Biotech and drug company stocks involve a different type of investing. The ability to sell new drugs hinges on approvals from government bodies such as the Food and Drug Administration (FDA).

As a result, biotech companies, and to some degree, large drug companies, go into business ventures without the certainty of ever earning revenues, let alone profits. Hence, investors must approach investing in such companies with a different mindset, one that requires them not to think of these equities as individual stocks.

Evaluating Biotech Stocks Involves More Than Financials

Biotech stocks often become some of the most difficult to evaluate. They usually begin in the startup phase and depend on a small number of experimental drugs. To be sure, biotech stocks sometimes lead investors to outsized gains. At other times, a drug tests poorly, and a once-promising stock loses more than half its value.

The other issue centers on the limited help of a financial statement when evaluating a firm’s potential. Examining the financial statements can give insight into potential cash flow issues or the ability to raise debt.

However, the success of biotech stocks usually hinges on products that face the possibility of never making it to market. Hence, a scientist with a Ph.D. in biochemistry could potentially evaluate a biotech company better than a financial analyst can.

Treat Biotech Stocks Like Stock Options

Investors must realize that biotech stocks more closely resemble stock options. Instead of expiration dates, the critical date hinges on test results.

Negative results could take a stock to zero, or at least to a much lower value. Positive test results could bring this “option” massive gains. Most biotech companies focus on research only. Hence, most sell themselves to or partner with a larger company if testing succeeds.

Investors who prefer less risk can diversify. This can come in the form of biotech ETFs (exchange-traded funds) such as iShares NASDAQ Biotechnology Index (ETF) (NASDAQ:IBB). Investors can also turn to de facto biotech ETFs, better known as big pharma stocks.

Big Pharma Stocks Offer Diversification

Big pharma stocks derive some cash flow from drugs and products they have sold for decades. This results in financial statements that can show company stability and present an investment case to risk-averse investors.

Such is the case with the largest pharma company, Johnson & Johnson (NYSE:JNJ). JNJ stock has served as a cash-flow bellwether for decades with 56 years of annual dividend increases. JNJ also boasts a AAA credit rating, one of only two companies to do so.

However, the majority of big pharma profits come from new drugs under patent protection. To create these patented drugs, they spend billions every year on biotech research. Unlike small biotech stocks, large companies research dozens of potential medications at the same time. Hence, each of the major big pharma stocks acts as a well-funded, diversified biotech ETF.

If a Merck & Co., Inc. (NYSE:MRK) or a GlaxoSmithKline plc (ADR) (NYSE:GSK) sees poor results in a drug trial, the negative effects on MRK stock or GSK stock are limited. If the drug trials succeed and FDA grants approval, stock gains could exceed that of the S&P 500.

Pfizer Inc. (NYSE:PFE) serves as an example of both situations. When Lipitor and Viagra brought success in treating certain conditions, PFE stock performed well. Unfortunately, PFE has not developed new drugs that match the past success of Lipitor or Viagra. When the patents on both drugs expired, company profits fell, and PFE stock plateaued.

However, PFE continued to spend money on research, and its next great drug may come on the market soon. Owners of PFE stock will enjoy a 3.7% dividend yield while they wait for this new drug.

The Bottom Line

Given revenue uncertainty, investors should treat biotech stocks like stock options, and big pharma equities like ETFs.

In this field, even professional scientists struggle to evaluate potential drugs. Hence, investors can rarely tell whether a biotech stock will become the next great buyout story or fall to zero. For this reason, bets on biotech stocks should not venture beyond small, speculative investments.

Investors should devote most of their focus and investment capital to ETFs or the de facto ETFs known as big pharma companies. These firms research dozens of drugs at the same time. For that reason, their stocks can withstand multiple testing failures. They also have the ability to market these new drugs and earn revenues from previously approved drugs.

Profiting from drug stocks can make investors rich or at least keep them rich. However, to succeed with biotech or big pharma stocks, one must understand how they actually work and invest accordingly.

As of this writing, Will Healy did not hold a position in any of the aforementioned stocks.