A Prescription for Value Investing: Considerations When Investing in Pharmaceuticals and Biotechnology
Drug development can be a lengthy and costly process, but the final lifesaving product is arguably priceless.
Perhaps the most important rule of long-term value investing is diversification into businesses with strong economic moats. But what about industries such as pharmaceuticals or biotechnology, where there really isn't much public/available data to start with? Given the future growth prospects of the pharmaceutical and biotechnology space, an allocation to these industries must be considered as part of a balanced portfolio.
However, value investing metrics focused on the financial fundamentals of a company, such as a leverage ratio (net debt/earnings before interest, taxes, depreciation, and amortization) < 2.5x, or a payout ratio (dividend/free cash flow) < 80%, simply do not compute for the majority of early-stage pharma and biotech companies. Investing in pharma and biotech thus requires us to look into the future with a firm appreciation for the past, and specifically focus on a company's pipeline as they develop specific pharmaceuticals through a process that includes four major trial stages:
- Stage 1: checking for safety
- Stage 2: checking for efficacy
- Stage 3: confirming results in a larger population
- Stage 4: testing long-term results in a more diverse population
There is a general exponential growth of the sample size as the drug passes through the first three phases. It is, however, important to focus one's attention on Phase 2 and 3, as Phase 1 usually has the smallest number of participants, when compared to Phase 3, which has the most data. In order to get a better idea of the chances of success of a drug's development as a means to use it as a benchmark, the Biotechnology Innovation Organization (BIO) conducted a large-scale study, covering 7,455 programs.
According to the report, only 63.2% of drugs make it from Phase 1 to Phase 2, 31% make it from Phase 2 to Phase 3, and 58.1% make it from Phase 3 to the final Phase 4. Indications, the technical term for treatment purposes, can also lead a drug candidate at different phases at the same time; so, it is therefore important to evaluate different success rates in this light. For instance, oncology only has a 40% Phase 3 success rate, which is significantly lower than other indications. Using statistical analyses, we can similarly calculate the likelihood of approval (LoA) by multiplying the probability at each phase of the development, yielding one final informative ratio.
Using the average success rate per phase and indication is important to evaluate investment decisions as a first step. It is also prudent to then evaluate the specific data results and contextualize them with their potential commercial impact. For instance, if the drug candidate would be the first in the market to treat a specific disease, even if it has a statistically lower chance to get approved, we can assume that it should have a significantly higher value during the early phases of development.
On average, it takes around 10 years and almost 1,000 different candidates for a single drug to get to the marketplace from its initial discovery, which is why successful companies are granted a solid economic moat of patent protection (sometimes for close to 20 years). The aforementioned clinical trial stage, involving the different phases, usually take an average of six to seven years with the preceding the discovery stage taking an average of three to six years.
More specifically, Phase 1 usually takes several months, Phase 2 typically takes several months to two years, and Phase 3 takes, on average, one to four years. After completing the first three phases, the drug goes through the New Drug Applications or Biologics License Applications (NDA/BLA) process, subsequently going through Phase 4, which, by definition, is evaluating the long-term effects of the drug. It is also important to note that trials vary in both length and frequency, that participants may leave at any point, and that researchers may prematurely end it. Interestingly, around 80% of clinical trials are delayed due to a lack of enough volunteers.
According to the U.S. Department of Health and Human Services, a Phase 1 trial typically costs around US$4 million, with Phase 2 trials costing around $13 million, and Phase 3 costing approximately $20 million, with costs differing substantially based on the clinical indications and end points. More specifically, the median cost per participant of a Phase 3 trial stands at around $40,000. Accordingly, many factors, such as study size, locations and type (academic or commercial) impact the Clinical Research Organization (CRO) quotation for a specific drug.
It is important to take both the above timelines as well as the overall costs of the trial into considerations before making an investment in a pharmaceutical or biotechnology company. This will help us understand if the company has enough cash on its balance sheet to see through the development of their respective pipelines. Another important consideration is a deep dive into the backgrounds and track records of the board, managerial and clinical teams steering the company forward past the different phases.
At the end of the day, drug development can be a lengthy and costly process, but the final lifesaving product, is arguably priceless.