Portfolio Strategy, Biotech, Long/Short Equity, Healthcare
Contributor Since 2012
Source: George S. Mack of The Life Sciences Report (12/6/12)
Many components go into building a successful biotech company, but excellent management is a keystone. Combine good management with an innovative product or service, and investors can possibly unlock big multiples over their original investments. So says Principal Analyst and Fund Manager Ross Silver, co-founder of Vista Partners. In this interview with The Life Sciences Report, Silver brings obscure micro-cap ideas to life and discusses why they may have mammoth potential.
The Life Sciences Report: Your focus at Vista Partners is on small- and micro-cap companies where investors can potentially make big gains. Do you have a sector bias, and what sectors do you cover?
Ross Silver: To identify companies we believe are compelling investment opportunities we do two things. First, we invest our own capital into the companies. Second, we write research about these particular companies and disseminate our research and monthly newsletters for free on our website.
As for sector bias, we are generalists for the most part, but we tend to focus on healthcare and technology companies because we believe the majority of alpha is derived in those particular industries. A healthcare or early-stage biotech company with a $10 million ($10M), $20M or $30M market cap has the potential to become a multibillion-dollar company in a relatively short period of time-over 5-10 years, let's say. With a small-cap retailer that transformation would take a lot longer, although there are exceptions to that rule. Our core competencies and focuses are in healthcare and technology for that reason. I would add special-situation energy companies into that mix as well.
TLSR: You focus on companies valued between $5M and $1 billion ($1B) in market cap. You actually have one right now that's just over $3M in market valuation. What struck me is that even though a $1B market cap is still considered small-cap by most people, the spread between $5M and $1B represents different worlds entirely, doesn't it?
RS: There are a number of differences between the low end and the high end of the market cap spectrum. Mainly, when we talk about life science companies, it's the maturity of the business or the maturity of the drug candidate pipeline that causes the valuation disparity. The other difference is that because of the maturity on the higher end, companies closer to the $1B range will have additional coverage or a larger following from brokerage firms like Goldman Sachs or J.P. Morgan. More analysts will be writing research on them, and there will be more institutional investment in them. More people will be aware of them and therefore, typically, they enjoy higher trading volume or liquidity.
"An early-stage biotech company with a $10-30M market cap has the potential to become a multibillion-dollar company in a relatively short period of time."
At the bottom end of the spectrum, for a $5M market cap company, there is typically little to no institutional ownership, little to no research coverage and little to no one advocating for it. Therefore, these companies typically have less trading liquidity. It's a lot harder to get up to speed on the lower end of the range. That said, there is tremendous opportunity with the small- or micro-cap companies if an investor is willing to do some work and possibly accept additional risk.
TLSR: But doesn't the research on lower-end companies require different disciplines?
RS: Yes. The primary difference is that, in most instances, risk profiles differ greatly between smaller versus larger market cap names. In larger, more mature companies, the due diligence process is easier because investors can understand the competitive matrix, where a particular company fits within that matrix and how that company is going about obtaining market share. At the top end of the range it's more fundamental analysis, because the market is well understood. At the lower end of the spectrum, it's more blue sky, and there are usually more hurdles that companies will need to overcome before they will be adopted by a broader audience.
TLSR: Ross, I think you're saying that on the very low end, you really have to get into a company to get a handle on what it's doing, because there is almost no coverage of that company whatsoever. From my experience, even the websites of companies on the low end tend to be low information sources.
RS: You are exactly right. Investors have to be able to go through the Securities and Exchange Commission (SEC) filings and do all the work themselves. By doing homework and due diligence, investors may be able to identify companies with value and potentially determine the steps required to get to a valuation inflection point, where the company could be an acquisition candidate or a leader in its particular market or industry. If investors can get in early enough, and if they have enough guts and understand that things may take longer than anticipated, and if the investment thesis remains intact throughout, they may have a good investment opportunity on their hands.
TLSR: When you begin to consider a company, what do you look for first?
RS: First and foremost, we look at the management team. We want to make sure the management and board of directors are familiar with the industry they are competing in and that they understand the process of becoming the number 1 or number 2 company in that particular market or industry. We look for experience in developing the company or developing the product.
