Prescription drugs are big business: almost 50% of people regularly take prescription medication in the US alone, and almost 20% take over five types of them. The world, it seems, is addicted to – entirely legal – pills.
And the pharmaceutical industry is addicted to keeping it that way. With global sales of over $1.2 trillion, companies involved in researching, manufacturing, and distributing drugs can make a very healthy profit. And so can their investors: pharma firms have delivered a 280% return since the US pharmaceutical index was established in 2006, compared to 247% for the wider market. Assuming the population keeps aging in the way it’s expected to, the forecast market growth of 5% a year is likely to boost stocks much more.
But investing in pharma offers more than just returns from rising stock prices: big firms like Johnson & Johnson, Merck, and Pfizer are known for the hefty dividend payments they regularly hand out. Some investors favor the industry’s non-cyclical nature too: its stocks, in other words, tend to be resilient even when the economy is going down, making them a good way to balance a portfolio.
Of course, investing in pharmaceuticals isn’t without its risks, so in this Pack, we’ll help you deal in drugs responsibly by making sure you’re fully aware of any potential side effects. With a bit of luck, you’ll be able to get those market highs you’re after without letting your portfolio get hooked on just one sector…
The takeaway: The $1.2 trillion pharma industry is a good way to add resilience to your portfolio, but investing in it can be risky and complicated.
Before they can sell drugs, pharma firms need to make them. And before making them, they need to figure out what to make. That’s both time-consuming and expensive – so if you’re going to invest in the drugs business, you need to balance the time spent on all the failures with the potential of the rare success.
Drug discovery involves toiling away in a lab to first understand what causes a disease, then to figure out which molecules can stop it. Pharmaceutical companies do some of this work themselves, but they also fund university researchers to do the rest of it for them. That’s because of the sheer amount of research there is to be done: 5,000 to 10,000 different molecules will need to be tested for any one drug. The initial process alone typically takes around a decade, and costs around $500 million.
Eventually, the pharma firm will have shortlisted a few molecules it reckons might work, and that’s when the long process of clinical trials begins. Because before a drug can be approved for use – by the Food and Drug Administration in the US, and the European Medicines Agency in the EU – it has to pass three phases of clinical trials to check it’s safe and effective.
The first phase takes around a year, and involves confirming the drug’s safety and dosage with a very small pool of people. The second takes two or three years, and involves testing the treatment’s effectiveness on a few hundred human guinea pigs. If a drug makes it through both of those stages without revealing any nasty side effects, the third and final phase assesses thousands of test subjects to help evaluate the drug’s long-term impact.
Most drugs – 85-95%, to be specific – don’t make it through clinical trials. That means there’s a lot of trial and error involved in drug development, which is why it’s so costly. Estimates vary for exactly how much drug development costs from start to finish, but the (pharma-funded) Tufts Center for the Study of Drug Development says it’s an average of $2.6 billion. And $1.2 billion of that is what’s known as “opportunity costs” – the amount investors missed out on by not investing their cash elsewhere.
Others think $2.6 billion is too high. Harvard’s School of Public Health, for example, says Tufts uses “assumptions highly favorable to the industry” so they can justify their high drug prices, and that “the actual number is probably much smaller”. Either way, we’re still talking a lot of money to produce one drug. And because lots of the most easily cured illnesses have already been solved, drug development is only going to get harder and more expensive.
Still, you’d think that once they have developed the next blockbuster drug, the pain would be over for pharma firms. Manufacturing costs might be increasing (more on that later), but they’re still negligible compared to the costs of development. But no: turns out marketing a drug’s pretty pricey too…
The takeaway: Drugs can cost billions to develop, and the process can take decades.
Imagine you invested in a firm that spent billions of dollars figuring out how to cure cancer, only for someone else to swoop in and copy its treatment at the last minute. It’s fair to say you wouldn’t be too happy.
That’s why pharma firms get “patent protection”, which ensures they’re the only ones allowed to manufacture and sell the new drug for a certain period of time – normally 20 years. That guarantees them a monopoly, meaning they can charge more to recoup their development costs and then some: brand drugs have a net profit margin – revenues minus costs as a percentage of the product’s sale price – of 28%, among the highest margins of any industry.
The pharma companies aren’t the only ones profiting, either. They sell their drugs to wholesalers, which then sell on to pharmacies and, in the US, prescription benefit managers. Those “PBMs” buy the treatment in bulk for insurance plans, and ultimately have final say over which drugs are covered. In the UK, middlemen are cut out, and pharma firms negotiate with the NHS.
