The Next Home Run In Healthcare

Continuing my yearly outlook for 2014 in healthcare, I thought it timely to delve into the speculative picks today, and save the short candidates for my final piece in the series.

After Intercept Pharmaceuticals (NASDAQ:ICPT) exploded like an atomic bomb on the healthcare sector last week, everyone is looking for the next home-run. Pushing aside the fact that such events are extremely rare-even in biotech, this is going to be a major theme this year. Apparently, healthcare investors have little interest in getting rich slowly, and instead, are intent on swinging for the fences. And while I don't advise such a strategy by any means, I can offer some machinations on how to go about finding the next big thing in biopharma.

Postmortem on Intercept

The first thing we need to do is ask a question: Why the hell did Intercept blow up like it did?

The answer is simple enough. No one, not even management, had the slightest inkling that the company's experimental liver disease drug was going to perform so well. Consequently, there was a massive valuation gap prior to the data release.

Let me impress something upon you here. This is an extremely rare event, akin to finding a unicorn pooping in the woods. If anything, management teams greatly exaggerate their experimental drugs' value propositions, causing most stocks to be seriously overvalued, in my opinion of course. If you're read some of my other pieces, I've even pointed out where management has misled investors about potential market opportunities in order to hock their stock. And for the most part, it's a highly effective strategy.

Looking backwards, Intercept's management, if anything, was underselling their drug's potential. By this I mean that they weren't pumping out PR's every time a patient was treated or trumpeting interim results at every single investor conference on the planet. Both of these practices are, unfortunately, commonplace in the sector.

The end result was that Intercept was flying under the radar, creating a mismatch between latent and actual valuation. When the mid-stage results hit the Street, the dam broke and the gap was filled. That's an important lesson going forward.

Put simply, our search for the next Intercept needs to focus on drugs with a potential large valuation gap.

Not all drugs are created equal

To achieve this goal, one obvious route is to consider potential blockbusters in development that address an unmet medical need. If the drug is a frontline therapy, all the better.

To ferret out decent candidates, I think the best bet is to look at three broad categories known to generate blockbuster drugs: oncology drugs, anything to do with diabetes, and finally, hepatitis C treatments. With the hepatitis C market cornered by big and small players alike, we are left with diabetes and oncology drugs. The only company in the diabetes market that has major potential now is MannKind (NASDAQ:MNKD) and it is far from undervalued in my opinion. If anything, that story is played out.

That leaves us with oncology drugs/therapies.

So what kind of oncology drugs should we look for?

In my experience, investors love to fall into traps in the oncology sector, investing in therapies that are all hype and no hope.

Brain cancer drugs - not a chance in hell …

Lung cancer drugs - Small cell lung cancer - might as well throw your money into a bin and set fire to it. Non-small cell lung cancer - see small cell lung cancer.

Blood cancers - some very intriguing candidates on the horizon …

Pancreatic cancers - interesting second line candidates in trials, but fail blockbuster test …

Liver cancers - well, this is a given based on recent developments. On a side note, I am lumping liver cancers and general disorders together because they have a bad habit of co-habitation.

This should only be considered as an off the cuff list, and is in no way comprehensive. The list of cancer types is almost as diverse as beetle species, making it far beyond the scope of a Seeking Alpha article. But I think most folks would agree that hematological and liver diseases present the most compelling investment opportunities right now.

Companies will keep going after lung cancer treatments because of the potential market size, but the history of failures should make you wise up. Brain cancer treatments have proven utterly futile, although I know this will upset some speculators. Again, we are trying to compile a list of candidates that have some remote chance of working, not thrashing our brokerage account. On that note, let's move onto some speculative candidates.

Speculative stocks that could mimic Intercept

Blood cancer candidate - Geron (NASDAQ:GERN). Well, this one was easy. With the company's lead hematological malignancy drug imetelstat showing stunning results in a mid-stage trial last year, investors are keenly awaiting further developments. The problem is that imetelstat won't reach blockbuster status if approved for myelofibrosis alone. Novartis (NYSE:NVS) and Incyte's (NASDAQ:INCY) drug Jakafi does around $200 in million in sales per year as a treatment for myelofibrosis, far off the blockbuster path.

The trick would be to get imetelstat approved for a broad range of hematological diseases, which is Geron's ultimate goal. Looking ahead, I don't think Geron has the right stuff to follow in Intercept's footsteps, at least not yet.

Liver diseases/cancers - There are several candidates to choose from here. Yet, they tend to suffer from one fatal flaw-most drugs are very early in the clinical trial process. Because we live in a microwave society and most people have the attention span of a fruit fly, I think it's best to consider drugs that have the possibility of producing results sooner than later.

So my Hotpocket liver disease pick is … Ocera Therapeutics (NASDAQ:OCRX). If you haven't heard of them, don't worry, few people have. And that's one of the reasons I suspect it will end up being the heir to Intercept.

Ocera is a small cap biopharma that recently launched a mid-stage trial for an experimental hepatic encephalopathy drug called OCR-002, or ornithine phenylacetate. The drug has orphan drug and fast track status from the FDA. And most importantly for impatient investors, the study is expected be completed in Q4 of this year. With limited treatment options for the disease and orphan drug designation, OCR-002 offers one of the most compelling home-run scenarios in the sector right now.

Turning towards market potential, the company believes OCR-002 could see peak sales of around $500 million per year, if approved. So while that fails the blockbuster test, you should keep in mind Ocera's tiny market cap of a mere $228 million at the time of writing this article.

If we applied even a ridiculously low multiple of 3, Ocera's potential upside is conservatively close to 600%, again, if OCR-002 is ultimately approved. Discounting for the clinical and regulatory risks in the stock today, I thus believe the stock is undervalued by at least 300%.

Why is the market missing this opportunity? Because like Intercept, Ocera hasn't oversold themselves. In my book, it's always better to undersell and over-deliver.

So there you have it ladies and gentlemen, the next biotech home-run is Ocera, and it's flying well under the radar just like Intercept was before exploding.

Disclosure: I am long OCRX, . 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.