At what cost diversification?

In teaching about diversification strategies, one of the main theoretical arguments supporting diversification comes when firms provide financing for a portfolio of bets that can’t be separately financed through the stock market.

In his latest posting to “In the Pipeline,” Derek Lowe notes that such diversification has also been one of the historic strengths of Big Pharma. Quoting a blog comment by (longtime Lilly executive) Bernard Munos:

(Arthur) De Vany has shown that the movie industry has developed clever tools (e.g., adaptive contracts) to deal with (portfolio uncertainty). That may come to pharma too, and in fact he is working on creating such tools. In the meantime, one can build on the work of Frank Scherer at Harvard, and Dietmar Harhoff. (Andrew Lo at MIT is also working on this). Using simulations, they have shown that traditional portfolio management (as practiced in pharma) does achieve a degree of risk mitigation, but far too little to be effective. In other words, because of the extremely skewed probability distributions in our industry, the residual variance, after you've done portfolio management, is large enough to put you out of business if you hit a dry spell.

Both Munos and Lowe ask if Pfizer — the largest drug company in the world — doesn’t have a big enough portfolio to diversify against patent cliffs, who does?

In its forthcoming August 22 issue, Forbes is also running an article on the ideas of Munos to reduce R&D and outsource innovation. It also quotes criticism from former Pfizer R&D head John LaMattina, who thinks the death of the pipeline is greatly exaggerated.

Despite LaMattina’s criticism, I find persuasive the argument by Munos — published two years ago in Nature Reviews Drug Discovery — that the current model is running out of steam.

I don’t have enough experience with pharma R&D enough to offer my own fixes, but my sense is that outsourcing inefficient search processes to external partners isn’t going to work. Perhaps startups will have better intuition as to where to look versus a systematic search by big pharma, but if the discovery paradigm is busted, outsourcing it won’t solve the problem. Instead, that would suggest we need a new search or discovery paradigm.

Still this suggests a new debate to bring to my KGI grad students next spring in the innovation management class. In particular, I’d like assign the 2000 article in Research Policy by Scherer and Harhoff (or the Scherer et al article in the Journal of Evolutionary Economics) if their earlier coursework prepares them for the math. (The RP seems more relevant, but the 2002 De Vany article on movie studios cites the JEE).

Wednesday I sent an e-mail to Harhoff, who I visited many years ago and was once dissertation advisor to a friend of mine. He wasn’t aware of the recent visibility of his earlier work, so I guess I’ll have to use the forward cites from Google Scholar to help students make the connection.