low reward with high risk

HeOver the past decade, investors in biotech and pharmaceutical companies have taken risks out of proportion to the rewards. That’s what our new analysis of healthcare investments shows. Yet their contributions – and sacrifices – lead to important medical discoveries that benefit society as a whole.

A well-accepted principle of investing, known as the risk-reward balance, states that the expected return on investments should be commensurate with the risk involved. In the second decade of the 21st century, investors with a low risk appetite were happy with the 1% yield on US Treasuries. Others, who wanted higher returns, would have gambled on cryptocurrencies. However, no sane person would have invested in an asset with the expected yield of US Treasuries that carried the risk of cryptocurrencies.

Yet investors in biotech and pharmaceutical companies appeared to have behaved just as irrationally, at least on average, as investors in other healthcare industries when investing is viewed through the lens of return on equity.

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Profit margins are often used to compare investment attractiveness within an industry, because companies in the same industry tend to have a similar ability to convert assets into revenue. But profit margins are not valid measures of investment attractiveness across industries, because different ones can have very different efficiencies in asset utilization. For example, car manufacturers need a much larger asset base than software manufacturers to generate the same revenue.

People generally think of biotech and pharmaceutical companies as attractive investment opportunities by looking at the profit margins of a few prominent companies. We used a different measure – return on equity – that is more suitable for comparing profitability across industries, to compare companies as a whole in the healthcare sector. Return on equity is measured as net income divided by average equity in a given year, as reported in each company’s annual financial report to the US Securities and Exchange Commission. Return on equity is a more appropriate measure of investor profitability because it looks at three factors: 1) how are shareholder investments augmented by borrowing to create assets; 2) how assets are used to generate sales; and 3) how much profit will be generated from the sale. Interestingly, gross margin is only one leg of this three-part scale.

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In a study published Wednesday in PLOS ONE, we found that between 2010 and 2019, biotech and pharmaceutical companies had average annual returns on equity of -53% and -18%, respectively. Note that these are median values ​​and are not driven by outliers.

This return is significantly lower than the other eight healthcare sectors we looked at – healthcare devices; health care products; health care distributors; health services; health centers; managed health care; health technology; and life science tools and services — which ranged from -3% to +14%.

In addition to low returns, investing in biotech and pharmaceutical companies also carried the highest risk, which is contrary to the precept of risk-return balance. The median standard deviation of return on equity between 2010 and 2019 was more than 40%, while in the other eight industries it was below 25%. A large standard deviation means more uncertainty in investment returns.

The stock market tells a similar story. Compared to other healthcare sectors, biotech and pharmaceutical companies had the lowest median returns and the highest median stock return volatility over the same period. Buy-and-hold yield is a measure of the realized return on investments in company stocks. The idiosyncratic volatility of stock returns is a measure of the risk of an investment, beyond the risk of investing in the entire stock market.

Despite low total returns and high total risk, investors seem to love biotech and pharmaceutical companies more than other healthcare companies. At the end of fiscal year 2021, biotech and pharmaceuticals had a combined market value of $3 trillion, while the other eight healthcare sectors had a combined market value of just $4 trillion.

Biotech and pharmaceutical companies live and die largely by the results of research and development. While a single investment can generate lottery returns for investors, there are many others like lottery tickets that fill trash cans and litter sidewalks. Investors, including working-class Americans who buy these stocks for their retirement accounts, facilitate the discovery of new, effective drugs and fund their marketing, but don’t seem to profit much overall, even though their investments benefit the public and facilitate a. a dynamic drug discovery ecosystem that attracts brilliant minds to seek new cures.

Investors’ voluntary contributions of trillions of dollars to biotech and pharmaceutical companies seem more like a public service. When investors’ bets go wrong, they lose their own money. When they get it right, the public and patients around the world benefit.

Anup Srivastava is Professor of Accounting and Canada Research Chair at the Haskayne School of Business at the University of Calgary, where Rong Zhao is Associate Professor of Accounting. Ge Bai is a professor of accounting at the Johns Hopkins Carey Business School and a professor of health policy and management at the Johns Hopkins Bloomberg School of Public Health. The authors declare no potential conflicts of interest with respect to the research, copyright, or publication of this article. The opinions expressed here are the authors’ alone and do not necessarily reflect the opinions of the organizations they are affiliated with.


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