Investing in Biotech: High Risk for a Potentially High Reward

Key Points

• Biotech companies are among the market's riskiest investments, but that's exactly why they have the potential for high returns.
• Investors interested in biotech can mitigate risk in several ways, including focusing on stocks traded on major exchanges or purchasing a basket of biotech stocks through an exchange-traded fund.
• Because successful clinical trials and regulatory approval are not guaranteed, investors can see sudden, sharp drops in their biotech stocks.
• A successful trial or FDA approval can result in big upside trade, as can an acquisition from a bigger pharmaceutical company. 

Have you been wondering how to invest in biotech stocks? You may have watched biotechs rally fast and post significant gains and felt you missed out. You may also have seen biotechs and biopharma stocks reward shareholders when acquired.

There are a few factors to consider when considering investing in biotech. In this article, we'll look at whether biotech stocks are a good fit for your portfolio and also some possible pitfalls to avoid. 

What Are Biotech Stocks?

Biotechs are companies that develop specific medicines or therapeutic treatments. Often, they focus on a single product. 

When looking for the best biotech stocks to buy, be aware that many companies with promising technologies have market capitalizations of less than $2 billion, often well under. Some are also categorized as penny stocks, priced below $5 a share. These biotech startups frequently have no earnings and very little revenue, as their operations are funded by venture capital. 

Biotechs are generally considered a risky category of investment. There is a great deal of potential in a company with a product successfully brought to market, but there is also the risk of disappointment.

Overview of the Biotechnology Industry

The biotech industry hinges on bringing a hit product to market. Biotech companies may undergo years of research and development, only to learn that the treatment doesn't deliver the expected and hoped-for results in clinical trials. It's similar to the movie business, where a studio may invest millions into producing a motion picture, only to find that it flops when released. There's no guarantee that years of hard work and capital investment will pay off. But when it does, the treatment could eventually become a "blockbuster," a term it shares in common with Hollywood. 

The biotech and pharmaceutical sectors share similarities but differ in key ways -- they are more like cousins than siblings. 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.

Pharmaceuticals bring existing, FDA-approved products to market. They have manufacturing and marketing chops, as you can see by the slew of drug commercials on TV. The biggest pharmaceutical companies typically acquire or license new treatments once they are already developed. They aren't taking the risk of research and development, which may not result in a marketable product like biotech companies do.

Qualities to Look for in a Biotech Stock

Investing in even the top biotech stocks comes with risks. However, there are certain things you can look for to help manage it.

• A “Hot” Research Area: Focus on companies targeting diseases or conditions affecting large populations, as successful products will have high demand and quicker returns on R&D investments. Hot research areas can also lead to breakthrough "orphan" drugs with extended market protection.
• Collaboration: Smaller biotech companies benefit from partnerships that provide financial and logistical support. 
• Cash on Hand: Look for companies with ample cash reserves and minimal debt. Frequent secondary share offerings indicate financial instability and can dilute share value.
• Product Pipeline: Companies with multiple products in clinical trials offer better risk management than those relying on a single product.
• Market-Ready Products: Prioritize companies with products nearing market readiness, as completing clinical trials and securing FDA approval are critical steps.
• Market Rebounds: Invest in companies with the potential to rebound from temporary setbacks, using dips in share price as buying opportunities.
• Management Team: Trustworthy management should include both business-savvy leaders and those with scientific or medical expertise to ensure effective resource allocation and accurate research interpretation.

Steps and Phases for Developing New Drugs 

Before a biotech firm can bring a product to market, it must go through several steps and phases. Investors should understand these processes, as they can greatly affect company operations and the stock's price.  

1. Research and Development: Identifying target diseases, developing testing processes, and optimizing the drug's formulation for safety and efficacy.
2. Preclinical Testing: Conducting pharmacology and toxicology studies, often on animals, though emerging technologies may reduce this need.
3. Clinical Trials: Testing the drug's safety and efficacy in humans across three phases, with increasing participant numbers and testing rigor.
4. Regulatory Approval: Submitting comprehensive clinical and preclinical data to agencies like the FDA for approval to commercialize the drug.
5. Manufacturing: Scaling up production, often through contract manufacturers or licensing to larger pharmaceutical firms.
6. Marketing: Promoting and selling the drug to healthcare providers, insurers, and patients, often involving distributors and marketing campaigns.

