Within the universe of investment options available to those trying to grow their hard-earned cash, there is perhaps no more compelling investment thesis than the science of life.

Life sciences is a term that is broadly defined as any branch of science — for instance, biology, medicine or ecology — that studies the organization of living organisms, their relationships to each other and the environment.

The sector is generally divided into pharmaceutical companies, which focus on chemistry and small molecules, and biotechnology companies, which use living organisms or their derivatives to make products for specific healthcare uses. There are also companies that focus on diagnostic testing and firms that make medical devices that manage pain and check for irregularities in bodily functions.

Over the years, as medical science and other technologies, like computing power, have advanced, the industry has morphed into a sector containing hundreds of companies, some of which have market capitalizations well over $50 billion.

With healthcare eating up an ever-greater proportion of government budgets — last year, health expenditures represented close to a quarter (23 percent) of government spending in the United States — and the western world’s reliance on pharmaceutical drugs unlikely to abate, investing in health-related companies is a solid investment strategy.

While the life sciences sector is not immune to the vagaries of stock markets and macroenomic trends such as inflation and economic growth, recent numbers show that it has done quite well in the face of some challenging economic headwinds.

The Wall Street Journal reported that healthcare mutual funds “gained 19.7% on average in the 12 months through Nov. 15, [2012], and are up 12.6% each year over the past three years,” according to investment-research firm Morningstar. By comparison, the S&P 500 (INDEXSP:.INX) stock index gained 10.1 percent during the same period.

The sector is also considered a safe haven due to baby boomers — a large and growing market segment whose consumption of pharmaceuticals and need for an endless array of healthcare services is only going to get more pressing.

Harry Dent, bestselling author and financial forecaster, said this month that he sees life sciences as a good place for investors to be, particularly due to continuing economic uncertainty.

“If I am right, and stocks crash again in late 2014 or early 2015, I want to buy in the healthcare sector in the U.S. and Europe, especially the most leveraged areas: biotech, medical devices and pharmaceuticals. The baby boomers will continue spending on healthcare and healthcare products, even as budgets get crimped by entitlement reductions,” he noted.

Small-pharma, cancer treatment are investment targets

John McCamant is the editor of the Medical Technology Stock Letter, an established source for stock recommendations and news about medical technology companies. McCamant believes that from an investor point of view, pharmaceutical companies carry the best chance of high returns considering their potential for developing cures for intractable diseases like cancer, Alzheimer’s disease and multiple sclerosis. Companies that succeed in finding cures can develop drugs whose patient costs run up to $100,000 a year; while that is a heavy burden to pass onto a patient, it translates into huge profits for the corporations that manufacture such drugs.

Investors who get into these stocks early enough can see returns in excess of 10 times their original investment. However, there are risks, an important one being side effects from drugs. For example, those associated with chemotherapy can make the treatment unworthy of the payoff. McCamant equates it to the stock market in terms of risk versus reward. “It’s risk versus benefit or greed versus reward,” he said in an interview with Life Science Investing News. “How much effect am I having on the patient versus the side effects?”

McCamant also noted that unlike the resource or tech sectors, where there is normally a stark division between academia and business, in pharmaceuticals the line is blurred, with about half of new drugs coming out of universities. That means that investors interested in life sciences should keep their ears to the ground on discoveries made at medical schools or associated institutes.

“They often start off with some interesting science and then the companies form and start creating different molecules to go after the technology they own,” he said, adding that drug company CEOs often start out as academics or scientists. “The technology has shoes — often the guys will start off at universities and move into commercial.”

Cancer treatment is an area that McCamant sees as an important area for life sciences investors to consider.

He pointed to the high-profile case of NHL hockey star Mario Lemieux, who in 1993 was diagnosed with Hodgkin’s lymphona and was forced to miss games while undergoing aggressive radiation treatments. The Pittsburgh Penguins forward was prescribed the cancer drug Rituxan and within two months was back on the ice, his cancer in remission. Rituxan, manufactured by Genentech, is now one of the world’s largest selling drugs, thanks in part to the publicity generated from the Mario Lemieux story.

“That’s where we get excited is that when you get to the actual cause of disease and maybe you can create a cure and and get close, you’re certainly going to get better treatments and fewer side effects,” McCamant said.

Number one rule for investors: look at management

But given that literally hundreds of companies are conducting research and studies into potential cures, how does an investor separate the wheat from the chaff?

McCamant recommended that investors do their homework, and most importantly, look at the management behind life sciences companies. Very often, the people running these companies need to come with a diverse set of skills in order to understand the complex science behind the treatments and to communicate that understanding to an investor audience.

“These are some of the hardest companies in the world to run in terms of the level of complexity,” said McCamant. “You’ve got to be able to interact with your own scientists, the FDA are very detailed and they also need to know and understand the science, and if you’re public you need to deal with Wall Street. You also need to potentially do partnerships with large and small companies.” Those that do well are the ones that best manage expectations, he noted.

Another common mistake: “don’t rush into an investment and make sure you know what you’re getting into on multiple levels.” McCamant pointed out that investors need to be aware of the phases that most life sciences companies go through as they advance from initial drug testing to human clinical trials, to eventual commercialization. Timing it right can result in every investor’s dream of a 10 bagger. Mistime it and your gains could quickly turn to losses, especially if the company has poor testing data or runs afoul of the FDA, whose job is to protect the public.

And like other sectors, it’s important to watch out for red flags such as overdilution, or what McCamant describes as “monsters,” such as Obamacare, which resulted in the whole sector trading off.

Those who persevere, however, may not only be rewarded with handsome returns, but can also sleep well at night, secure in the knowledge that their investment is actually helping to change people’s lives in a positive way.

“We’re making a difference at the end of the day, it’s not trivial in any form,” McCamant said.

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