Ideas in the Biotech Sector

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 |  Includes: AMAG, CASC, DNDN
by: Marc Lichtenfeld

By Marc Lichtenfeld, Investment U Senior Analyst

The recent financial crisis wasn't a fun period for most people. Major banks became insolvent, portfolios were decimated and houses were foreclosed. But for small-cap biotech investors, the carnage provided more opportunities than they could handle.

Last week, I was in New York meeting with various fund managers. While we didn't always agree on each individual stock, we all agreed that it's much harder to find good ideas, which makes the company I think you should keep your eye on today all the more valuable.

Two years ago, and even last year, the ideas were falling in our laps as beaten-up stocks made the risk/reward profile much more favorable.

Any small-cap biotech investor knows the chances that his favorite company will take a mid-stage clinical trial drug and successfully launch a product on the market are slim. After all, only one in 1,000 drugs in pre-clinical trials become an FDA approved drug.

But that doesn't mean there aren't ample opportunities to make money. Investors can cash in on the hype and high expectations of drugs in their earlier stages of Phase 2 trials and get out with a profit before the drugs' late-stage trial results, when the anticipation of positive results is the highest (and often wrong) ...

The Macro Picture of the Biotech Sector

I was excited to meet one portfolio manager for dinner at one of New York's well-known steak houses. This fund manager is one of the sharpest investors I know. He's not a guy who appears on CNBC or is quoted in The Wall Street Journal. He keeps a tight lid on his ideas, only sharing them with a few close confidants.

Fortunately, I happen to be one of them.

In past discussions, the ideas would flow like a waterfall. There was always an exciting new opportunity to talk about. This new medical device or that new cancer drug.

But last week, as we dined, the conversation drifted more towards the macro picture for both the market and the biotech sector rather than specific stock ideas.

We did talk about one interesting company with a deep pipeline that I'll be looking into. If it amounts to anything, I'll report back. But for the most part, the idea well was dry.

Another meeting, which I had in the lobby of my hotel, also had the same tone. In fact, we both expressed frustration that good ideas are harder to come by these days.

And no wonder. In the small-cap biotech sector, valuations have doubled over the past year.

One year ago, the price-to-book ratio of the S&P Small Cap Biotech Index stood at 2.7. Today, it's at 5.4. The price-to-sales ratio also nearly doubled to 6.1 from 3.2. In 2009, during the crisis, the ratios were about the same. There's no sense looking at price-to-earnings ratios since most small-cap biotechs aren't profitable.

Small-Cap Biotech Companies Valuations Double in 2011

Investing in small-cap biotech is all about risk versus the potential reward. And many stocks in the sector are packed with both. So when valuations are twice what they were just 12 months ago, it shouldn't be surprising that shrewd investors are having a tough time finding stocks with acceptable levels of risk compared to the potential profits.

An Undervalued Opportunity in AMAG

One of the few small-cap names that I think still has a lot of value is AMAG Pharmaceuticals (NASDAQ:AMAG). AMAG's product is Feraheme, for anemia in chronic kidney disease patients. The company has over $11 per share in cash and no debt.

Feraheme is much more convenient than its competitor Venofer. Feraheme is given in two injections while Venofer requires eight to 10 doses.

And while its label was recently changed to include the mention of some serious adverse reactions, the observation period for patients receiving Feraheme was reduced to 30 minutes from 60 minutes, which should be seen as a positive for its safety profile.

The stock is trading at less than two times book value, including all of that cash. So Wall Street is putting very little value on its business.

If AMAG can surprise Wall Street with higher-than-expected revenue, don't be surprised to see a higher multiple in the near future.

And although you never want to buy a stock because it's a takeover candidate, AMAG would be a nice little tuck-in acquisition for a larger pharma or biotech company that can use its sales force to ramp up Feraheme sales. There are some activist investors involved in the stock who I'm sure would love to see the company sold.

Small-Cap Biotech Stocks Enriching Investors

Small-cap biotech stocks can enrich investors like very few other sectors. One only has to look at the charts of Dendreon (NASDAQ:DNDN) or Oncothyreon (ONTY) for proof.

But following the sage advice of buying low and selling high is particularly tough right now. AMAG may be one of the few opportunities out there. Otherwise, it may be best to wait for some stocks in the sector to come to order to reduce the risk.

I hope we never go back to the days when we worried if we'd be able to get our money out of the bank. But I wouldn't mind having more good ideas than I knew what to do with again.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Investment U expressly forbids its writers from having a financial interest in any security they recommend to our subscribers. All employees and agents of Investment U (and affiliated companies) must wait 24 hours after an initial trade recommendation is published on online - or 72 hours after a direct mail publication is sent - before acting on that recommendation.