Tuesday, 19 July 2016

A Guided Tour of the Market 1

Over the long haul, a big part of successful investing is building a mental database of companies and industries on which you can draw as the need arises.

Health Care

Health care firms benefit from consistent demand. Even when the economy is in the tank, people still get sick and need doctors and hospitals. As a result, the health care sector has traditionally been a defensive safe haven.

Health care companies often benefit from economic moats in the form of high start-up costs, patent protection, significant product differentiation, and economies of scale. This makes it tough for new players to enter the market, particularly for drug companies with valuable patent rights, managed care organizations with large provider networks, or medical device firms with long clinical track records. These characteristics make for great profitability [...].

Size is another barrier to entry for drug companies. Developing a single drug can take 15 to 20 years to get through the entire research, development, and regulatory process and can cost hundreds of millions over that time frame.

Brand name drugs enjoy patent protection for 20 years from the date the company first completes the patent application. However, because a patent application is usually filed as soon as a drug is identified and not when it hits the market, drugs rarely enjoy 20 years of monopoly profits because a significant portion of the protected period is eaten up by trials and the approval process. Many drugs enjoy only 8 to 10 years of patent protection after they are launched in the marketplace.

Generic drug makers can charge much less because they don't have to recoup the $800 million in per drug research and development costs.

If you're considering buying shares in a drug company that depends on a specific drug for a significant percentage of its sales, don't bank on the money continuing to come in after the patent expires.
Drugs that treat conditions affecting a large percentage of the population typically have better potential than niche products. So do drugs that treat chronic conditions, because patients must continue taking the medication to stay healthy.

It might sound strange to view megablockbuster drugs as a negative, but they can become a disadvantage. If a drug's revenues become a large enough piece of the pie, a company's fate can be linked too heavily to that drug. Because that drug will eventually lose its patent protection, we think it's wise for investors to account for the single-product risk by demanding a slightly larger margin of safety.

Although the best biotech companies can generate enormous free cash flow [...] most are too speculative for all but the most aggressive investors. Picking successful firms requires a bit of skill, some understanding of the science, and a lot of luck.

As with the other health care sectors, the aging population and increase in life expectancy will drive sales growth in medical devices.

In addition to their attractive growth characteristics, device companies also typically boast wide economic moats. Economies of scale, high switching costs, and long-term clinical histories all serve as high barriers to new entrants.

Device firms are not without risk. Product cycles can be very short, so companies must spend heavily on research and development to keep up with their competitors.

Insurance and managed care firms are subject to intense regulatory pressure and widespread litigation, making them somewhat less attractive than some other health care industries. They typically don't have wide economic moats.


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