A drug’s mechanism of action (MOA, for short) explains how and why a drug produces its intended effect. As an example, the human body produces prostaglandins that cause inflammation, fever, and pain, among other effects. Two of the enzymes that help produce prostaglandins are COX-1 and COX-2. Ibuprofen is a commonly used, over-the-counter drug that blocks COX-1 and COX-2, which is why ibuprofen reduces inflammation, fever, and pain.

Why does a drug’s MOA matter?

1. MOA guides further testing of the drug in clinical trials. Knowing how ibuprofen works, an investigator might test it for management of COX-related inflammatory diseases. However, since ibuprofen is not known to impact metabolic pathways, it might not be a good candidate to treat type 2 diabetes.

2. It predicts a drug’s side effects. COX-2 plays a role in producing prostaglandins that cause inflammation and pain. On the other hand, COX-1 produces prostaglandins that protect the stomach lining. Ibuprofen just happens block COX-1 in addition to COX-2. Because COX-1 gets blocked, repeated use of ibuprofen can reduce the stomach’s mucus production and cause gastric side effects. Knowing this, physicians can appropriately counsel patients on ibuprofen use and closely monitor them for gastric adverse effects, as needed.

3. MOA can predict behavior of other drugs in the same class. Naproxen is another drug that blocks COX-1 and COX-2, in the same class as ibuprofen. Knowing what we now know about ibuprofen, we can reasonably predict that taking naproxen might help patients with inflammation, fever, and pain with the concomitant risk of heavy use causing gastric side effects.

4. Revising MOA can result in better drugs. Since blocking COX-2 usefully addresses symptoms and blocking COX-1 appears to cause gastric issues, it would be great to have a drug that only blocks COX-2 since this would do all the useful things ibuprofen does with fewer adverse effects. This logic led to the development of celecoxib: cele short for selective, cox for the COX enzymes, and ib short for inhibitor. Celecoxib selectively inhibits COX-2, causing fewer gastrointestinal side effects than ibuprofen and naproxen while still reducing inflammation, fever, and pain.

These four points provide a sufficient rationale for you to pay attention to it and learn about it.

Why do investors need to know and understand a drug’s MOA?

1. Determine the degree of differentiation a drug might provide, particularly in the competitive environment at time of launch. As an example, I would be less excited today about the launch of a PD-1 inhibitor in melanoma designed similarly to Keytruda and Opdivo. Since these two blockbusters are already entrenched in the melanoma market, a new PD-1 inhibitor that is expected to be undifferentiated from them would be unlikely to gain significant market share.

2. Estimate the probability of success. The disadvantage from being late to launch within a drug class could be counterbalanced by the increased likelihood of success. Ojjaara’s clinical development in primary myelofibrosis had a higher likelihood of clinical success since Jakafi, another JAK inhibitor, already demonstrated efficacy.

3. Assess the potential for indication expansion. Sildenafil, a PDE-5 inhibitor, helps patients with erectile dysfunction and pulmonary hypertension. If you were analyzing tadalafil when it was in clinical trials for a single indication, knowing about the two indications in which sildenafil works would show you that tadalafil might be expanded to at least two indications as well. This could allow you to identify additional revenue opportunities that other retail investors might miss.

These three points provide a sufficient rationale for you to know it for drugs in which you are considering an investment.

A watch-out for investors

MOA is a complex biological topic. For instance, although selective COX-2 inhibition helps with gastrointestinal side effects, it might be associated with worse cardiac effects. Although worse cardiac effects have not been observed with celecoxib, another selective COX-2 inhibitor named rofecoxib has been withdrawn due to this. Keep in mind that inferences in biology often lead to unexpected results when moving a drug from the lab to the clinic.

Like many, I have benefitted from index fund investing. Paraphrasing Charlie Munger, the diversification provided by an ETF tracking the S&P500 served as a useful protection against my ignorance at the time. I believed in the broader growth of the US public market but did not know which companies would win. A successful decade in VOO and ITOT had me convinced of the index fund strategy. Recent re-reading of value investing texts pushes me to ask if these returns simply reflect an unusually positive period for US equities. Today, while index funds continue to offer retail investors value, I have become less convinced that indexing will outperform informed security selection for me.

