Over the last decade, investors in biotech and pharmaceutical companies have been taking risks that aren’t commensurate with the rewards. That’s what our new analysis of health care investing shows. Yet their contributions — and sacrifices — lead to important medical discoveries that benefit society as a whole.
A well-accepted principle for investing, called risk-reward parity, says that the expected returns on investments should be commensurate with the risks. In the second decade of the 21st century, investors with low appetite for risk were satisfied with 1% interest yields from U.S. Government bonds. Others, seeking higher returns, would have gambled in cryptocurrencies. No rational person, however, would have invested in an asset with an expected yield of U.S. government bonds that carried the risks of cryptocurrencies.
Yet investors in biotech and pharma companies seemed to have acted equally irrationally, at least on average, when compared to investors in other health care industries when investing is seen through the lens of return on equity.
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Profit margins are often used for comparing attractiveness for investments within an industry, because companies in the same industry tend to have similar abilities to turn assets into revenue. But profit margins are not valid measures for attractiveness of investments across industries, because different ones can have widely different efficiency in asset utilization. Automobile manufacturers, for example, require a much greater asset base than software developers to generate the same amount of revenue.
People generally think that biotech and pharma companies are attractive investment opportunities by looking at the profit margins of a few prominent companies. We used a different measure — return on equity — which is more suitable for inter-industry profitability comparison, to comprehensively compare companies across the health care sector. Return on equity is measured as net income divided by average shareholders’ equity in a given year, as reported in each company’s mandatory annual financial filing with the U.S. Securities and Exchange Commission. Return on equity is a more appropriate measure of investors’ profitability because it considers three aspects: 1) how are shareholder investments enhanced with borrowings to create assets; 2) how are assets used to generate sales; and 3) how much profit is created from sales. Notably, profit margin is just one leg of this three-part measure.
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In a study published Wednesday in PLOS ONE, we determined that between 2010 and 2019, biotech and pharma companies had median annual returns on equity of -53% and -18%, respectively. Note that these are median numbers and are not driven by outliers.
These returns are substantially lower than those of the other eight health care industries we examined — health care equipment; health care supplies; health care distributors; health care services; health care facilities; managed health care; health care technology; and life sciences tools and services — which ranged from -3% to +14%.
In addition to low returns, investing in biotech and pharma companies also carried the highest risks, which runs opposite to the precept of risk-return parity. Their median standard deviation of return on equity between 2010 and 2019 was more than 40%, while that for the other eight industries was below 25%. High standard deviation means higher uncertainty in returns from investments.
The stock market tells a similar story. Compared to the other health care industries, biotech and pharma companies had the lowest median buy-and-hold returns and the highest median idiosyncratic stock return volatility during the same period. Buy-and-hold returns are a measure of realized returns from the investments in the shares of companies. Idiosyncratic stock return volatility is a measure of risks of investment, over and above the risk of investing in the entire stock market.
Yet despite the low overall returns and high overall risks, investors seem to love biotech and pharma companies more than other health care companies. At the end of fiscal year 2021, biotech and pharma had a total market capitalization of $3 trillion, while the other eight health care industries had just $4 trillion combined.
Biotech and pharma companies largely live and die by their research and development outcomes. While an occasional investment may generate lottery-type returns for investors, many others are like the lottery tickets that fill wastebaskets and litter sidewalks. Investors, including working-class Americans who buy these stocks for their retirement accounts, facilitate the discoveries of new, effective drugs and fund their market launches, but do not seem to benefit much overall, even as their investments benefit the broad population and facilitate a dynamic drug discovery ecosystem that attracts brilliant minds to seek new cures.
Investors’ voluntary contributions of trillions of dollars to biotech and pharma companies seems to be more of a public service. When investors’ bets go wrong, they lose their own money. When they bet right, the general public and patients around the world benefit.
Anup Srivastava is a professor of accounting and Canada Research Chair at Haskayne School of Business at the University of Calgary, where Rong Zhao is an associate professor of accounting. Ge Bai is a professor of accounting at the Johns Hopkins Carey Business School, professor of health policy and management at the Johns Hopkins Bloomberg School of Public Health, and a visiting scholar at the U.S. Congressional Budget Office (CBO). The authors declare no potential conflicts of interest with respect to the research, authorship, or publication of this article. Bai received funding from Arnold Ventures. The views expressed here are the authors alone and do not necessarily reflect those of the institutions they are affiliated with.
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