How to analyse and pick biotech stocks

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Investing in biotech stocks is an exciting opportunity, with the potential to capitalize on cutting-edge innovations like bacteria-based cancer cures, stem cell blindness treatments, and lab-grown meat. The biotech industry is at the forefront of scientific advancement, with scientists worldwide working on revolutionary products that could transform our lives and generate substantial returns for investors. This comprehensive guide will equip you with the knowledge needed to navigate and invest in biotech stocks effectively.

What is biotech?

Biotechnology is all about using living things to make products. It’s been around in agriculture for a while – companies like DowDuPont and Bayer genetically modify crops to make them pest-resistant or more nutritious. But the really hot bio-business these days is medicine.

Unlike traditional pharmaceutical companies, which use chemicals to develop their drugs, biotech firms manufacture their medicines with enzymes and bacteria. This can be much cheaper and easier than other techniques, and can allow for new kinds of treatment – whether those be long-awaited cancer cures or gene editing to cure hereditary diseases.

Why does that matter to me? For one thing, if you or your loved ones suffer from presently incurable diseases, biotech could come to the rescue. There’ll also be wider ramifications for society as new treatments for deadly diseases become commonplace.

The growth of the biotech industry

In recent years, the biotech industry has boomed: between 2000 and 2023, the total revenue of biotech companies in the Nasdaq Biotechnology Index rose by eleven times. And that growth looks set to continue: at a rate of almost 10% annually, over the next two years. Biotech is therefore a genetically modified field ripe with investment opportunity – and what’s more, you’re really helping keep the doctor away when you pick these apples.

But investing in biotech isn’t like investing in other industries. Convoluted research and development programs and strict regulations make it a hard sector to get to grips with. It’s also pretty high risk – so rushing straight in is not a good idea. Just as well you came to us, then: in this Pack, we’ll provide a broad overview of the biotech sector and then give you the tools you need to analyse biotech stocks before taking the plunge. All your headaches will magically disappear…

The takeaway: Biotech is a fast-growing but risky industry with loads of investment opportunities.

What's unique about biotech?

Unlike software development or electric vehicle design, making complicated drugs using cutting-edge processes takes a really, really long time. The average drug’s journey from concept to creation is a whopping 12 years.

First of all, the boffins have to figure out the science – how to get a bunch of bacteria to behave the way they want, for example. Even if they do come up with a wonder drug, the process doesn’t end there. Governments are understandably wary about what citizens have crammed in their cannulas, and need to be convinced that new treatments are both safe and effective. Years of closely watched human trials ensue.

In the US (where the vast majority of biotech firms call home), this stringent process is overseen by the Food and Drug Administration (FDA). Clinical trials take place in three phases. The first takes around a year, and involves a very small pool of people who confirm the drug’s safety and dosage. Phase two takes a few years, and involves a few hundred human guinea pigs testing the treatment’s efficacy – and if there are any nasty side effects. If a drug makes it through those stages, the third and final phase takes another few years: thousands of test subjects help scientists evaluate the drug’s long-term impact.

The whole process takes forever, and failure is all too common. 85-95% of all prospective drugs fail to be approved by the FDA, which can really kibosh a company.

Why invest in biotech stocks?

Investing in one of these companies is obviously a massive risk, but it could also bring massive rewards. Biotech essentially lets you play at being a startup investor – picking companies that you think might make millions from drug sales later down the line. Potential profits for biotech companies are, naturally, massive. Their drugs have longer patent protection than other types of pharmaceuticals (12 years, rather than five), they’re significantly harder for rivals to copy, and their creators are top prospects for a multi-billion-dollar buyout by a big pharma company.

Because making biotech drugs is so time- and resource-intensive, firms need money to see them through their decade-plus of revenueless research. And with the risks often too high for bank managers’ loan books, companies look to investors instead. Biotechs tend to list shares on stock markets pretty early on in their lives – in 2018, Homology Medicines raised $166 million in its initial public offering, despite not having a single drug yet in clinical trials.