Passive index fund investing typically does not depend on valuation. As passive ownership grows, we must ask whether securities not commonly purchased by index funds are undervalued. Many such securities also have smaller market caps, with lower liquidity, institutional participation, and analyst coverage creating potential mispricing. Index funds still serve a purpose for some, but investors with deep business knowledge in specific niches could find opportunities to perform better.

Larger companies do have advantages that cannot be easily achieved by smaller companies, such as economies of scale. However, this is often paired with organizational inefficiencies that enable smaller companies to win in specific industries. In recognition of this seeming contradiction, my goal was to identify an industry satisfying the following conditions:

1. Smaller companies are not at a disadvantage solely due to their size and can effectively compete with larger companies if run well

2. When they win, smaller companies have the potential for rapid growth, which would correspond to outsized investment returns

3. Specialized knowledge can materially improve the accuracy of revenue stream predictions

Companies operating in the life sciences, including biopharmaceuticals, medical devices, and biotechs, satisfy these conditions. Furthermore, the complexity of these businesses may discourage generalist investors, preserving mispricing opportunities for those with expertise. Of note, life sciences companies have a durable value proposition, even in an era of LLMs, since demand for improved health outcomes will not disappear. Even if the method by which they develop and commercialize products evolves, people will continue paying for better health.

Every pill in your medicine cabinet represents a decade of science and billions of dollars coupled with a high-stakes race against time. For investors, this race decides who profits and whose fortune vanishes. Understanding the pharmaceutical life cycle is the difference between reading a headline and seeing an opportunity before the crowd.

Use this article as a starting point for your investing journey in the life sciences sector. A large part of understanding a new sector is learning its vocabulary so pay close attention to the words used here and look up any that are unfamiliar, as you will continually encounter them during investment research.

1. Discovery: Identifying a potential drug candidate

It all starts here. A scientist identifies a biological target (like tumor necrosis factor, or TNF) key to a disease-related pathway (cancer and inflammation pathways in TNF’s case) and researchers test a large array of compounds with the hopes of identifying some that interact with it. Fun fact: blockbuster drugs (>$1 billion annual revenue) like Remicade and Humira interact with TNF and started on this discovery step in the 1990s.

Why this matters to investors

It seldom matters to individual retail investors. Of the thousands (or tens of thousands) of compounds that enter this stage, very few make it to market.

2. Preclinical testing: From the bench to living systems

Once a compound is known to interact with the biological target of interest, it needs to be tested in humans to ensure it works as needed, to assess the dosages at which it works as effective treatment, and to review adverse effects that may result from treatment. But before a compound can reach a human, it must pass 2 types of preclinical studies: (1) in vitro studies in a laboratory (think of a stereotypical chemistry lab with glass beakers) and (2) studies in animals, often mice or rats.

This critical stage minimizes risk as much as possible before a compound ever reaches a human. If a compound successfully passes this stage and is a candidate for clinical trials, an application for an investigational new drug (IND) can be submitted.

Why this matters to investors

Like the discovery stage, preclinical testing is too early for most retail investors. Less than 100 drugs launch in the United States annually, while thousands of IND applications are filed. The odds are brutal.

3. Clinical trials: Safety and efficacy in humans

Clinical trials are where science and uncertainty meet market psychology, with human testing being the most critical and costly step for drug approval. You should be familiar with phases 1-4 of clinical trials, but your focus should primarily be on phases 2 and 3.

After the phase 1 trial establishes safety and dosage ranges in humans, a phase 2 trial is initiated as a pilot to test whether the drug is effective and to assess its adverse effect profile. Promising candidates then proceed to large-scale validation in a phase 3 trial that confirms positive results observed in the phase 2 trial and compares the drug candidate to either a placebo or the existing standard of care. If successful, the drug could proceed to regulatory review and launch.

Post-launch, a phase 4 clinical trial could be launched as post-marketing surveillance to evaluate how the drug works in the long-term. Also, keep in mind that the clinical trial process is not always as clear-cut as outlined above. For example, phase 1 and phase 2 clinical trials can be combined into a phase 1/2 trial that could accelerate the development process.

Why this matters to investors

Phases 2 and 3 lie at the heart of valuation and are where market mispricing often begins. Consider Viking Therapeutics’s announcement of positive phase 2 trial results near the end of February 2024 and the consequent >2x of its stock price from less than $40 to over $80 a share.

