Biotechnology Stocks

One of the most fascinating but potentially risky sectors to invest in is the biotech sector. This sector includes companies involved in the research and development of therapeutics and vaccines to relieve a wide range of conditions and diseases.

The Covid-19 pandemic brought on by the novel coronavirus in 2020 put the sector squarely in focus. However, due to the unprecedented assistance from the U.S. government through Operation Warp Speed (OWS), the growth in some biotech stocks was also an anomaly.

Seasoned investors in the biotech industry understand that products go through a lengthy, rigorous, and expensive testing process. However even when (and if) a drug makes it through that process, it still has to be approved by the U.S. Food & Drug Administration (FDA) before going to market.

And a harsh reality of the biotech sector is that many products will never make it to market, which adds a level of risk to any biotech investment. The good news is there are ways to help minimize the risk by understanding what qualities to look for in biotech stocks.

In this article, we’ll describe what a biotech company is and how it’s different from (and in some cases similar to) a pharmaceutical company. We’ll also share a few practical tips that can help you in performing your due diligence on biotech companies.

What Are Biotech Companies?

Biotech companies are involved in developing therapeutics and drugs for chronic and/or life-threatening conditions. Many of the companies in this sector are small-cap companies (i.e. stocks with a market cap of less than $2 billion). Some are also penny stocks (meaning they have a stock price of under $5).

However, the opportunity to buy low and sell high is part of the attraction with biotech stocks. If these companies successfully bring a product to market, their stock price could double or more virtually overnight.

On the other hand, perhaps no other sector comes with so much risk. The reality is that many of the products that these companies develop never make it out of clinical trials, or get approved by the FDA. And that means that investors can also lose the majority of their investment.

How a Biotech Company Is Different From a Pharmaceutical Company?

The biotech and pharmaceutical sectors are related but more like cousins than siblings. One key point that distinguishes the two sectors is that investing in pharmaceutical companies is more about what is while biotech stocks are about what could be. And that changes the risk profile for both.

A pharmaceutical company has revenue coming in from products that are commercially available and has other products in development. Because they typically have one or more revenue streams, pharmaceutical companies are generally profitable. In some cases, these companies also offer investors a dividend, which can be a significant part of an investor’s total return.

By contrast, a biotech company is primarily research-driven. The company is using science to develop a potential therapy or vaccine. However, many of these companies are small-cap stocks that do not have a commercially used product. This means that in addition to not being profitable they are generating little to no revenue. And the small fraction of biotech companies that are profitable rarely pay a dividend.

Another distinction between the two companies is that pharmaceutical companies spend a great deal of money in marketing and sales. On the other hand, biotech companies see their strength as being in research and development (R&D). This focus on R&D may cause biotech companies to raise capital which can dilute their share price even further.

Where the two sectors overlap is that pharmaceutical companies are increasingly pulling back from research and are looking to partner with biotech firms for innovation. This helps create an opportunity for investors who know what to look for in a biotech stock.

Qualities to Look For in a Biotech Stock

There’s no sure-fire way to take the risk out of biotech stocks. However, there are certain things you can look for to help manage your risk.

1. Look for a “hot” area of biotech. This means looking for a company that is doing research for a disease or condition that affects a large segment of the population. Should the company be successful, there are two obvious reasons why investors will be rewarded.
   
   First, there will be a high demand for the company’s products. Second, the companies would be able to get a faster return on their significant R&D and licensing efforts. Another reason to look for a hot area of research is because it can lead to breakthrough “orphan” drugs and treatments that – if they are first to market - are typically protected from competition for many years.
   
   An extreme example of this occurred during the Covid-19 pandemic as companies that were developing vaccine candidates saw their stock prices soar on the expectation that one or more vaccines would be fast-tracked through the FDA.
   
   However, investors see the same speculative activity occur with biotech firms that are researching treatments for areas such as cancer, AIDS, heart disease and neurological conditions. When drugs and therapeutics successfully move through clinical trials it creates higher demand for the company’s stock.
   
   
   
2. Look at companies that are collaborating with others. Many biotech companies are small-cap companies. This can help them maintain a singular focus. However biotech development is expensive and when smaller companies form collaborations with other companies, it can help provide financial and logistical support. And if one collaborator is good, more is better.
   
   
3. Cash is king. The record pace at which multiple Covid-19 vaccines were developed underscores the normal length of time it takes to bring a product to market. And that means that you should be looking for companies that have an ample cash reserve. It’s not uncommon for small-cap biotech firms to raise money through secondary share offerings. This has a dilutive effect on the shares of a company. Companies that continually need to issue share offerings should raise a caution flag for investors.
   
   In addition to finding companies that have an ample supply of cash, you also want to find companies that are not overly extended with debt. Companies that are heavily burdened with debt will often need to raise more capital which can lead to an unsustainable spiral.
   
   
4. Look for companies with a deep pipeline of products that are in clinical trials. Many biotech companies have one product candidate. However, that’s a high-risk, high-reward proposition for investors. If that product fails, a company might have no other way to recoup their R&D costs. But companies that have several products in development give themselves multiple bites at the apple.
   
   
5. If possible find companies with market-ready products. A deep pipeline is one thing, but at some point a company has to be able to bring a product to market. Completing clinical trials on human patients is only the first step. The product needs approval by the U.S. Food & Drug Administration (FDA). And that can take some time. Nevertheless, getting a drug successfully through clinical trials is a good indicator that a product will come to market sooner rather than later.
   
   
6. Look for biotech stocks that have the potential to rebound quickly. These are typically companies whose stocks are being sold on temporary bad news. The process of getting a drug to market is notoriously complex. Along the line, many speculative investors will trade on the news. However investors can use a temporary drop in share price as a great opportunity to buy on the dip. Of course, you have to believe that the news is actually much ado about nothing. If so, investors can use these opportunities to accumulate additional shares.
   
   
7. Have trust for who is in charge. It’s important that the management team consists of not only business-savvy entrepreneurs but also individuals who have the necessary scientific or medical credentials. This ensures that the company will not only be able to allocate resources towards the most promising products, they will also be able to properly interpret research data and make corrections as necessary.

How to Invest in Biotech Stocks?

The easiest and more popular way to invest in biotech stocks is to buy stocks of individual companies. However, investing in exchange-traded funds (ETFs) can be a smart way to manage the inherent risk of this sector. There are several biotech ETFs that track an index (a basket) of biotech stocks. Some of the most popular biotech ETFs are:

• S&P Biotech Select Industry Index (INDEXSP: SPSIBI)
• NYSE Arca Biotechnology Index (INDEXNYSEGIS: BTK)
• NASDAQ Biotechnology Index (INDEXNASDAQ: NBI)
• iShares NASDAQ Biotechnology ETF (NASDAQ: IBB)

Some Final Thoughts on Investing in Biotech Stocks

Investing in biotech stocks can be one of the most profitable sectors for risk-tolerant investors. Biotech companies are engaged in research and development for chronic and life-threatening conditions. If these companies are able to successfully bring a product to market, its stock price (which in some cases is trading as a penny stock) can double, triple or move even higher.

However, there’s also a tremendous risk to biotech stocks. The process to get a product approved is lengthy and expensive. And just getting a product through clinical trials is not sufficient. There is still an approval process through the FDA. And, unlike the speed at which Covid-19 vaccines were approved, this can also be a lengthy process.

To invest in biotech stocks requires knowledge of not only financial fundamentals but also the science and medicine behind the company. Individual investors who have a background in science and medicine may have the ability to separate the contenders from the pretenders.