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The pharmaceutical industry, with nearly $1.5 trillion in global sales a year, offers many opportunities for investors. Some pharma stocks provide dividends, while others have potential for significant growth. Beyond these potential upsides, investing in pharmaceuticals also helps expand health care for people around the world.

But as with any industry, pharmaceutical stocks have risks, and investors would be wise to research each company before they buy stock. Here’s some key information about the industry and ways to find pharmaceutical stocks for interested investors.

An Intro to the Pharmaceutical Industry

Pharmaceutical companies research, develop, make, and sell medications, including preventive medicines, treatments, and vaccines. Two segments of therapeutics make up the industry: pharmaceuticals and biologics. It’s also important to know the difference between pharmaceutical stocks and biotech stocks.

Pharmaceutical drugs are tablets or pills made out of synthetic or plant-based chemicals. Because they are small and fairly easy to make, companies can produce hundreds of thousands of them. When drugs are first approved, they generally have a patent or market exclusivity, meaning that only the pharma company that developed them can manufacture and sell the drugs.

Once the patent or exclusivity ends, other companies can create generic forms of the drug and begin to compete with the pharma company. The generic drugs are chemical copies of the original drug but sell at lower prices, making it hard for the original pharma company to compete. This can lead to its stock losing value.

Meanwhile, biologics are products such as vaccines, gene therapies, and medications for blood disorders that are large, protein-based molecules made out of living cells. Biologics are more complex to manufacture, which is one reason they’re more expensive.

They also have tighter restrictions on distribution than pharmaceuticals do. These factors make it more challenging for companies to enter this space and for competitors to succeed. If competitors do create a similar product, it is called a biosimilar. Unlike generics, biosimilars aren’t interchangeable, so biologics don’t have the same stock drop-off that pharmaceuticals do.

It takes about 10 years and an average of $1.3 billion to $2.8 billion to bring a new drug to market, but in special circumstances, the FDA can expedite approval.

Why Invest in Pharmaceuticals?

With pharmaceuticals, whether investors are looking for high growth potential, long-term value, or stable dividends, they can find a pharma stock that will fit the bill. There are hundreds of early-stage and established stocks, mutual funds, and exchange-traded funds out there.

About 10,000 Americans turn 65 every day, according to the AARP. And by 2030, the country will have more residents 65 and older than children, the Census Bureau has projected.

This means more people needing health care and pharmaceutical drugs, which in turn is expected to make pharma stocks grow. U.S. health spending is projected to reach nearly $6.8 trillion by 2030, according to the Centers for Medicare & Medicaid Services.

Pharmaceutical stocks don’t always follow the same trends as other stocks because people need medications no matter what is going on in the market. This doesn’t mean that pharma stocks always perform better than the broader market, but sometimes they don’t follow the same lines. Certain pharmaceutical exchange-traded funds (ETFs) have historically performed quite a bit better than the S&P 500 Index.

The health care sector can perform well during tough economic times, since people always need health care no matter what is going on in the world. About 49% of people in the U.S. report having used at least one prescription drug in the past 30 days, with 24% using three or more, according to the Centers for Disease Control and Prevention.

This translates to the companies that make those drugs consistently earning revenue even when the rest of the stock market is down. Larger companies have fairly consistent income streams, while smaller companies that show promise get funding from investors and sometimes get acquired by larger companies.

A few other reasons pharmaceutical stocks look promising as a long-term investment are:

•   People are living longer, and the majority of elderly Americans take prescription medications. The longer people live, the more years they will be paying for those drugs.

•   The health care sector is expanding in countries outside the United States.

•   The government has been spending more on health care research.

•   New types of therapies, such as gene therapy, are getting more sophisticated. Some of these are very expensive.

How to Choose Pharmaceutical Stocks

With so much potential in pharma, it can be difficult to navigate the hype and figure out what’s really a good investment. Billions of dollars are invested in medical research and drugs each year. But not every company becomes a success.

As with any stocks, investors will want to research pharma stocks before buying. Here are a few key factors to look at when evaluating stocks.

Growth Prospects

By looking at a company’s earnings and revenue, one can see how much it’s been growing and whether growth is slowing down. Investors can also look into each company’s pipeline to see how close to market a drug being developed is.

Pharma companies have to go through certain steps to develop, test, and get drugs approved. They often make pipelines available to the public, so investors can see which drugs are in the early stages of development, preclinical testing, going through clinical trials in humans, or getting FDA approval or other necessary regulatory approvals.

Drugs may get approval for treatment of certain diseases or for specific demographics, but the makers can then apply for approval for additional uses. If they get the expanded approval, this can lead to growth for the company.

Knowing when to buy stocks is challenging, and trying to time the market generally isn’t a good strategy. That said, investors can follow different pharmaceutical companies to see when they have the potential to grow and become successful. If a pharma company has patents that are close to expiring, for instance, this may slow down growth, as competitors can create generic forms of the same drugs.

