Investing in biotech stocks and shares is a risky endeavour. But it’s also one of the few stock market sectors that offer immense growth potential. Thanks to innovations from scientific research, biotechnology has become a new leading approach to discovering and developing medical therapies.

Yet bringing these therapies to market is a pretty arduous process that, in most cases, ends in failure. But, should a biotech stock succeed, it can not only lead to enormous returns for risk-taking investors but also improve the quality of healthcare for the world.

Let’s explore the details of investing in biotech shares, the scale of the opportunity for my portfolio, and, of course, the level of risk to investors.

What are Biotech Stocks?

Biotechnology stocks represent companies that are focused on the development of new medicines and vaccines for treating common and rare disease. This is very similar to a pharmaceutical company. However, the key difference is the approach taken.

Biotech-derived therapies use living organisms, like bacteria and enzymes, as a base for creating new drugs. By comparison, pharmaceutical companies create chemical-based medicines.

There are plenty of biotech stocks around today, especially in the US. Some leading companies include Johnson & Johnson, Moderna, Merck, and GlaxoSmithKline. And many of these businesses are responsible for the rapid creation of the Covid 19 vaccine

Developing a new drug occurs in several stages. And it’s important to know where a stock in the biotech sector resides before investing. Why? Because depending on where it is in the product pipeline is a strong indicator of how risky the business is to invest in.

Let’s take a look.

• Research & Discovery – This is right at the bottom of the production pipeline. Biotech stocks residing here are exceptionally risky as they often don’t even have a drug candidate yet. This is where most biotech companies fail before they even start.
  
• Preclinical – Once a firm has found evidence of a potential new drug candidate, they need to make sure it has enough promise to warrant further investment. This is done through preclinical testing either in vitro (in a test tube) or in vivo (in a live animal like mice). Investing in biotech shares in this stage is still exceptionally risky. There is no guarantee of success with a long road still ahead if the initial results are positive.
  
• Clinical – If the preclinical trials show evidence of the drug working, the time for human clinical trials have come. This process is broken down into three main phases.
  • Phase 1 – Small scale studies aimed at finding the highest possible dose that can be given to a patient without causing harm. It’s worth noting that over 90% of drug candidates fail at this stage of development.
  • Phase 2 – The clinical trial study is expanded, typically to over a hundred patients, to determine whether the drug candidate is actually working effectively while simultaneously finding the optimum dosage.
  • Phase 3 – Assuming solid evidence of efficacy has emerged from Phase 2 along with no severe health side effects, the final phase of drug development can begin. The study size is once again expanded and can venture into the thousands. The goal is to prove that the treatment is both safe and more effective than existing solutions on the market. This is easier said than done and can take years before this part of the drug development pipeline is completed.
    

• Commercial – If a drug successfully makes it past the Clinical stage of development and regulators give the green light, a biotech stock moves into the Commercial stage. These companies have reached the finish line and have a product on the market that is generating income. This naturally reduces the business’s risk profile as it tends to be far less reliant on external financing for future developments.
  • Phase 4 – An often forgotten part of the drug development process is Phase 4 trials. These are carried out after the drug has reached the market. The objective is to continue to monitor patients throughout the rest of their lives to see if the drug causes any long-term consequences that aren’t detected during the initial development process.

The Risks and Challenges Faced by Biotech Shares

I’ve already touched on some of the risks biotech stocks have to contend with. But given the high-risk nature of this sector, I feel it’s important to reiterate in more detail.

• Multiple Hurdles Regulatory Hurdles – The road from discovery to commercial is long and filled with barriers that most biotech stocks fail to overcome. Beyond the challenge of raising the money to fund the drug development process, all this capital can quickly go down the drain if regulators reject an application. Even if regulatory approval is given, the company still needs to convince doctors, medical institutions, and insurance companies to offer treatment to patients.
• Global Distribution – Due to the challenges of drug development, biotech firms typically like to focus on finding new treatments with ample global market opportunities. But even if a revolutionary treatment is proven to work, the success is meaningless if the business cannot solve the logistical problems of delivering it to medical institutions. Look at the early Covid 19 vaccines as an example. These required storage of up to -90°C – something not easily achieved in a standard freight vehicle.
• Funding Development – Finding investors willing to take on the enormous risk of funding an early-stage biotech business is not exactly easy. And that challenge becomes even harder if the early data doesn’t show encouraging results. This is actually one of the main reasons why so many young drug developers fail. With no products on the market, the money eventually stops flowing, often resulting in a death sentence.
• Finding Expertise – Developing new drugs, especially in the biotech field, is a pretty complex process that requires immense experience and knowledge. Suppose a business cannot attract or retain such personnel. In that case, the odds of making it to the commercialisation stage are near non-existent.

