Drug stocks can offer lots of potential for investor profit—but there are three major hurdles most drug makers face.

Investors often comment that we sometimes differ with the mainstream view on which stocks make good investments. That’s especially true with drug stocks.

The general view on drug stocks seems to be that they are can’t-miss investments because the baby boomers are reaching an age when they will need more and more drugs for a wide range of medical conditions.

Look beyond rising demand from boomers when investing in drug stocks

We agree with the idea that the aging of the baby boomers will create demand for drugs. But the consensus overlooks some drug-company drawbacks. Here are three major hurdles most drug stocks face:

1. High research and regulatory costs: Drug firms need to spend heavily to create new drugs, and spend even more to gain regulatory approval. Even then, they only get to profit for a limited time before patents run out and generic products appear. Also their research spending usually leads to dead ends, rather than new drugs that fill a need and can earn the approval of regulators. Failed research may add to the general body of knowledge, of course. But for the company that spent the money, it’s a write-off.

2. Aggressive competition: Drug companies must deal with increasing litigation and aggressive competition from generics as patents on their drugs expire.

3. No brand loyalty: Demand for effective drugs can evaporate overnight, long before the patent expires, if more effective drugs come along. Unlike many other manufacturers, drug stocks don’t benefit from brand loyalty. What’s more, if investors come around to the common-sense view that the best treatment for diabetes is a combination of improved diet, more exercise and fewer calories, they may lose their appetite for the high risks of drug stocks.

Finding drug stocks to invest in

Drug stocks acquired their reputation as high-quality investments in the 1990s. Their earnings and stock prices were soaring in those years, and many books and periodicals wrote about their glowing prospects. As a result, investors and brokers focused on those glowing prospects and ignored the drawbacks.

Drug stocks are high-quality businesses, but they only make sense as investments if they trade at prices that reflect their risk.

Drugs stocks with a dividend history

If you are adding a drug stock to your portfolio you may want to consider a drug company that has been paying dividends. We think very highly of companies that have been paying dividends to its investors for at least 5 to 10 years. Companies can fake earnings, but dividends are cash outlays. If you only buy dividend-paying drug companies, you’ll avoid most frauds.

Early-stage drug stocks are highly risky—and especially penny stock drug or biotech stocks. Their limited number of drugs undergoing trials are very likely to fail to reach commercialization. Even then, they could lose out to competitors.

Drug stocks with a strong pipeline
A big source of hidden value is successful research and development spending. These outlays get written off against current-year income, much like day-to-day expenditures such as rent and utilities. This accounting treatment depresses current earnings. But if the research turns up anything of value, it adds to long-term profit.

Drug companies with strong research spending and with a wide range of drugs with commercial potential typically offer the best growth prospects,
For instance, look for drug companies with drugs spread across the four research stages:

In the U.S., once a new drug clears the initial testing phase, it must pass the three main stages of clinical evaluation used by the Food and Drug Administration (FDA).
In Phase I trials, a small group of 20 to 80 healthy volunteers is selected to assess the new drug’s safety, tolerability and possible side effects.

Phase II trials typically involve groups of 20 to 300 people. These trials assess how well the drug works and continue Phase I safety assessments. When a new drug fails, it usually occurs during Phase II.

Phase III studies are the strictest scientific trials. These are conducted by two or more clinical research centres on patient groups of 300 to 3,000. They aim to compare the drug to the current "gold standard" of treatment. Phase III trials are the most expensive, time-consuming and difficult to design and run.

Look to medical-supply firms for lower risk

If you want to invest in drug stocks, we think you should focus on those that have high cash holdings and a number of drugs in the pipeline as mentioned above. All the better if they have access to fast-growing markets such as China, India and Latin America.

Alternatively, instead of drug companies, consider medical-equipment suppliers. Demand for medical equipment tends to grow, or at least hold steady, regardless of swings in the overall economy. Many of these firms also get recurring revenue, mainly from long-time customers. They also face little competition from generic products, and stand to gain from the aging of the boomers.

C.R. Bard (symbol BCR on New York) is one example of such a stock. We cover C.R. Bard in our Wall Street Stock Forecaster newsletter.

C.R. Bard makes over 15,000 medical devices in four main areas: oncology products that detect and treat various types of cancer (28% of 2013 sales); vascular products, like stents and catheters (27%); urology goods, such as drainage and incontinence devices (26%); and surgical tools (16%). Other medical products supply the remaining 3%. The company’s products are typically only used once, so customers must continually buy new ones.

Bard is also benefiting from its new growth strategy, which involves selling slower-growing businesses and buying other medical device makers.

Another part of Bard’s strategy involves expanding sales outside of the U.S., which accounts for two-thirds of its total sales. The company believes its sales to clients in emerging markets like China, India, Russia and Turkey could more than double by 2020.

Do you currently hold drug stocks in your portfolio? Do you feel like they have any long term value? Share your experience with us in the comments.

Note: This article was originally published in April 2012 and has been updated.