The 9 Levels Of Biotechnology And Who Should Invest: Part 2

by: Brian Nichols

In Part 1 we looked at four of the more stable segments of the healthcare space. Hopefully, you now realize the level of diversification that exists in the space, and that one investment alone in the sector may not be enough to fully be diversified. These are companies and segments that all serve different purposes, and in this article I'll focus on five more segments in the space. Now I will explain which companies may be suitable for your consideration and how you might want to invest in each.

Small/Mid-Cap Explosive Growth

If you are looking for an exciting investment in a company that is in the early years of a product launch, then this is your space. The Small/Mid-Cap category typically trades with billion or multi-billion dollar valuations while in late-phase clinical trials, sometimes without a product on the market. These are companies with high expectations that had great support from the start. However, this category of Small/Mid-Cap Explosive Growth is comprised of companies that often fall through the cracks and seemingly come from nowhere. These are companies that often have micro cap valuations during clinical testing and then rally as they defy the odds.

Some good examples of these kinds of companies are Jazz Pharmaceuticals, Questcor Pharmaceuticals and even Pharmacyclics (NASDAQ:PCYC). My favorite, at this time, is Santarus (NASDAQ:SNTS), a $1.1 billion company that has risen from being a $75 million company just three years ago. This is a stock that has seen clear gains and is trading with a price/sales ratio of 5.08 and a forward P/E ratio under 15.0. The company grew sales by 60% during its last quarter and is now expecting growth between 50% and 60% growth for this upcoming year. Therefore, despite large gains the stock is still cheap and should have significantly higher upside.

In my opinion, this particular space is where the greatest upside/safety exists, because most of these are fly under-the-radar companies while in clinical studies, or they had questionable products. In a way, this is the complete opposite of the previous categories discussed (Mega, Big and "Wannabe" Pharmas), which is why these stocks see such large gains as the market adjusts to a product's potential once proven successful. As an investor, to buy one of these stocks you must be willing to endure more volatility and accept a longer-term time horizon. This space is very distorted in value, meaning you can find several undervalued companies with great growth that produce market-leading returns. But beware of the overvalued slowed growth companies that are also present.

Newly Approved

This is, in my opinion, the most dangerous time to buy a biotechnology stock. If you look at recent examples you can see the large losses posted by both Amarin (NASDAQ:AMRN) and Arena Pharmaceuticals (NASDAQ:ARNA) following drug approvals. The reason is that after a company is awarded an FDA approval its stock typically catapults to reflect the potential of that drug. It's not uncommon for the stock to trade higher in the weeks following an FDA approval. However, as the drug awaits launch by jumping through the regulatory hurdles that exist, the market often begins to reassess and price in any potential downside. Not to mention, a company with a $1 billion or more valuation immediately following an approval has high expectations and investors must realize that drug launches for a company with a newly approved product are usually a slow process.

These companies do not have the resources of Pfizer, yet investors expect billion-dollar sales quickly. With that being said, I don't think that the Newly Approved stage is a good time to buy a biotechnology stock. I believe there is much greater upside after the product has been launched and is producing growth (category above) or prior to the FDA approval as the market builds a stock in excitement. Therefore, only those who have multi-year hold time outlooks should entertain this space, and even then it would probably be wise to seek better value.

The Expected Approval

It's not hard to find companies in this space, as they are usually among the year's best performing stocks. And if timed correctly, there can be a great amount of upside present. One of my favorite candidates is ACADIA Pharmaceuticals (NASDAQ:ACAD), and it has risen from an $80 million company to a market cap greater than $600 million with the successful trial of pimavanserin. ACADIA is special because it had low expectations prior to data in November of 2012, and despite immediate gains greater than 100% following successful data, the stock was still cheap thanks to years of low expectations. In 2013 the stock has rallied 70% and has become one of the market's favorite momentum stocks.

The key with stocks in this space is value. These are stocks that move fast - and if you are interested in the space you must find a level at which you believe the stock is undervalued and overvalued. A stock in this space will often trade beyond the overvalued level. But then after an FDA approval it sees the "Amarin effect," which is profit taking as sales potential and valuation realign. My formula for finding value in this space is one times peak sales potential. If I find a stock that trades below this level then I consider it a "Buy."

The reason for this calculation is because biotech stocks often trade at four-six times sales during the marketing process, meaning upside would still exist at one times peak sales potential. On a side note, investors should realize that as these levels in biotechnology decline, more risk is being presented. In this category we expect an approval, but there is always a chance that the FDA will deny a drug due to more data being needed, a manufacturing issue, or a problem with safety. Thus, investors must keep this in perspective and realize that, not only do you have to account for value, but also all potential FDA responses to a drug when making an investment in this space.

