Australia's biotech sector is uninvestable

Few sectors have as many disaster stories as biotechnology. Here's why you should steer clear.  

If you're out to buy lottery tickets, you'd be hard pressed to find a more popular dispensary than biotechnology. Australia consistently punches above its weight on the global stage, producing 3% of the world's medical patents, while having only 0.3% of its population. The local biotech sector is capitalised at twice the OECD average as a proportion of the stock market, with more than 50 companies to choose from.

Many investors try to make their fortune in biotechnology. Those who make the attempt, however, quickly learn the differences between theory and practice.

Reason 1: Circle of competence 

The biggest mistake we see investors make when buying biotech stocks is this: they buy with hope that a clinical trial will work out - often encouraged by excitable management and a clever marketing department - despite no special insight into the approval process or compounds under review. 

In fact, you could argue that biotech stocks lie outside everyone's circle of competence - even the company's scientists don't know whether the treatment works, that's the whole point of clinical trials.

Large pharmaceutical companies - the smart money - rarely invest in early-stage biotechs, preferring instead to license a product after it receives approval or buy the company just prior to commercialisation. 

Reason 2: You're rolling the dice

A biotech's ability to make money hinges on a product - usually just the one - passing through the various stages of approval and three main phases of clinical research. That journey can often last a decade and the payoff is uncertain. 

A 2014 study of biotech success rates published in Nature found that only two-thirds of clinical trials make it past Phase I, then just 32% of Phase II trials proceed to Phase III. And, even if they make it that far, there's still only a 60% chance they'll move from Phase III to commercialisation. Put all that together and a typical product has little more than a 10% chance of making it all the way through. Even then, there's no guarantee a product will be a commercial success.

Reason 3: Built to lose

Early-stage biotechs are unlike most other stocks because they're specifically designed to bleed cash and roll the dice with investor funds. Inconveniently, of the 50 or so biotechs listed on the ASX, only four have actually earned any money. Ever.

What's more, limiting yourself to companies whose products are in late-stage development is no fail-safe either. These companies have a better life expectancy than biotechs lingering in Phase I no-mans land, but it's those final stages of development that are also the most costly. Expenses are growing exponentially and Phase III trials generally account for around 60% of total costs, which almost always stretch into the tens of millions for large studies. 

So if you are fortunate enough to get an email saying your stock's Phase II trial was successful, nine times out of ten you'll wind up with another email informing you that your ownership stake will be heavily diluted by a capital raising to fund the final stage of the trial process. And if you think you can get away with only buying companies past Phase III, the odds are still against you: other investors will have seen the positive headlines and may have chased the share price too high. 

Picking the long-term winners in this industry is next to impossible, let alone trying to predict a company's future profits and come to an appropriate valuation. We're happy to watch the biotech sector from the sidelines.


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