Key Financial Metrics to consider before Investing in Biotech Stocks

Understanding the key financial metrics for analysing biotech shares is very important. So, let’s explore the metrics I think are critical to investigate before investing in biotech stocks.

• Cash Burn – Divide the amount of cash available to the company by its annual expenditure. This gives a rough indicator of how long management can keep the lights on before needing more money.
• Gross Profit Margin – Gross Profit margin is essential. It signals whether the company will remain profitable in the long run or not.
• Profit Growth – Generating profits is important. But even more important is profit growth. As it keeps investors and shareholders satisfied. For early-stage biotech shares, profitability could likely be several years down the road, further increasing their risk profile.
• Revenue Growth – When the biotech company starts generating sales, revenue growth is a sign of a healthy company.
• Research & Development – Biotech shares are only as good as their research. So, if the budget for research & development is starting to decrease, it could be a sign of financial distress.
• Return on Research Capital– For a business that has reached the commercialisation stage, this ratio reveals how much value is being generated from its investments in research & development.
• Debt-to-Equity – As biotech shares are highly dependent on external financing, this ratio is a quick method of checking to what degree of leverage they are operating at. Too much debt could create serious financial problems later down the line.

Key Terms to Know before Investing in Biotech stocks

The complex nature of drug development is equally paired with a lot of jargon that investors need to know before investing any capital into biotech shares. With that in mind, let’s explore some common complex terminologies that I feel are worth knowing.

• Abbreviated New Drug Application (ANDA) – A simplified submission permitted for a generic version of an approved drug.
• New Drug Application – Application filed with the FDA Center for Drug Evaluation and Research (CDER) for approval to market a small-molecule drug.
• Antibody – Immune system protein produced by humans and higher animals to recognise and neutralise bacteria, viruses, cancerous cells, and other foreign compounds.
• DNA Sequencing – The process of determining the exact order of bases in a segment of DNA.
• Cell Therapy – This is the process of introducing new cells into a tissue to treat a disease.
• Gene Therapy – The replacement of a defective gene in a person or organism suffering from a genetic disease.
• Genetic Engineering – The manipulation of genes to create heritable changes in biological organisms and products that are useful to people, living things, or the environment.
• Genomics – The study of genes and their function.
• Mutant – A cell or organism harbouring one or more mutated genes.
• Mutation – A change in the base sequence of a gene that results in it not performing its normal task in a cell.

Market size and Forecasted Growth of the Biotech Industry

After the pandemic exposed the dire need for further investment in the biotech sector, governments around the world have begun introducing new schemes and subsidies to accelerate research. Covid-19 also highlighted several bottlenecks in the regulatory approval process that are already being improved.

Combining this with the high degree of technological innovation paired with continued demand, especially for chronic care, and the sector is forecast to surge. In fact, a recent report by Global Market Insights predicted the sector will grow by an impressive 9.4% annually until 2027 reaching $932.13bn!

Top Biotech Stocks in the UK by Market Capitalisation

Below are the top five biotechnology stocks in order of market capitalisation listed in the United Kingdom.

Top Biotech Stocks in the US by Market Capitalisation

Here are the top five biotech companies listed in the United States.

Should I Invest in Biotech Shares?

In the past few decades, innovation in the health sector has been remarkable. Moreover, many serious diseases and ailments now have a cure, which seemed impossible about 20 or 30 years ago. Hence, today diseases like cancer, hepatitis, and other conditions like epilepsy are curable. Without a doubt, the credit for these developments goes to biotechnological innovation.

Investing in biotech shares can be rewarding, in my opinion. But it’s essential to understand at which stage the biotech company is operating and the risks associated with it. Hence, I believe once I am clear about my investment goals and risk acceptance level, investing in biotech stocks could prove to be a worthwhile venture, even with the high degree of risk associated with it.

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Saima Naveed does not own shares in any of the companies mentioned. The Money Cog does not have a position in any of the companies mentioned at the time of publishing. Views expressed on the companies and assets mentioned in this article are those of the writer and therefore may differ from the opinions of analysts in The Money Cog Premium services.