Biotech investing 101

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Biotech can be an exciting sector full of companies using cutting-edge technology to create the medicines and foods of the future.

Like the tech sector, it’s an area of the market that’s full of established companies, but also plenty of start-ups that have yet to prove themselves. Here’s some information that investors might find helpful before investing in the biotech industry.

Related: Pros & cons of investing in tech stocks

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What is a biotech stock?

Biotech investing 101

A biotech stock is an ownership share of a company that focuses on biotechnology. The biotech industry focuses on the study and use of biological processes to make agricultural and medical products.

The medical branch of the industry focuses on the creation of new drugs and ways to treat diseases, and the agriculture branch uses genetic modification to help create new pest-resistant crops, for example.

Biotechnology has its roots in the first DNA cloning experiments at the Stanford, California lab or researchers Stanley Cohen and Herbert Boyer in 1973. Since then, genetic engineering has been used to edit genetic sequences, design genetically modified microorganisms and cells and even create transgenic plants and animals.

Currently, biotechnologists use techniques such as gene cloning, DNA sequencing, directing genetic mutations, biomolecule labeling and detection and RNA interference.

Since the 1970s, biotech companies have largely existed outside of the chemical-focused pharmaceutical and agricultural companies that came before them.

Biotech start-ups can be found around the globe, though they often clustered near sources of venture capital, such as Silicon Valley or in research hubs, such as North Carolina’s Research Triangle.

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What’s the difference between biotech and pharmaceuticals?

Biotech investing 101

So, what’s the difference between biotech and pharmaceutical companies? After all, they both produce medicines and treatments for disease, so an investor would be forgiven for confusing the two. Yet the industries have some distinct differences. Here’s an overview:

Pharmaceutical companies have historically researched and developed medicines based on artificial or chemical sources. For example, they may take a look at traditional remedies and isolate the active ingredients, turning it into a drug that can be manufactured synthetically.

Or through an act of serendipity, a pharmaceutical company may stumble across a chemical compound that can be used as a drug.

Portions of these companies may also focus on biotech. However as a whole, these companies may not be viewed as strictly biotech companies, because this sector is not their main source of revenue.

Biotech companies, on the other hand, focus on biological processes such as DNA sequencing and genetic modification.

Investors may also encounter the term “biopharmaceutical”, which can refer to the medicines produced by biotech processes. For example, a biotech process known as biosynthesis can produce chemicals — including some medicines — inside cells with the aid of multiple enzymatic reactions.

If it’s used for medicinal purposes, the resulting chemical might be referred to as a biopharmaceutical.

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What are the risks?

Biotech investing 101

As with any stock, there are risks associated with biotech companies, many of which that are specific to the industry. Before investing in these companies it’s important to understand what some of these risks are.

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Clinical failure

Biotech investing 101

Clinical failure is one of the most important risks to understand. All biotech companies that are producing medical products must test them rigorously to assess their safety and how well it actually treats the condition it targets. There is a possibility that the drug or treatment will not be effective or will prove to be too dangerous for consumption.

The process of testing begins in preclinical trials in which treatments are tested in a lab in test tubes or petri dishes without using human or animal subjects. Other preclinical trials might use animal subjects to test drugs. Many drugs don’t make it out of this phase of testing, so a biotech startup with drugs that are only in preclinical trials may be especially risky since the future success of these drugs is largely unknown.

If a drug passes the preclinical phase, it goes on to phase one, where the safety of a drug is tested. Then it moves on to phase two trials, which test dosage levels and how well the drug works. And finally, phase three trials are large clinical trials that test the efficacy and safety of the drug. A very small percentage of drugs make it past this final phase.

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Regulatory issues

Biotech investing 101

Even if a drug successfully makes it through its clinical trials, it must win approval from the U.S. Food and Drug Administration (FDA). A rejection by the FDA may mean the drug is dead in the water.

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Selling the drug

Biotech investing 101

Once a drug is approved by the FDA, biotech companies still have to convince doctors to use it and insurers to healthcare programs to pay for it. The company will also likely need to assemble marketing teams to promote the drug to doctors and consumers. These efforts can be costly and can fail to produce consumer demand.

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Patent expiration

Biotech investing 101

Biotech companies can enjoy protection from competitors in the form of a patent for 20 years. But once the patent runs out, competitors can make their own version of the product, which often stock drives prices down.

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What role does the FDA play?

Biotech investing 101

One of the FDA’s responsibilities is to evaluate medical treatments before they hit the market. These evaluations prevent medicines that don’t work from making it to consumers, and they provide information to doctors and patients about how to use the drug correctly.

When a company develops a new drug, they first test it themselves and then send the result to the FDA’s Center for Drug Evaluation and Research.

