Many investors succumb to the lure of discovering the diamond in the rough by buying shares in biotech companies.
That's because some of those companies look like a potential blue sky investment. For example, there are many companies researching cures for heart disease, stroke and cancer which are the top three causes of death in Australia.
But are biotechs a good investment?
Being an investor in a small biotech company can be a trying exercise. A company or research program which sounds like a good idea might not always the best investment.
With most biotechs, the developmental stage is essentially a cash-burning machine. It's not enough to have a good product; much of the success also depends on cash in the bank, management of funds, communications and a good marketing strategy.
When it comes to biotechs, forget trying to work out fundamentals. Since there are usually negative earnings and large research and development expenditure, most of the ratios you try to work out make no sense at all.
So how can you evaluate a biotech company if you're interested in investing in one?
First of all, the largest market for pharmaceuticals is the US market. It also has the highest per capital sales in the world. When it comes to the US market, the FDA (Food and Drug Administration) is the body which looks after the approval of drugs. Approval in itself is a long and drawn-out process which usually takes years to complete.
There are three pivotal stages in the approval process that a drug needs to pass before even thinking about mass commercialisation. Each phase is capital-intensive which is why you see lots of capital raisings before a drug gets to the commercialisation stage.
Phase 1 companies are usually not listed on the ASX. These immature companies are usually funded by venture capital. This is the stage where a company may have a good idea for the drug and is testing it on a small number of people.
Phase 2 is usually when biotech companies go to IPO (Initial Public Offering). The company raises funds to do an in-depth study to evaluate efficacy and safety.
Phase 3 is usually where the drug is tested on a large group of people to confirm its efficacy, safety and monitor the side effects.
Once a company passes stage 3, it can then apply for approval of the drug. The FDA then approves or rejects the application. If granted approval, the FDA endorsement may still have attached cautions or disclaimers.
So if the drug is rejected, you can imagine what usually happens to the share price!
Don't forget that because obtaining approval can take so long, there is the threat that a better drug may be developed by another company.
Phase 4 is where the company looks at longer-term safety and the best use of the drug. It's also the stage where a large chunk of the company is sold to a larger company to fund commercialisation as well to get access to the market.
Generally investors like to stick to buying biotech companies that are at phase 3, mainly because there is less time to wait until commercialisation.
Even if the FDA approves the application, there's a long way to go before the business might become a success. The crucial next steps, like finding a joint venture partner or funding, then ensuring the product sells, can all mean that it may not all be smooth sailing.
So, as with any investment decision, it's important to weigh up your risk versus your potential return. But with biotech companies, the return could be more than just financial – it could also help improve the way we live.
Happy trading!
Julia Lee Equities Analyst Bell Direct
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