As the biotech analyst for Motley Fool Rule Breakers, it is my task to find the best investments in the drug industry. It's an exciting time to be investing in biotech companies because decades of research and investment are paying off in the successful development of superb new drugs, such as Tysabri from Biogen Idec (NASDAQ:BIIB) and Elan (NYSE:ELN).
Despite the ongoing medical breakthroughs, many investors have reservations about investing in biotech companies. Two of the biggest reasons people stay away are that they do not understand the technology or think the companies are too risky. Both of these arguments certainly have merit, though I don't think they should preclude investing in drug companies. So today, I am going to focus on the risk component of investing in the drug industry.
I bet many people would describe investing in biotech as a crapshoot -- you put your money into a company that will sink or swim on the fate of a single drug. If the drug doesn't pan out, you lose big. But if it hits, your returns are phenomenal. A lot of people just aren't interested in playing the feast-or-famine game.
I understand. But I also want to say this: You don't have to. There are other ways to invest in the drug sector than to put your money in companies that have high-risk drug development pipelines.
Specialty Pharma
One of the more conservative approaches is to look at specialty pharmaceutical companies. These are drug companies that generally develop and market drugs to small "specialty" markets. In some cases, these markets exist simply because they are too small for the large pharmaceutical companies, such as Pfizer (NYSE:PFE) or Merck (NYSE:MRK), to have an interest. A good example of a specialty pharma that has gone after niche markets is Salix Pharmaceuticals (NASDAQ:SLXP). Salix has a portfolio of products for gastrointestinal disorders, which it markets successfully. The approach has worked so well that the company's stock is up 250% over the past two years. That's a heck of a nice return for investors who saw the value the company was creating.
Drug Delivery
Another business model that specialty pharmas use is to improve the delivery of existing drugs marketed by the major pharmaceutical companies. The specialty pharmas working in this area are called "drug delivery" companies, and there are quite a few of them to look at. To give an example, one method of improving drug delivery is to start with a drug that has to be taken two or three times a day and formulate it to be taken once a day. This creates a more patient-friendly product that has a clear competitive advantage.
When drug delivery companies hit the mark, they can be solid performers for investors. One tiny gem of a drug delivery company that I'm happy I came across was Atrix Laboratories. Atrix had a broad platform technology and a drug for prostate cancer, Eligard, that has clear competitive advantages over the competition. On the strength of this product, Atrix reached profitability and was doing so well that it was purchased last month by Canadian biotech company QLT (NASDAQ:QLTI) for $855 million. Atrix shareholders who purchased the company's stock by late 2002 saw a 100% return on their investment in just two years because of this merger.
Stick With What Works
The reassuring thing about companies working on drug delivery is that we already know the drug works. This is because the specialty pharmas using this business model are often applying proprietary drug delivery technologies to existing drugs that have gone off patent. Though generic drugs are also branded drugs that have gone off patent, the versions made by specialty pharma can be superior to the generics because of the improvements to the delivery.
The bottom line with the drug delivery companies is that the active molecule has a long history of use by physicians who know the product well. When I say that specialty pharmas are low-risk, it is because on the R&D side of the business, using drugs that are already established is a lot more likely to succeed than developing new drugs.
Specialty pharmas can also be a lower-risk investment than many small biotechs because many of them are already profitable. Along with Salix, companies such as Axcan Pharma (NASDAQ:AXCA) and Connetics (NASDAQ:CNCT) are operating in the black. If you invest only in companies that have positive earnings, these are the drug companies for you.
Competitive Risk
R&D programs with low technical risk and growing profits offer an attractive combination that could make specialty pharma appealing to investors who might otherwise shy from small drug companies. Despite these benefits, I need to mention that specialty pharmas do not come without risk. These companies face competitive challenges that need to be taken into consideration.
A specialty pharma, especially a drug delivery company, has to be able to differentiate its product from both generic and branded competition. Proving that the product has a competitive edge will be required both to attain market share and retain pricing power in a market that has generic competition.
Investors interested in specialty pharma should look for companies that have a broad platform technology that provides a true competitive advantage and that can be applied to a whole portfolio of products. This decreases the reliance upon a single product and increases the future growth potential of the company.
I also recommend looking for a seasoned management team. Competing against both generic and branded products is not easy. As an investor, you want the person steering the ship to have prior experience successfully marketing drugs in competitive fields.
If you think that small biotechs are too risky and that large pharma isn't growing fast enough, specialty pharmaceutical companies could be the right fit for your portfolio. In next week's commentary, I will highlight a handful of promising companies in this segment that I think are worth taking a look at. Though specialty pharmas are not developing cutting-edge, novel drugs, that does not mean they are automatically excluded from Motley Fool Rule Breakers. Like Salix and Atrix above, these companies can be fast growers that deliver tremendous returns to investors. That makes me very interested in this segment of the drug industry.
For additional articles on the drug industry, see:
- Genetics of a Rule Breaker
- Spin the Medicine Bottle
- Picking Biotech's Winners
- Don't Be Afraid of Biotech
Motley Fool Rule Breakers biotech analyst Charly Travers owns shares of QLT. The Motley Fool is investors writing for investors.
