Biotech and Pharmaceutical companies that are in the development phase of their drugs can be highly risky investments. However, given the aging population and the immergence of obesity in the United States, both type of drug developers are gaining in popularity in the financial investment world. Of particular interest are companies that deal with diabetes, heart disease, obesity and mental health issues as those are seen to be the biggest issues facing Americans and therefore have the biggest potential markets if they can manufacture a successful drug.

There are three phases involved with getting a drug from the testing stage to the pharmacies. Phase 1 studies focus on the safety of the drug where they try to determine if there are unacceptable side effects. Phase 2 studies try to determine initial effectiveness of the drug as the people who are stricken with the ailment the drug is said to heal are given the drug in a trial. Other people with the same ailment are given placebos and the two different tests groups are compared to each other after a period of time. If the efficacy of the drug is sufficient, then Phase 3 is initiated. Phase 3 is much like Phase 2 except the sample size of the people tested is about 5-10 times larger to sure statistical significance i.e. the drug has been proven without a doubt to be effective in curing whatever disease it is intended to combat.

Should a company's drug be proven effective after Phase 3 with minimal side effects, the company can then send in an application to the FDA for approval to sell the drug in the US market. The FDA plays a major role in the timing of the company's revenues as they can stall a drug's release onto the market even after Phase 3 was successfully completed. Meaning they can stop the drug from getting onto the market even if it is proven effective with minimal side effects until they are 100% satisfied with it.

Given the expense and length of time it takes to develop a drug as well as the risks involved if it fails, there are several steps you should take in order to mitigate your risk when investing in these companies. It is never a good idea to chase a biotech that has been on a run on a rumour of success in the market. If you review Arena Pharmaceuticals, ARNA on the NASDAQ stock exchange, you can see it dropped from $7 to $2 in a few days Mid-September 2010 after it went on a healthy run from about $3 in June 2010 to $8 at the end of July. It has continued to sink under $2 since then as speculators are selling the stock and investors are trying to determine how much of a financial hit their current situation will cause them. The FDA was concerned with cancer development in rats from the testing of their obesity drug. Given that obesity has natural cures like diet and exercise, the FDA is hesitant to put drugs out on the market to cure that particular ailment. Now the company will have to spend its time and money proving to the FDA that the dosages given to the rats were well above what a human would have to intake to slim down safely.

Although there are success stories of biotech and pharmaceutical companies such as Dendreon (DNDN on the NASDAQ), which went from less than $3 in March of 2009 to over $50 a year later, the majority of these companies that have just one drug in their pipeline do not have good long-term returns if their stock price has already risen substantially over the past few months. There is an appropriate time to buy stocks which have had a fate like ARNA's which I will get into more detail in this article.

In order to protect yourself if you do choose to invest in these riskier companies, it is a good idea to invest in biotechs and pharmaceuticals with several drugs in their pipeline with them all being at different phases of development. This ensures that there is always a steady stream of news being disseminated in the market. If one of their drugs were to fail and the stock drops on the negative publicity, it's a lot more likely to turn around quickly if the next drug in its pipeline made progress a month later. Just by the nature of the stock market, the failed drug is long forgotten by the speculative traders and investment money starts to pour into the stock from the recent good news.

You also want to make sure that the company has plenty of cash to ensure that they have enough funds to go through the various phases for all their drugs. If there is bad news and the stock is under negative pressure, at least the company doesn't have to dilute the shares at low stock prices to remain solvent. They can wait until their stock price increases again to dilute the shares for an influx of cash, if needed.

The most conservative way of investing in drug companies is to invest in mature companies with many drugs currently earning them revenues. This group includes Merck, Pfizer, Novartis, Bayer, GlaxoSmithKline and others. This group is highly resilient to bad news. If you recall the Vioxx scandal a few years ago, Merck is the producer of the drug and still faces years of settling disputes. A smaller company would have gone bankrupt long ago but Merck still survives as it can use its revenues to pay for the settlement of those claims. Conversely, someone who is to invest in mature drug companies cannot expect a very high rate of return like DNDN. The adage of risk vs. potential return is very apparent in the biotech and pharmaceutical industry.

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