Late-Stage Clinical

Sometimes the market misses clear value, and if you can identify it, then this can be a very rewarding space. The companies in this category are ones that are near an announcement of late-stage data. This is also a space that can range in valuation from $100 million to $2 billion. Typically, larger valuations are rewarded to companies that have higher expectations. But every now and then the market misses one of these opportunities and it creates unprecedented gains, such was the case with ACADIA Pharmaceuticals.

Within this space you can really see the domino effect in biotechnology for the first time. It's when a company such as ACADIA Pharmaceuticals begins as a small and speculative stock, and then grows into an expected approval stock and then ultimately into a growth stock. One of my favorites in this segment is ImmunoCellular Therapeutics (NYSEMKT:IMUC).

ImmunoCellular Therapeutics is a $125 million company, but with its current trial, it could very quickly be transformed into a billion dollar company. To better understand, consider Sarepta Therapeutics (NASDAQ:SRPT): In its Phase 2 trial it produced incredible results with its drug eteplirsen, treated on just 12 patients (8 received drug and 4 on placebo). With strong Phase 2 results it became a billion dollar company, and is now expected to earn an accelerated approval (making it a late-stage company).

ImmunoCellular Therapeutics' drug ICT-107 is treating one of the most deadly forms of cancer in existence, glioblastoma multiforme ((GBM)), one in which patients live just over one year following diagnosis and must surpass three lesser degrees of glioblastoma before being diagnosed as having GBM. In a 16 patient trial, patients lived on average 23.8 months longer than historical standard of care (SOC) and eight of 16 lived more than four years. These results are unprecedented, and if ImmunoCellular can produce any level of benefit in its Phase 2 trial then it will receive an accelerated approval because of the disease's severity.

Typically, an investor would seek a Phase 3 product for late-stage clinical investments. However, the goal of this category is to find investments in biotechnology that are near FDA decisions and are unrealized by the market. With ImmunoCellular Therapeutics, and data due at the end of this year, an FDA decision will most likely be within the next 16 months. With all these positives in consideration, investors must realize that these are companies with upside tied to clinical development - and anything can happen in large trial settings. I think ImmunoCellular looks very attractive, but investors should only buy if they can withstand excessive volatility, strong opinions, and only to compliment a biotechnology portfolio, as no stock in this space should be the center of your portfolio.

Micro-Cap Speculative

In this final segment of biotechnology, you can see where the retirement-like upside is first created. However, finding one is like finding a needle in a haystack ... it is not easy. The problem that retail investors make is with large positions in such stocks, when what you need is good research in locating possible "needles" combined with a very small investment that you can afford to lose, whether it be $1,000 or $5,000. This is a space where retail investors often chase dreams, hoping to cash in on the next Pharmacyclics as a $50 million company. But unfortunately, most of the companies in this space never materialize, and present the greatest level of risk to the investor.

While most never materialize, some do, and it's stories such as Jazz Pharmaceuticals (NASDAQ:JAZZ) that keep investors seeking the next big one. In just four years the stock has increased more than 6,000%. At one time the company was valued at just $35 million, but is now valued at $3.2 billion, meaning a very small $3,000 investment could've been worth almost $300,000, and its gain such as this that attract people to the space. Every year, I choose one-two stocks to buy, with small investments, and in 2013 I bought OncoSec Medical (NASDAQ:ONCS).

I know that the company is really small and extremely speculative, but I really like its OMS Technology. My interest began after interviewing an analyst whose experience in the space led me to research the company. I find its usage of IL-12 to be very encouraging (due to the effectiveness of the agent) and I think its technology of using electricity to create pores (electroporation) and direct treatment to a tumor could be highly effective, and has also produced great results. This is a platform that has great revenue potential in a number of indications - and with a number of catalysts upcoming, it is very possible that its rally could begin in the coming weeks.

For every Jazz Pharmaceuticals, there are 100 that do not succeed. In the process of identifying such a company an investor must seek stocks that are unrealized, have large market potential if its product is successful, have a late-stage product with previous data, and it needs catalysts among other areas of research. Not to mention, you have to realize that these are the highest of risks within the space and that sometimes you will be wrong with your investment. Therefore, understand that this space has by far the greatest upside, but should be explored with caution.


Hopefully, you found this series useful and that now you have an idea of how you can use the information to invest in this industry. If you are still having trouble, then try to use the following as a rule: Companies at the very top of the list (Part 1) have the least amount of risk and the smallest upside in performance; those at the bottom (Part 2) have the best upside, but the most amount of risk. In addition, you may want to determine the size of the investment based on the category, as an investment in Big Pharma should be much larger than an investment in Late-Stage Clinical. I encourage readers to take the information, use it as a guide, and then explore the industry in search of the best value. Good luck!

Disclosure: I am long JAZZ, SNTS, ONCS, IMUC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.