The process companies go through to develop and bring drugs to market is generally as follows:

•   Drug discovery: During this phase, drugs and the diseases they can potentially treat are discovered.

•   Preclinical trials: Potential drugs get tested in test tubes or on live animals.

•   Clinical trials: Small human trials determine a safe dosage and how humans react to it. Then, groups of 100 or more people test the drug to discover short-term side effects and optimal dosage. Finally, groups of hundreds or thousands of people test the drug to determine efficacy and safety. When drugs reach the clinical trial stage, this could be a good time for investors to keep an eye on them. If a drug makes it through trials, the company has potential for significant growth. But if the drug fails during testing, the stock is unlikely to do well.

•   Regulatory approval: In the United States, the Food and Drug Administration’s Center for Drug Evaluation and Research assesses and approves new drugs, and in the EU, approval is completed by the European Medicines Agency. If the benefits of the drug outweigh the side effects and risks, and the drug is a good alternative or additional treatment for the disease it is targeting, these agencies will consider approving the drug.

Types of FDA Application

There are different types of pharmaceutical FDA applications, some of which give companies more potential for stock growth than others. The application types are:

•   Investigational new drug application: This is the first application step that companies must go through.

•   New drug application: This is an application to market and sell a new drug. Companies filing this application have the most potential for stock growth because they are introducing a new product to market.

•   Abbreviated new drug application: Companies developing a generic form of an existing drug go through this application.

•   Therapeutic biologics application: This is required under the PHS Act for biologics.

•   Over-the-counter drug application: This is for companies looking to sell over-the-counter drugs, which are categorized as being safe to distribute without a prescription.

Dividends

Not all pharmaceutical companies pay dividends, but some of them do provide consistent payouts to investors. The dividends can add up.

Qualitative and Quantitative Metrics

The same rules apply to pharmaceutical stocks as to any other stock when it comes to evaluation. Investors should look at a company’s valuation, revenues, growth, leadership team, product pipeline, and other key metrics to decide whether to invest. Stock valuation ratios, such as price-to-earnings ratio and price-to-earnings-growth ratio, are very useful when comparing different stocks within the same industry.

However, some pharmaceutical companies are not yet profitable if they are in the drug development and trial phases. In this case, investors can look at the rate of cash burn: how much money the company is spending each quarter to develop a drug. It’s very expensive to develop a drug, so if a company is burning through cash and doesn’t have much left to work with, this might not bode well for the stock.

Another useful metric to look at is the price-to-sales ratio. This compares a company’s sales to the price of its stock. If the company doesn’t have sales yet, investors can make predictions about what those sales figures might look like.

Trends and Developments

Over time, trends in the types of diseases being targeted and the types of therapies being developed change. Investors can look into stocks in popular areas of treatment to find stocks with growth potential.

For instance, many drugs are in development to treat breast cancer and non-small-cell lung cancer. Treatments that are bringing in significant revenue globally include oncologics, antidiabetics, respiratory therapies, and autoimmune disease drugs. Additional lucrative treatment areas include antibiotics, anticoagulants, pain, and mental health.

Risks of Investing in Pharmaceutical Stocks

As with any type of investment, pharma stocks come with some risks. Some of the main risks to be aware of are:

•   Clinical failure: Many drugs don’t make it through the phases of clinical trials. If a drug has made it to the final stage, it’s more likely to succeed, but even at this phase, drugs can fail.

•   Inability to obtain approval: Just because a drug does well in trials doesn’t mean it will be approved by regulatory agencies.

•   Difficulties getting reimbursement and pricing drugs: Health insurance companies, government programs, or individuals must cover the cost of drugs, and companies aren’t always able to secure the money they need. Sometimes, companies are pressured to lower the price of drugs to make them more accessible, and this can result in financial struggles for the company.

•   Industry competition: As mentioned, when patents run out, pharma companies can struggle to keep up with competitors that develop cheaper generic versions of drugs. In addition, during the drug development phase, it’s not uncommon for multiple companies to be working on medications to treat the same illness. If one company can make it to trials or get approval first, this can put them way ahead of the competition, especially if it results in patent exclusivity.

•   Litigation and liability: In the pharmaceutical industry, lawsuits are common. Drugs can also be recalled from the market if they’re found to be unsafe.

Investing in Pharmaceutical Stocks

If you’re looking to start investing in the pharmaceutical industry, you might consider buying pharmaceutical ETFs. Or, you could do your due diligence and choose individual stocks, aiming for stable dividends or growth potential. Before investing, it helps to familiarize yourself with the pharmaceutical industry to better understand how to choose pharma investments, and also ensure you understand the potential risks of investing in pharmaceutical stocks.

Online platforms are a great tool to use if you’re investing in ETFs and other stocks, whether in the pharmaceutical industry or elsewhere. SoFi Invest®, for instance, offers a suite of tools to track specific stocks, select individual stocks, trade fractions of stocks, or purchase ETFs.

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