But the biggest difference between the US and the UK – and lots of other countries that abide by the same rules – is that the UK puts a cap on its drug prices. America doesn’t, which is part of the reason almost 50% of pharma sales by value come from the US. Pharma companies, then, spend a lot of money making sure it’s their drugs – as opposed to competing medications – doctors are giving to patients. And that’s why they often spend a lot more – sometimes twice as much – on marketing as on research and development.
They’re on the clock, after all: pharma companies have 20 years to make big profits before their patents expire, and once they do, that source of income can evaporate. In fact, according to the Federal Trade Commission, the sudden competition can cause prices to drop by over 85%. That competition also changes who makes the money: wholesalers and PBMs make a lot more from non-branded drugs than branded ones, because they can negotiate even bigger discounts. The big losers are the pharma firms themselves, whose profit margins drop from 28% to “just” 18%.
Take Pfizer’s drug Lipitor as an example. It once brought in $13 billion in annual revenue, but that dropped below $2 billion when its patent expired and its rivals entered the fray. And since those rivals didn’t have to spend the millions on R&D that Pfizer did, they could afford to be significantly more competitive on price.
Of course, pharma firms have other ways to shore up their profits. For one, they take incentives. Part of the reason so much money is spent on researching cancer and diabetes is that there’s a massive market for treatments. But not all diseases are as common or high-profile. So to encourage research into rarer illnesses, governments offer incentives – like tax benefits and longer exclusivity periods – for so-called “orphan drug” development.
For another, they often choose to work on drugs that are expensive to manufacture, which protects the drug’s profits by making it harder for competitors to muscle in on the market. It’s also part of the reason behind the recent push toward biotechnology drugs – or those made from living organisms. You’d need to make a “biosimilar” drug if you wanted to copy a biotech – and that’s a lot more expensive and a lot more complicated to do than copying a standard medication.
And last but by no means least, pharma firms are constantly “refilling the pipeline”. As soon as a new drug’s approved, the clock starts on the 20 years of profits it’ll give the company. And since it could take another 20 years to develop your next blockbuster, the research has to restart all over again. The cycle never ends – though as we’ll see in the next session, it does change...
The takeaway: Pharma profits are sky-high while a drug’s under patent protection, but once competition’s allowed, prices and profits drop.
Nanobots in your bloodstream. Medical advice from machines. Smart toilets that analyze your poop. The changes happening to the pharma industry are wild, and that could put pharma in line for some big windfalls.
Investment bank Goldman Sachs expects the industry’s US profits to grow 2% annually through 2023, and EU profits to grow by 7% annually. Pharma-focused bank Torreya has looked even further ahead, and thinks pharmaceutical revenues could almost triple to $3.3 trillion by 2060. And with so many lucrative drugs on the horizon, that’s not an entirely unreasonable figure: Merck’s cancer treatment Keytruda, for one, is about to become the most lucrative drug in history with over $27 billion in forecast sales.
Still, it’s becoming all the clearer that if it wants to get in on those gains, Big Pharma’s going to need some help from, er, small biotech. Biotech firms – which independently develop their own revolutionary drugs using living products, like enzymes and bacteria – tend to be quicker at innovating. But they also often need pharma companies to help them navigate the knotty clinical trial and marketing process. So it makes sense that when one comes knocking with its series of paychecks – one to buy the company and its research, one to bankroll the trials, and one to roll its drugs out – the biotech would climb on board.
In 2019 alone, pharmaceutical firms spent over $350 billion buying smaller companies – many of them biotechs – to essentially outsource the research stages and swoop in when they sniffed profits. That strategy isn’t without its risks, though: Eli Lilly paid $1.6 billion for ARMO BioSciences in 2018, only for its flagship drug to fail clinical trials a year later.
To fund all these acquisitions, pharma firms are slimming down and selling off some of their most lucrative units. Pfizer, GlaxoSmithKline, and Novartis have all spun off their consumer health units – brands that make over-the-counter products – in recent years, and rival Sanofi is reportedly planning to do the same. That’s fine by investors, who think they’ll get more value from a stable consumer health business. Companies that do too many things, after all, typically have a lower value than the sum of their parts. Of course, that does mean investing in pharmaceutical companies is becoming even riskier: you’re just investing in the drugs themselves.
That might worry some investors, especially as risks in the pharmaceutical industry keep mounting. For one, the accelerating pace of innovation means the firms might spend ten years developing a drug, only for a new miracle cure to sneak up from behind. Acquisitions are one way to protect yourself from that, sure, but there’s always the risk you’ll be blindsided.
