While the ideal for most drug developers might be to consistently turn out the next Lipitor or Avastin, a few biotech companies are focusing smaller, on drugs to treat rare diseases. They do so despite the fact that sales of these drugs may never come close to those of the blockbuster names.

Spending hundreds of millions to develop a drug whose market is extremely limited may, however, have some investors question how successful a business model based on rare-disease drugs can be.

Genzyme , for instance, recently received Food and Drug Administration approval for Myozyme, its drug to treat Pompe disease, a progressive muscle disorder that affects only 5,000 people in the U.S. According to the Cambridge, Mass.-based biotech, it has spent more than $500 million to date on developing and marketing the drug.

"The way we look at that is it's not so much the size of the market, but the therapeutic value of the drug," says Genzyme spokesman Dan Quinn.

Genzyme is an exception, however. The company is known for having built its business from the ground up on rare diseases, and 300 patients were on Myozyme in a matter of weeks after the drug's U.S. launch last month.

Using Genzyme as a role model, it looks like some smaller companies, such as BioMarin Pharmaceutical ( BMRN - Get Report), Nektar Therapeutics ( NKTR - Get Report) and Isis Pharmaceuticals ( ISIS) are following in its footsteps, analysts say. Specialty-pharmaceutical player Shire is also getting a piece of the market through its acquisition of rare-disease drugmaker Transkaryotic Therapeutics last year.

Nektar is developing a drug for rare fungal infections of the lungs. Rare metabolic disease treatments are expected from BioMarin, which is co-developing Aldurazyme with Genzyme, among other enzyme products. Isis Pharmaceuticals is also developing a treatment that's been granted orphan-drug status by the FDA for a rare genetic disease called homozygous familial hypercholesterolemia, which causes a severe elevation of cholesterol levels.

Incentives for Orphan Investing

Companies, like Genzyme, that look to develop new so-called orphan drugs may seem to be focused more on the science than on the recoupment of development costs. The FDA, however, is aware of the expenses and offers incentives to companies willing to develop drugs to help patients with rare diseases and unmet medical needs.

Based on the FDA's 1982 Orphan Drug Act, companies developing drugs for diseases that affect fewer than 200,000 patients in the U.S. may be eligible for government tax credits, as well as a monopoly over the market through a seven-year exclusivity period and an extended patent life since sales of the drug aren't expected to be "commercially viable," according to the act. Orphan-drug designation is granted for drugs intended to treat diseases for which there is no other treatment on the market.

While recouping development expenses is a concern, there are some advantages to focusing on rare diseases, especially for smaller companies, according to at least one analyst. Since the disease being treated is so rare, no other treatments exist, and there are a limited number of disease specialists who have experience with the disease, there's no need to hire a large sales force or legal team, he says.

"You basically just need to be one guy in a lab coat," says Les Funtleyder, health care analyst at institutional trading firm Miller Tabak. And it doesn't matter whether a company develops the drug itself or whether it picks up scrapped projects from a Big Pharma that may have shelved an orphan drug in favor of pursuing a potential blockbuster, as long as you have a drug that works, Funtleyder says, adding that even manufacturing can be outsourced.

Add to that significant tax credits and seven years of market exclusivity under the Orphan Drug Act and you come up with what could be the ideal situation for some smaller drug companies.

Factors in Pricing

Since the market for orphan drugs is so small, clinical trials are easier to manage and there's a guaranteed market for the drug, according to Funtleyder. Orphan-drug status, and the fact that the diseases being treated are severe and often deadly, "also practically guarantees insurance reimbursement and a longer patent life," he adds, and this means the companies can virtually set whatever price they want.

"I don't like the argument that a company's R&D structure is so high that we need these 90% margins," says Funtleyder. "Eventually the government is going to say 'enough,'" and put a limit on orphan-drug prices, he adds.

Until then, companies list a number of factors they use in determining a drug's price.

According to Genzyme, trial and manufacturing costs factor into a drug's price, but possibly the most important consideration is how rare a disease is since the company's overall costs are divided by a small number of patients. The company also says it factors in its expected investments in its current pipeline, which the company needs "to create and sustain an enterprise." Genzyme says it invests about 20% of its gross revenue in developing new products.

Little Interest From Big Pharma

While a year's supply of Pfizer's ( PFE - Get Report) blockbuster cholesterol drug Lipitor costs less than $1,000, a year's worth of Genzyme's Gaucher disease drug Cerezyme costs, on average, between $175,000 and $200,000, the company spokesman says. The company's other orphan-drug prices are around the same range.

While the drug prices may seem compelling for drug companies, consider that Lipitor brought in more than $12 billion last year for Pfizer, while Cerezyme sales were about $932 million.

"I think for a long time the pharma focus has been on much bigger markets," adds Sectoral Asset Management's Stephan Patten, who manages his firm's Quaker Biotech Pharma-Healthcare Fund.

Even though drug giant Merck ( MRK - Get Report) received orphan-drug status for Zolinza -- a proposed treatment for advanced cutaneous T-cell-lymphoma, a rare blood cancer that affects 20,000 patients in the U.S. -- the company says its drug belongs to a new class of anti-tumor drugs being investigated as a treatment for solid tumors as well as blood cancers.

"Unless the market and sales can prove to be very big, within the constraints of the orphan-drug designation," Big Pharma is unlikely to pursue an orphan drug, says Sectoral's Patten.

In terms of investments made by biotech and pharma stock watchers, it's difficult to say whether the rare-disease drug developers in general are a good group in which to invest. The companies need to be considered on a case-by-case basis, says Miller Tabak's Funtleyder. Possibly the only general rule among companies targeting rare diseases goes along with Funtleyder's belief: Smaller companies go where big caps don't want to be.