"There is tremendous opportunity with the small- or micro-cap companies if an investor is willing to do some work and possibly accept additional risk."
We also look for an understanding of how the capital markets work. One of the issues that comes up with small- and micro-cap companies is that of the brilliant scientist who has a very interesting compound but is unable to understand how the public markets work. In the process of trying to raise funds to continue development of the company, the scientist paints himself in a corner and ultimately sets the company up for failure. We see this very often.
On the other side, you can have a management team that is very clever with the workings on the capital market side, but the company's development pipeline is very weak. We try to find management teams and boards of directors or scientific advisory boards with the perfect combination of science and market savvy, because at the end of the day, you have to trust them to move a product or idea forward in a timely manner and efficiently from a capital-use perspective.
TLSR: Certainly you have to look at the product side. What do you look for?
RS: Investors should consider looking at the product to see where it fits within the competitive matrix of a particular market or industry. Is it going to displace an existing therapy or technology? Is it going to be used in combination with another therapy, or is it going to be a "me too" product? We try to avoid the "me toos," copycat versions of existing drugs. We're OK with combination therapies or technologies, but we try to find products that could displace existing therapies or technologies, should they be approved.
The last part of the equation is capital structure. How has the company financed itself to date? Who has put money into the company? Are they short-term investors who are just looking to give the company money and arbitrage out and flip the warrants, or are they long-term investors? The ideal scenario would be to have a top-tier fund in the stock that has been in that particular company for a while.
How much stock does management or the board have? How did they acquire that stock? Have they been purchasing stock in the open market? You want to see management buying stock consistently when the window is open, and you want to see them very hesitant to dilute shareholders. You also want to see them doing a great job managing their cash. Acorn Energy Inc. (ACFN:NASDAQ), in my opinion, is a prime example of what you look for from a management team, as the management team and board have been consistently buying stock.
TLSR: Speaking of management, when you're looking at and considering a company, do you insist on meeting management?
RS: We will not follow a company unless we speak with the management team. That's our first conversation. We want to be able to meet them, speak to them and get comfortable with them. It is a critical component.
TLSR: Could you go ahead and address some of the companies that you cover?
RS: I'll start with Acorn Energy. It's a technology/energy company providing digital solutions to improve energy infrastructure by making it more secure and more reliable. It's a compelling company because it's very different relative to what we normally see in the public domain. I say that because Acorn is a holding company with four separate subsidiaries, meaning that investors are essentially buying a portfolio of small companies. It's nice to have some diversification.
In the last four years John Moore, the CEO of the company, has successfully sold two companies at a multiple of revenues after initially funding them and building them up. He has done very well. As I said earlier, the first thing investors should look at is management, and Moore has validated his model. Also, insiders including Moore and some members of his board have been purchasing stock in the open market periodically over the last year, which is another very good sign. The company pays a dividend, which is a rarity among small-cap growth stocks. The dividend was meant to serve as a way for investors to participate monetarily in the sale of Acorn companies. It paid a special dividend after the sale of a previous portfolio company, as well as paying an ongoing quarterly dividend.
"We try to find the perfect combination of science and market savvy."
Each of Acorn's four current portfolio companies has different products, some of which overlap synergistically. But each is positioned in multibillion-dollar markets, and each has already achieved a level of validation within these markets. As continued validation occurs, the valuation of each of these companies will increase, and we believe the increase will be substantial. Acorn is a very exciting company to follow.
The company also has good capital structure. In addition to the dividend payments, Acorn has a strong balance sheet. One very interesting thing, from a short-term perspective, is the large short position that could create a potential short squeeze. This situation occurs when short positions run out of stock to short. Add some good news, and you have a significant amount of buying that comes in and forces the shorts to cover, and the stock can go up significantly.
TLSR: As of the middle of November, there were 3.9M shares short, representing about 25% of the float. If shares begin to resume their bullish upturn, how long could it take to close these positions to get some hefty upside in the stock?
RS: Based on the average trading volume for Acorn, which is a little over 100,000 (100K) shares a day, it would take well over 70 trading days to cover the position if the short seller were to buy back stock and if he were to represent 50% of the daily volume. However, it is unlikely that anyone will represent 50% of the daily volume, especially if they are buying, because they would potentially cause the stock to soar. So the unwinding of a short position would most likely take a lot longer than 70 days.
