On the surface, it seems crazy: Eliminate a portion of the patient population as potential customers for a drug.

But scratch just below the surface, and you'll see that drug makers are crazy like a fox. By targeting a smaller patient population made up of people more likely to benefit from a given drug, drugmakers can both increase the likelihood of getting a drug onto the market, and sell it for a higher price.

Individuals aren't averages
When companies report clinical trial data, we typically get the average response for the entire patient group. However, within that group there's usually a wide range of responses, from "did really well" to "sort of did better." If the drug is the only one available, then that range doesn't really matter -- after all, for those at the low end of responses, some response is better than no response.

But as the number of drugs that can treat a given disease begins to grow, it becomes increasingly difficult to beat what's out there. In other words, how can the new drugs differentiate themselves? One way to do this is to just target a subset of those with the disease. Then the drugmaker might be able to show efficacy that's good enough to get the drug on the market.

Building a better mousetrap
This is already being done to some extent. Perhaps the most famous of all targeted therapeutics is Genentech's (NYSE:DNA) Herceptin, which inhibits the HER2 receptor. Unfortunately, there are some breast cancers that don't have high levels of the HER2 protein, and consequently don't respond to the drug. By testing for HER2 overexpression before administering treatment, doctors can limit the patient population to just those who will respond to the drug.

Here's another example: Rule Breakers pick Exelixis (NASDAQ:EXEL) is testing its oncology compound, XL647, in women or Asians or non-smokers who have lung cancer. Seems like an odd combination, but XL647 is an inhibitor of the EGF receptor (a protein that helps the tumor grow), and sensitivity to EGF receptor inhibitors has been linked to mutations found in those classes of patients. By limiting the population, Exelixis is increasing the chances for the drug to work well enough to compete against drugs like Genentech's Avastin or ImClone Systems' (NASDAQ:IMCL) and Bristol-Myers Squibb's (NYSE:BMY) Erbitux, if the latter is approved to treat lung cancer.

Bystander growth
It's not just drug companies that will benefit from targeted medicine. Diagnostic test makers will, too, because patients will need to be tested to determine whether the drug is right for them. Insurance companies should be willing to shell out for the test because the testing could save big bucks by avoiding payment for drugs that don't work.

For instance, Invitrogen (NASDAQ:IVGN) has a new test that's able to detect HER2 expression in order to tell whether Herceptin will be effective in fighting the cancer.

These tests don't just check to see if a drug works, they can also test to see if a drug is likely to cause adverse reactions. For instance, Myriad Genetics (NASDAQ:MYGN) has a test to determine whether patients will have an adverse reaction to the chemotherapy treatment 5-FU/capecitabine. Another example in this class is patients' sensitivities to blood thinner warfarin, for which the FDA now recommends testing.

Targeting better returns
How can investors get in on the new era of targeted or personalized medicine? Keep a keen eye out for drugs in pipelines that target smaller groups of patients. That may look odd, but the drugs are likely to do better than me-too drugs that target larger groups, while not working any better than what's currently available.

Complementing that with a well-selected group of diagnostic test makers could result in some seriously high returns.

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Fool contributor Brian Orelli, Ph.D., doesn't own shares of any company mentioned in this article. The Motley Fool owns shares of Exelixis. The Fool's disclosure policy is one-size-fits-all.