According to GlaxoSmithKline (NYSE: GSK) CEO Andrew Witty, the pharmaceutical industry is a mess. That's the basic gist of his opinion piece in The Economist.

You can read the whole thing here, but Witty basically thinks there are multiple problems that have contributed to the degradation of the industry:

  • The patent cliff causing a loss of more than $200 billion in revenue in just a four-year period.
  • A decline in research and development productivity so that revenue from new drugs isn't replacing the lost revenue from patent expirations.
  • Pricing pressure from governments -- health-care reform -- and private insurance.
  • Increasingly safety-conscious regulatory agencies like the Food and Drug Administration making it harder to get drugs onto the market.

None of this is news to anyone who has watched the pharmaceutical industry over the last few years.

It's the solutions that Witty proposes that should pique investors' interest, as they give ideas of where to invest and how to evaluate whether pharmaceutical companies are headed for a turnaround.

Increased innovation
Coming up with novel drugs is easier said than done, but Witty thinks pharmaceutical companies need to get back to the basics. Rather than relying on brute-force screening techniques to plow through thousands of compounds, it makes more sense for companies to hire the brightest minds to design new drugs. As Witty puts it, drug development is often more art than science.

I think researchers will have an advantage over the next few years as we'll likely see huge payoffs from the human genome project. Knowing what genes do in the cells is the first step in figuring out which ones to use as targets. It's taken much longer than we would have expected, but the fruits of the basic research will pay off in the long run.

Streamlined development
That's code for killing off losers earlier in development. Like investors that can't bear to part with a losing stock for fear that it might rebound, drug companies often refuse to stop development of drugs despite their low likelihood of success.

Rather than take anything and everything further into clinical development, Witty suggests that pharmaceutical companies should pick and choose their battles.

The development process could also be streamlined if the FDA were clearer about exactly what it expects of drugmakers. For example, the agency refused to accept the application for Roche's and ImmunoGen's (Nasdaq: IMGN) trastuzumab-DM1, and Eli Lilly (NYSE: LLY) and Amylin Pharmaceuticals (Nasdaq: AMLN) were shocked by a second rejection for their diabetes drug Bydureon in October after the FDA came up with new requirements not mentioned in the first rejection of the drug.

The obvious way to increase innovation and streamline development is through partnerships.

Pharmaceutical companies can benefit from letting smaller drug developers discover the drugs and then partnering with them to bring the drugs to market. Recently, partnerships have often allowed pharmaceutical companies to keep much of the risk on the small drug developer. Arena Pharmaceuticals (Nasdaq: ARNA) and Orexigen Therapeutics, for instance, got $50 million each up front in their deals with Eisai and Takeda, respectively, but the majority of the payments aren't triggered unless the drugs hit sales milestones.

Larger pharmaceutical companies can also join forces. Glaxo and Pfizer (NYSE: PFE) combined their HIV drugs to create a joint venture called ViiV Healthcare. sanofi-aventis and Merck (NYSE: MRK) have rejoined forces in an animal health venture called Merial-Intervet. Drug development might have a little to do with the partnerships, but a streamlined sales force is likely a bigger factor when large drugmakers pair up.

Where to invest
Small drug developers offer the greatest potential rewards, albeit with substantial risk. Pharma's appetite for drug candidates isn't going to go down anytime soon, so there's plenty of potential to the upside for drugs that work.

But investors shouldn't forget Witty's third point above; payers are still ultimately in control of the revenue stream. Novel drugs that truly benefit patients will be able to command premium pricing, but me-too drugs that don't offer much innovation are going to have a hard time competing against the numerous generics available for many diseases.

Look for biotechs with those types of innovative drugs and pharmaceutical companies interested in partnering to bring them into the fold, and you'll likely do well.

"Companies have two choices: innovate or die," says Sean Williams.

Pfizer is a Motley Fool Inside Value recommendation. ImmunoGen is a Motley Fool Rule Breakers choice. The Fool owns shares of and has written covered calls on GlaxoSmithKline, which is a Motley Fool Global Gains recommendation. 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.

Fool contributor Brian Orelli, Ph.D., doesn't own shares of any company mentioned in this article. The Fool has a disclosure policy.