Pros and Cons of Investing in Biotech

Because the biotech sector is notoriously volatile, it is essential that you understand the pros and cons before making an investment.

Biotech investing can be very lucrative for some key reasons: 

• Price Appreciation: The old concept of buy low, sell high is very clear with biotech stocks. If a company has successful clinical trial data or gets regulatory approval, its stock price could rocket significantly higher.
• Innovation: Biotech companies are at the cutting edge of medical innovation. The market rewards companies with new technologies that bring obvious changes to people's lives, including treating diseases and chronic health conditions.  
• Growth Potential: Biotech companies can grow fast once a product is successfully brought to market. In addition, investors are often rewarded when a biotech is acquired by a larger pharmaceutical, a very common occurrence. 
• Diversification: Investing in biotech companies can diversify an investment portfolio, as these companies are not necessarily highly correlated to the broader market, simply due to their business models and research and development cycles. 

The potential negatives of biotech investing include the following: 

• High Risk: Perhaps no other sector has so much inherent downside risk. Many products these companies develop never make it out of clinical trials or receive FDA approval. This means investors can see the stock price decline to nearly nothing. 
• Lengthy Development Timelines: Biotech companies generally have long development cycles. This can translate to significant costs and delays in bringing products to market. Investors must be patient if they want the reward at the end of the process - if that reward comes at all. 
• Clinical and Regulatory Uncertainty: Successful clinical trials and regulatory approvals are required before a biotech can bring a product to market. Both these processes can be lengthy and riddled with uncertainty. There's no guarantee of success. 
• Limited Access to Capital: In shaky market conditions, such as 2022, investors, including venture capitalists and those on the public markets, may be hesitant to put more money into unproven biotech. This may result in a slower research and development process. 

Future of Biotech Stocks

As with infotech, the biotech industry should solve problems and improve conditions. Those are exactly the types of companies that the market rewards, as they can potentially increase revenue quickly. 

Possible growth areas of the biotech industry include: 

• Gene Therapy: Gene therapy can potentially upend the treatment of many genetic disorders, such as cystic fibrosis and sickle cell anemia. The FDA has already approved many gene therapies, and more are developing.
• Immunotherapy: Industry analysts see a lot of promise in immunotherapy for treating cancer by channeling the body's immune system to attack cancer cells. Here again, the FDA has already approved some therapies, and more are expected.
• Artificial Intelligence: Artificial intelligence is permeating nearly every industry at this point. In biotech, it's used to speed up and streamline drug discovery, clinical trial design, and patient monitoring. This could help rapidly accelerate the development of new drugs.

High Risk Can Result in High Reward

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.

Biotech is an exciting and promising area, and investors with some patience, the stomach for volatility, and a high risk tolerance can potentially benefit.  

FAQs 

Here are a few of the most commonly asked questions about biotech investing.

Should you invest in biotech stocks?

Biotechs offer exposure to an industry with high potential for big price gains, but that also comes with higher-than-average downside risk. If clinical trials are disappointing, or if a new product fails to get FDA approval, your investment will almost certainly plummet in value. Conversely, successfully bringing a product to market can mean big rewards for investors, as can an acquisition by a larger company.

How can I invest in biotech with little money? 

If you have little money to invest, one way to minimize your risk is by purchasing a basket of biotechs using an ETF. This can often be a sound approach, as you aren't simply betting your entire investment on one biotech, which is an extremely risky prospect. An ETF spreads the risk among many biotechs, meaning you'll participate in the gains of more than one company. You'll also participate in losses of multiple companies, but an ETF will generally smooth your return and reduce volatility. 

Is biotech a safe investment?

No equity investment can be called safe. 

Young, small companies with unproven technologies populate the biotech industry. It can take years to bring a product to market. A company's clinical trials may fail. The product may never get regulatory approval. For those reasons, investing in biotech can never be considered safe, although there is potential for a high return. But that comes with a great deal of risk.