4. Regulatory review: FDA decision moment

Upon the successful completion of clinical trials (step 3), pharmaceutical companies submit either a new drug application (NDA) for small molecule assets or a therapeutic biologics application (BLA for biologics license application) for biologic assets. These documents can be thousands of pages long and contain detailed trial data, some of which may not be publicly available. The FDA uses them to either approve a medication (green light to launch), return a complete response letter (more data required), or reject a medication (no launch in the United States). Of note, there are other applications companies can use, such as the abbreviated new drug application (ANDA) or the over-the-counter drugs application (OTC), but these form the minority of new launches.

Why this matters to investors

The regulatory review step is a significant source of uncertainty; again, not a source of quantifiable risk but a source of unquantifiable uncertainty. Sometimes, despite a successful phase 3 trial, companies may receive a response letter, delaying or derailing expected earnings. Although unexpected non-approvals are not very common, you must account for these by building in a margin of safety to your valuations.

When building a discounted cash flow model to value an asset, it would be a mistake to assume that cash flows begin at the end of a successful clinical trial. The commercial launch of a pharmaceutical asset follows many months after conclusion of a phase 3 trial due to trial calculations / publication, regulatory submission, review period, and commercial launch planning.

Importantly, regulatory responses can provide bargain situations for the keen investor since markets often overreact to regulatory updates. As an example, a drug with high expectations receiving a response letter (not approval, not rejection) may cause a downward market overreaction in the pharmaceutical company’s stock. If you read the response letter and recognize that the drug is likely to be approved (albeit with a delay) or if you see that the company’s expected cash flows from other assets in its portfolio justify a higher valuation, you could potentially buy the company’s stock at a bargain price.

5. Launch: Make or break moment

FDA approval is just the beginning. A commercially successful drug still needs to win over patients, doctors, and insurers. As part of their launch plan and commercial strategy, pharmaceutical companies need to build and mobilize a sales force, invest significant capital in marketing, negotiate payer coverage, and setup post-market activities for adverse effect monitoring or potential indication expansion. Successful drug launches require pharmaceutical companies to navigate an increasingly complex healthcare system and are critical to value creation.

Why this matters to investors

Like regulatory review, commercial launches carry uncertainty, but with more levers for analysis. Physician adoption, payer coverage, and the company’s launch history can all shape commercial outcomes.

You need to remember that, for better or worse, how good a drug is does not always correspond to its commercial success. A brilliant drug can fail commercially and a subpar drug can exceed earnings expectations. Consider the example of Aduhelm that gained approval but faced commercial challenges and did not become a blockbuster drug.

6. Market maturity: From the balance sheet to the income statement

These are the golden years of profitability when years of upfront capital investment turn into high-margin profits. To extend success, company’s often pull levers like label expansion and alternative formulation development. Until patent expiry, the company enjoys a monopoly for selling a compound in the United States. Following patent expiry, other companies can manufacture the same compound and compete.

Why this matters to investors

This (along with step 3) should be an area of focus for you since it is the primary revenue driver in the life cycle. It is challenging to accurately model the number of patients who could benefit from a medication and the price at which a medication would sell. But coming close, particularly for medications that achieve blockbuster status (>$1 billion annual revenue), can be immensely rewarding for investor portfolios.

7. Patent expiry: Understanding the cliff

Also known as loss of exclusivity, patent expiry opens the door for generic or biosimilar competitors that cause market share losses and share price declines. However, pharmaceutical companies do have strategies at their disposal to minimize the decrease in revenue, and other players in the healthcare system have their own strategies to counter these. This complicates the prediction of expected cash flows.

Why this matters to investors

Unless you specialize in drug pricing, you do not need to model this in detail. Assume post-expiry cash flows decline sharply and focus on whether the company has a healthy R&D pipeline with the next wave of drugs. Post-patent expiry cash flows are years or decades in the future and small changes in assumptions will not meaningfully affect net present value.

Concluding thoughts: Long-term rhythm of risk and reward

The pharmaceutical life cycle involves early optimism, mid-stage testing, late-stage reward, and unavoidable decline. Don’t fear this rhythm, time it. Smart investors do not invest in headlines. The best returns often come not from predicting the next miracle drug, but from understanding how well a company manages this cycle.

No content shared in this article constitutes financial advice; see disclaimer for details.