNAi drugs out there. But how is what Ionis is doing different?

Macaluso: So Ionis focuses on antisense technology. Just like RNAi, it focuses on silencing genes by targeting messenger RNA. But they do it through different pathways. And to be honest, Kristine, even with a crayon, I don't think I would be able to illustrate the difference between those two; they're both very complex. Now, the difference that investors should focus on here is Ionis has a huge platform of antisense drugs that are going through clinical development right now, and it has an FDA-approved drug already on the market -- that's Kynamro. It treats a very rare disease that results in dangerously high cholesterol levels. And it's the first antisense drug to reach the market. So that bodes very well for validating the company's platform. Do you have a guess on how many drugs Ionis has in its pipeline? I'm guessing you may already ballpark know, based on your previous discussions.

Harjes: Geez, it's a ton. I'm going to guess 60?

Macaluso: Oh, almost! Well, not quite. [laughs]

Harjes: [laughs]

Macaluso: It's 38, but close to 40 drugs in a pipeline, for a company this size, is incredible. It also has a number of partnerships with big pharma companies like AstraZeneca, Bayer, GlaxoSmithKline, Biogen. They have a hefty cash pile on its balance sheet, around $800 million in cash and short-term investments. So, again, investors are going to have to be incredibly patient with Ionis. The development of drugs of this complexity takes a lot of time, but management is very solid. If you haven't heard of Stanley Crooke, incredible CEO, very interesting story, very passionate about the company and the technology they're developing. So this is definitely one to watch.

Harjes: And, for listeners who have heard us talk about them previously, this is company that used to be known as Isis Pharmaceuticals, changed their name to Ionis. So, Max, last question I have for you: If you had to put money behind one company that we've talked about today, which would it be?

Macaluso: That's a great question. I'm not a shareholder of any of the companies we spoke about today, but I am thinking about buying shares in Alnylam. It's the stock I've done the most amount of research on, and in my mind, it has the most exciting platform. RNAi, like I said, is very complex. But, you know, the reward comes with a great deal of risk as well. Like we talked about, they have yet to get the drug approved by the FDA. If that happens, I'll feel more comfortable investing in it, only because it will validate the platform. But if I were to put an investment behind one of these stocks, it would probably be Alnylam.

Harjes: Sounds like a good choice. As always, people on the program may have interests 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. Max, thank you so much for joining me today. This was fun.

Macaluso: Thanks to you, Kristine.

Harjes: Folks listening, let us know what you thought of today's episode, or feel free to send us pictures of snakes and leaky faucets, or your own portfolio illustrated by crayon. Our email address is industryfocus@fool.com, and you can also reach us on Twitter, @MFIndustryFocus.

Kristine Harjes has no position in any stocks mentioned. Max Macaluso, Ph.D. owns shares of Celgene and Merck, Inc.. The Motley Fool owns shares of and recommends Alnylam Pharmaceuticals, Celgene, and Ionis Pharmaceuticals. The Motley Fool recommends Biogen. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.