The takeaway: Drug development can take over a decade, and there’s no guarantee of a drug passing clinical trials.

Analysing biotech companies

How do I figure out if a biotech company will succeed? In short – you probably can’t. As any teenager knows, human bodies are complicated, and even the brightest biologists can’t say for sure which drugs will and won’t work. The only way to find out is to try.

The further along a drug is in the development process, the more likely it is to end up being successfully approved and marketed. There’s a trade-off, however. The later you invest, the lower the risk – but with other investors cottoning on and pushing up demand for the developer’s shares, and therefore their price, the potential gains are smaller too.

Investing in a biotech company before it’s begun clinical trials is extremely risky. Even in the clinical stage, you’re still gambling on everything staying peachy. Still, there are ways of mitigating the risks. You can visit the ClinicalTrials.Gov website to see details of ongoing trials worldwide and browse test results. If you’re comfortable with statistics, you can even try to analyse the data yourself and work out if a drug’s effects are statistically significant. Otherwise, sift through the biotech press to see what people are saying – but treat company-issued press releases with an appropriately scientific scepticism…

One positive sign is a firm voluntarily including a control group in the first and second phases of drug trials. Testing for the “placebo effect” isn’t a legal requirement until phase three, so a company deciding to do it earlier may be a sign of confidence in its product.

Some biotech firms will already have working treatments on the market, but even these are risky investments. Most plough all of their profit back into the company, and if sales don’t keep growing at the forecast rate (due to unexpected competition, for example), the stock price could tumble.

What else should I look for?

It’s smart to scan for companies with more than one product in development. That way if one fails, there’s a backup that could still offer some chance of success – so you’re less likely to lose everything. Take note of the diseases they’re targeting, too: some, like Alzheimer’s, are notoriously hard to cure.

You should also see if any big players have taken a shine to the company. Drug development is much easier when you’re sharing facilities and expertise with larger partners who can also help with marketing and distributing a product if it ever does get approved. Once again though, this is a trade-off: a company that partners with a big pharma firm will likely have to split any eventual profit, meaning less lolly for its shareholders.

Finally, it’s worth looking at the people behind the company – particularly the senior management. It’s always important for those in charge to understand how a business actually works, and that’s especially true in the fiddly field of biotech. Some investors choose to focus on firms run by scientists: you don’t want someone who doesn’t know how to drive behind the wheel, after all…

All this can you give an idea of if a drug might end up working – but that’s not much use if the company can never make money from it.

Your biotech stock checklist:

• Drug development process:

  The further along a drug is in its research and development, the less risky the company is likely to be.

• Products already on the market:

  A company with drugs already out there might be generating cash it can reinvest in developing new medicines, reducing the risk to investors.

• Multiple drugs in development:

  More drugs in development means less potential downside if one of them doesn't move forward.

• Target diseases:

  Some are notoriously difficult to treat, whereas historical progress against others suggest a greater likelihood of a company succeeding.

• Partnerships:

  Teaming up with big biotech or pharma players can give biotechs a leg-up when it comes to marketing and distributing a successful product.

• Management:

  A track record and experience of the industry could be a risk-reducing bonus.

Assessing biotech finances

Crunching the numbers of biotech companies isn’t easy, but there are a few pointers that can help you make a more informed decision about which bets might win out.

What kind of disease is the company targeting?

Biotech is split into mass-market and “orphan” drugs. The former target the big diseases – cancer, diabetes, heart disease – that affect a large number of people. Companies focused on these areas could see higher sales, but also face increased competition – which could drive the price of their drugs down.

Orphan drugs, meanwhile, target rare diseases that affect fewer than 200,000 people in the US. That rarity means companies can charge much more for the drugs (with government subsidies available too) and get help with development (such as tax credits and longer exclusivity periods). Both types of drug can make money, but orphans are less likely to win big.

What type of product is the drug?