The CDER uses a team of scientists, doctors and pharmacologists to evaluate these results and determine whether the drug’s benefits outweigh its known risks. If they do, then the drug may be approved. If not, the drug company is sent back to the drawing board.

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Choosing a biotech stock

Biotech investing 101

There are a number of factors to consider when evaluating a biotech company, from a company’s financials to the problem it targets to how it’s managed. Before investing in a biotech company, investor may want to research the following:

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Funding

Biotech investing 101

It may take years for a biotech company to develop a product, license it and make back the money it spent developing it. As a result, investors may want to look for companies with a cash reserve of two years or more.

Investors should also investigate where a company is getting its funding and if there’s a possibility to get more. For example, can the company sell more shares to fund its development? The flip side of that process is that selling too many shares may actually be diluting the market.

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Debt

Biotech investing 101

Developing a biotech product can be expensive. In addition to being able to fund research, development and the marketing of a drug, biotech companies will likely have some debt to pay off. Investors may want to consider companies that aren’t overleveraged with huge loans to pay back to private investors or banks.

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Support

Biotech investing 101

Investors may also want to investigate what kind of outside support a company may have. Small companies in particular may have a hard time going it alone, but backing from a major corporation can put them on more stable ground.

Better, yet, a company with multiple partners is even more protected, because if one backs out, the company still has support from others and won’t be left floundering on its own.

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Management

Biotech investing 101

While investigating a company’s financials, investors may want to do a little digging into who is managing the firm, especially smaller startups. Managers with business acumen who are knowledgeable about startups are important.

But also take into account whether a company has management with scientific credentials such as MDs or Ph.Ds who can understand the research and science involved in the company.

Managers with a scientific background may be better equipped to understand the impact research results may have on the business side of things and be able make decisions accordingly.

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Area of research

Biotech investing 101

What issues a biotech product is tackling can have a big impact on their success. For example, investors may want to look to medical biotech companies that are targeting common diseases such as cancer, diabetes, or heart disease.

These diseases are prevalent among the population, helping ensure that a successful product may do well on the market.

The opposite of targeting companies with products that may have broad appeal is considering those that fill a small niche. Orphan drugs target extremely rare diseases. Because of the relatively small market for them many companies are loath to develop them.

However, this fact may help a firm that develops one become successful as it helps eliminate competition. And a successful orphan drug may be protected for a number of years under its patent.

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More than one product

Biotech investing 101

It takes a lot of resources to get a new medical treatment through clinical trials and FDA approvals. It’s not unusual for a biotech company to put a lot of its energy toward the product it thinks is most likely to make it over this hurdle.

However, crossing the finish line is not guaranteed. If a new drug isn’t approved and the company doesn’t have a backup plan, investors may be left hanging. So look for companies that haven’t thrown all their eggs in one basket and have another product or in the pipeline as well.

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Market readiness

Biotech investing 101

Investors may want to keep a close eye on companies with products that are nearing market readiness. One key sign to watch out for are drugs that are in control group trials.

Phases one and two of clinical trials don’t require controls, but phase three, the final phase of trials before the drug heads off for FDA approval, does require controls. That said, controls are an expensive undertaking, and including a control group in one of the first two phases of trials may signal a company’s confidence in their product.

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Press releases

Biotech investing 101

When biotech companies alert the public to new developments, there are a couple things to watch out for. If the company seems to be sending out an inordinate amount of press releases, it may be worth double checking why.

Take a look at Clinicaltrials.gov to see the status of a company’s active trials. If there are a lot of them, those press releases might make total sense. If there aren’t so many, then the company might be blowing a little bit too much hot air.

Additionally, clinical trials have both primary and secondary endpoints — the goals the company was hoping to meet. A company that touts its secondary endpoints while remaining largely silent on its primary endpoints may be masking the fact that it didn’t do so well meeting them.

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Getting started investing

Biotech investing 101

Investors who have researched biotech companies and are ready invest can open a brokerage account and buy individual stocks. They may also buy shares inside of retirement accounts such as an IRA or 401(k).

Investors who are interested in individual companies may choose an active investing account that allows them to handpick the stocks they are interested in.

Many biotech stocks can be pricey, and if an investor wishes to include a stock in their portfolio but can’t afford the full sticker price, they may consider dollar-based investing in which they can purchase fractional shares of companies.

For a more hands-off approach, investors may choose an automated investing account that creates a balanced portfolio that may include biotech stocks based on an investors goals.

Be aware that choosing individual stocks can open up investors to greater market risk should that stock perform poorly. Investors may consider mutual funds or exchange-traded funds that hold a basket of biotech stocks.

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This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.

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