And then there’s regulation. Like we said, almost half of all pharmaceutical revenue comes from the US, which is partly due to drug prices that are on average 56% higher than in other wealthy countries. So the industry is naturally pretty worried by talk of drug price regulation from politicians on both sides of the aisle – not to mention the prospect of the US government cutting out PBMs altogether, or negotiating drug prices for the entire Medicare program. As a major buyer, the US government would have a strong negotiating position and likely be able to force pharma firms to accept lower prices. The Chinese government has already started doing just that, threatening profits even more.
Still, let’s not get ahead of ourselves. A big institutional change like that isn’t likely to happen any time soon, and even if it did, pharma firms can afford to lose a big chunk before they come under any financial difficulty with profit margins as healthy as they are. So if you do want to invest, you’ll need to know how…
The takeaway: Miracle cures are on the horizon, but regulation could dampen profits.
Before you invest in pharma stocks, it’s sensible to figure out what role you want them to play in your portfolio.
As a “non-cyclical” industry, Pharma isn’t hugely affected by the economic cycle. because people need to buy drugs in both the good times and the bad (in contrast to, say, luxury goods). Putting money into the industry might not be a bad idea as a way of shoring up your portfolio during or in anticipation of a recession, then.
Other investors are keen on the sector’s dividends: pharmaceutical firms offer an average dividend yield of 2.27%, which gives them a reliable income alongside any potential gains in stock price. If that’s what you’re after, you might want to compare stocks by comparing their dividend yields, as well as by picking the firm with the healthiest balance sheet. In other words, picking one that has a better ratio of equity to debt, which will make it more resilient during a downturn.
If you’re looking for the company that’ll grow, there are some other things to explore. Look at how many drugs the firm is currently reliant on, when their patents expire, and whether there are promising new treatments in the pipeline. If any of the firm’s drugs are in clinical trials, you can view the results for yourself online to get a sense of whether things are going to plan. It wouldn’t hurt to look at both scientific and pharmaceutical press to see what experts are saying, either.
It’s also pretty easy to compare stocks by their price-to-earnings multiples. At the time of writing, Johnson & Johnson was trading at a price 15.6x higher than its forecast earnings for next year, in line with Merck but higher than Pfizer’s 12.2x. That suggests investors are less confident in Pfizer’s growth potential. If you disagree based on your own research, its stock might look like it’s going cheap.
To know that, you’ll want to get an idea of what a pharma stock is actually worth – and a discounted cash flow model is a good place to start. Our How To Value Stocks Pack goes into more detail, but the discounted cash flow model essentially helps you predict how much money a company will make in the future. Using the risk you’re taking on and the money you could be making elsewhere, you can then figure out how much its stock is worth now.
Of course, forecasting drug firms’ future cash flow is tricky. You might want to break it down by drug, estimating how big the potential market is for each of them and how much the company will be able to sell them for. Then you can add the various estimates together – along with the values of currently available drugs – to predict the whole firm’s future cash flow.
You could even take cash flow models a step further by risk-adjusting them. If, for example, you think Drug X has a 50% chance of making it through trials and bringing in $10 billion, and Drug Y has a 10% chance of making it through trials and bringing in $100 billion, the risk-adjusted value of Drug X is $5 billion, and Drug Y is $10 billion. Adjusting for the likelihood of success in this way helps you make a rational decision about what a potential drug is actually worth.
And if all these numbers have left you with a pounding headache, you could always just invest in the sector as a whole: funds like the Invesco Dynamic Pharmaceuticals ETF and iShares U.S. Pharmaceuticals ETF allow you to diversify your portfolio across a range of pharmaceutical firms.
See, aren’t you starting to feel better already? A dose of Finimize will do that for a patient…
🔷 The $1.2 trillion pharma industry is non-cyclical – that is, it doesn’t go with the economic tide – which makes it a good way to add resilience to your portfolio.
🔷 The drug development process is expensive and time-consuming – part of the reason drug costs are so high.
🔷 Pharma companies try to reap profits while they have patent exclusivity, because once that expires, prices and profits collapse.
🔷 Miracle cures are on the horizon, which has motivated a spree of acquisitions. But the threat of pricing regulation in the US concerns some investors.
🔷 You can look at P/E multiples to compare pharmaceutical stocks, or you can build a risk-adjusted cash flow model to figure out how much future drugs will be worth.
Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.