Investing in Pharma Stocks? Check These 3 Things First

The world of pharmacenutical stocks has a lot to offer investors. With their resilience in the face of economic issues and frequently in the face of market fluctuations as well, pharma stocks can serve as an anchor for your portfolio.

But it's a tricky category to invest in if you aren't sure what to look for, or how to judge whether a given stock is worthy of your money. Let's learn about three things that you should check on before taking the plunge with any pharma investment.

1. Capital allocation plans

Pharma companies use and generate a lot of capital. For example, in the trailing-12-month period, Eli Lilly (NYSE: LLY) reported capital expenditures (capex) of more than $8.3 billion. Reading a company's capital allocation plans lets you know whether to expect changes to spending across these key areas or not. If you as an investor don't really know how a company's capital will be used, you're essentially contributing your portion of shareholder's equity without being able to judge whether it'll be used efficiently and to your benefit.

Rather than buying equipment or other major categories of capex, pharmas tend to spend big on research and development (R&D). In Lilly's case, its latest 12-month R&D expenditures of $10.5 billion were nearly 26% of its revenue in the same period. Obviously R&D is a staple for growth, as biopharmas can't develop new medicines or new biotechnologies without it.

But dividends and share buybacks are also part of the capital allocation strategy, as is debt repayment. If a company you're thinking of investing in has a big debt load, but is opting to pay off its shareholders with a special dividend rather than start repaying its debts, that's probably a red flag that you need to look into before buying any shares.

So be sure to find that slide on capital allocation in the investor presentation, and think about whether it seems like a sustainable game plan for the business's health over the long term.

2. Big-earning drugs in the pipeline

Blockbuster drugs are medicines that earn more than $1 billion per year in revenue, and potential blockbusters are important for pharma investors to spot as early as possible in the R&D process.

The more demand there is for a given drug, the more its maker can benefit from economies of scale in marketing, manufacturing, and distribution, among other activities. So having a few blockbuster candidates in the pipeline implies more favorable margins down the line if they get approved for sale. If you're going to invest in a pharma stock, it behooves you to figure out how many big earners there might be in the works.

Take, for example, Amgen's (NASDAQ: AMGN) program for weight loss, MariTide; it should report phase 2 clinical trial data before the end of this year. Some estimates say that the main market it's targeting, weight loss, could be worth as much as $100 billion by 2030. In other words, MariTide wouldn't need to capture much market share at all to become a blockbuster, which is a bullish factor for Amgen's stock.

The alternative to a company with a lot of blockbuster drug candidates is one with niche programs. For a small biotech, targeting a small medical niche is often more than sufficient to drive big growth. But for pharmas, which are much larger and thus require far more sales and earnings to move the needle, developing a lot of niche medicines is not a substitute for having a few heavy hitters that could compete in the largest markets, or in untapped but likely sizable markets.

3. Big-earning drugs about to fall off

When a pharmaceutical business gets a medicine approved for sale, the timer starts ticking. That alarm goes off when its exclusivity protections expire, and competitors are allowed to produce generic copies. At that point, the drug's original developer usually sees its market share eroded very quickly by cheap new entrants.

Therefore, as an investor, it's important to check on when a pharma's biggest earners will lose their exclusivity. If there aren't many new programs expected to be approved to replace the lost revenue, the business will shrink afterward. And because it takes many years to develop a new medicine, it simply isn't possible to start work to replace an aging giant at the last minute. The more revenue a drug is responsible for, the more important it is to have suitable candidates lined up that could reclaim lost market share as soon as possible after the protections lapse.

Management teams confront this problem all of the time, but they don't always navigate it very effectively. The thing you should look for is a plan that's stated well in advance of when it's needed -- preferably at least three years before.

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Alex Carchidi has no position in any of the stocks mentioned. The Motley Fool recommends Amgen. The Motley Fool has a disclosure policy.