Vaccinations offer a fantastic preventative solution, and will often be taken by more people than a treatment will be. But they’re a single-use product; treatments are often valued more by investors because they offer an ongoing revenue stream that can bring in more money in the long run.

How much is the firm spending on R&D?

If you’re looking at companies that already have products on the market, a good metric to track is the amount they’re spending on research relative to their revenue. The few companies that earn more than they spend are stable investment opportunities – but have less chance of growth than those feverishly reinvesting their earnings.

How much money’s in the bank?

For the many biotech firms that don’t have revenue, what really matters is whether they’ll be able to survive the long clinical trial process. Doing so requires a lot of funding – and what you don’t want is for a promising drug to fail because the company’s run out of cash.

If a company doesn’t already have enough cash to cross the finish line, they’ll need to raise more at some point. That may well involve issuing new shares – which could dilute your shares, giving you a smaller piece of the pie come payday. While you can help avoid dilution by waiting until a company’s raised more money, you’ll be jumping on towards the end of the growth curve – and may not profit as much.

What’s the debt like?

Companies who don’t raise all their money from stock investors might have taken out loans or issued bonds instead. And while that might be fine for now, if there’s too much debt on the books then any funding they do have could get frittered away paying off those debts – especially if interest rates rise.

You’re now inoculated with the financial factors to look for at biotech firms. Next, we’ll give you a shot at putting that knowledge to use – and actually getting invested in biotech.

The takeaway: Thinking about companies’ drug strategy, debt load, and R&D costs can help you pick a good biotech stock.

How to invest

Turn to angel investing and crowdfunding

If you’re really up for a risk, angel investing and equity crowdfunding can let you buy chunks of biotech companies before they’re available to the masses. These will be very early-stage investments, and though they could result in massive gains, the risks are – all together now – correspondingly huge.

Wait until firms are publicly traded

A steadier approach is to wait until firms are listed on the stock market. You’ll be able to buy and sell the shares easily, and using the tools from the previous sessions you can go some way towards sensible stock-picking. Make sure to not put all your eggs in one test tube, though: it’s worth diversifying across different diseases to spread your risk.

Pay an expert to manage your investments

Because biotech is so complicated, you might be better off deferring to an expert. Biotech funds are managed by specialist professional investors, who may do a better job than you can of picking the hits. You’ll have to pay for their expertise, though – if you’d rather go for something low cost, you could just invest in an index fund like the iShares NASDAQ Biotechnology ETF, which puts money in all the biotech firms listed on the NASDAQ exchange, in order to align your fortunes with the wider industry’s.

Invest in land

Some investors advocate a “picks and shovels” approach, which takes its name from the California Gold Rush. Back then, the gold mining industry was a bubble – and it was the people that sold the tools to prospectors that benefited more than the prospectors themselves.

If you think biotech might be overhyped but want to benefit from the brouhaha, you could invest in the land that biotech firms use. Alexandria Real Estate Equities, for example, is a real estate firm that owns a lot of expensive lab space in innovation hotspots like California and Massachusetts.

Invest in CDMOs

Another option is to invest in Contract Development and Manufacturing Organizations (CDMOs). These firms actually manufacture the drugs once the research is done; large-scale production is generally too expensive and difficult for biotech firms to do themselves. While Lonza and Catalent are the biggest players, the CDMO game is currently a fragmented market – and increased acquisition activity could mean big paydays for investors in the near future.

Biotech is a complex industry, but it can also be a rewarding one. Not only could you make hefty profits, but you’d also be helping save lives – and that alone might be worth a look into the lab. Good luck – and don’t forget your safety goggles.

In this Pack you learned:

🔹Biotech is a fast-growing but risky industry with loads of investment opportunities.

🔹Drug development can take over a decade, and there’s no guarantee of a drug passing clinical trials.

🔹Investing towards the end of clinical trials is less risky – but means smaller rewards.

🔹Analysing biotech financials (like how much they’re spending on research) can help you spot winners.

🔹Exchange-traded funds and real estate trusts are two alternative ways to invest in biotech.