How investment in the biotechnology industry works

Filed under: Biotech ETF

The biotechnology industry may be defined in the simplest of terms as an industry that develops new drugs and treatments for the health-care industry by using the latest advances in technology and research. The critical factor in their success is approval from the FDA which can be required at several stages of the process from the initial stages to the final stage of the commercial launch of a product. You should be aware that, on average, more biotechnology companies fail than companies that succeed and it should therefore be viewed as a relatively high-risk investment. Despite the risk factor, biotechnology remains an attractive and potentially lucrative destination for investment because of the sheer number of companies who could multiply significantly in value if they succeed in successful product development. The normal company might double the value but very few industries have the potential to multiply value by many times.

Biotechnology concentrates on finding new drugs and treatments with the use of advanced research techniques. As a result, a biotechnology company may spend millions of dollars on the research and development process with very little tangible by way of assets to show for it. Many of these companies unprofitable for a fairly long time and have very few sales revenues to show for all that effort. You should always keep in mind that the difference between the pharmaceutical industry and the biotech industry is that the biotechnology industry is all about risk-taking while the pharmaceutical industries follow more conventional methods in diversifying and managing risk. Moreover the lead time for product development for biotech products is long (often in excess of one decade) and probably only one in every 20 companies survives. Yet if a company survives and successfully launches a product, the return on investment can be astronomical.

Biotech companies have no pretence to any skills in areas such as manufacturing or marketing and see themselves as pure research and development plays. In contrast, the pharmaceutical companies have mammoth marketing and distribution organizations and use the products from biotech companies to boost their own drug pipelines. Pharmaceutical companies are always on the lookout to acquire promising biotech companies and will often pay extremely fancy prices because they are cash rich.

Because pharmaceutical companies have a stable and successful business as well as a predictable cash flow, they are easily valued on the basis of discounting of future cash flows. You can therefore base your investment decisions on a reliable valuation. Biotech companies are far more difficult to value because they have neither revenues nor cash flows and their assets are largely intangible. The estimated value of a biotech company is therefore more art and science and is a bit of a leap of good faith.

If you do not have the know-how or the ability to assess the chances of survival for a biotech company, you are best advised to invest through a biotech ETF. You will get liquidity for your investment as well as automatic diversification by virtue of investing in a pool of assets. It is true that the return from the ETF is not going to be comparable to investment in individual stocks. Yet, you are getting an exposure to a potentially profitable sector without the risk of losing your shirt on a single stock.

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