TLSR: What was the reason for the large short position? Was it because the stock entered the Russell 2000 Index? Could that be the only reason?
RS: Often when companies are added to the Russell 2000 or Russell 300 Indexes-Acorn was added to both this year-a large short position comes in. That's because index fund managers are forced to buy the stock. The idea is that some of these companies may not last long and will get kicked out of the index, which would create a significant amount of selling by the index managers. That is potentially why you see this large short position.
TLSR: In keeping with the John Moore business model, is your investment thesis that these Acorn subsidiaries will ultimately be sold or spun out, and value created that way?
RS: Yes. Moore finds small companies, funds them, builds them up and then ultimately sells them at a multiple of invested dollars and/or revenues. He's done this twice over the last four years, and we anticipate that he will do it again because that is his skill set. That is what's so exciting about Acorn.
TLSR: Another one you wanted to mention?
RS: One that has a near-term catalyst is ADVENTRX Pharmaceuticals Inc. (ANX:AMEX), which is led by CEO Brian Culley. We are big fans of the management team, as well as the board, which includes Jack Lief, the CEO of Arena Pharmaceuticals Inc. (ARNA:NASDAQ). Arena's weight loss drug Belviq (lorcaserin HCl) was approved by the U.S. Food and Drug Administration (FDA) just this year.
ADVENTRX is developing its lead product candidate, ANX-188 (poloxamer 188), for sickle cell disease, which affects a very small portion of the population but is a serious issue for those patients. The company's compound is scheduled to enter a phase 3 trial before the end of this year, which we believe will be a significant catalyst and could result in a higher valuation. At the moment, ADVENTRX trades at a negative enterprise value, which means its cash value is higher than its market cap. We don't believe that is likely to continue much longer, especially upon initiation of the phase 3 trial. We're definitely excited about the trial starting.
TLSR: I found clinical trials for poloxamer 188 going back a dozen years. The product has been used in foods, drugs and cosmetics for more than 60 years. What is special about this preparation? Also, we're talking about a compound that has been in the public domain for a long, long time. What about patent protection?
RS: One of the good things about the product being in the public domain for a long time is that it has an established safety profile, which is positive. Regulatory risk is mitigated to an extent because of the long-standing safety profile. As far as what's special about the product, ANX-188 is a purified version of poloxamer 188. Because of that the company believes its patent protection is sound and the compound may be used for other indications, which the company is currently exploring.
Another thought to consider is that sickle cell disease is an orphan indication, which means the company gets orphan exclusivity, enabling it to market its compound unobstructed by competitors for eight years. That's another bit of protection ADVENTRX has in this particular market.
In addition, the company had about $40M in cash at the end of Q3/12, according to its latest filings with the SEC. The company stated that the phase 3 trial would cost about $15-18M. It is sitting on a nice pile of cash, which would seem to give it a lot of flexibility.
TLSR: Ross, you are clearly saying that ADVENTRX can complete its phase 3 studies without partnering, right?
RS: Well, yes-but it might be attractive for them to partner. Also, a partner could come in at any time. I don't know if you've seen some of the partnership deals that have been announced, but there have been some pretty big ones. Novartis AG (NVS:NYSE) partnered with Selexys Pharmaceuticals (private) to gain access to its lead asset in a deal that could be worth up to $665M, including upfront and milestone payments for its sickle cell candidate. That was just in September. Last year Pfizer Inc. (PFE:NYSE) partnered with GlycoMimetics (private) to gain access to its sickle cell candidate, currently in a phase 2 trial, and that deal could be worth up to $340M in payments, plus royalties.
TLSR: What's your next idea?
RS: The next company is Ohr Pharmaceutical Inc. (OHRP:OTCBB). One of the reasons we're keen on this one is that Regeneron Pharmaceuticals Inc. (REGN:NASDAQ) has had tremendous success with its drug Eylea (aflibercept) for wet age-related macular degeneration (wet AMD). There is also Genentech's (acquired by Roche Holding AG [RHHBY:OTCQX]) Lucentis (ranibizumab) for wet AMD. Those two drugs combined should do about $5B in sales this year, as the demand increases and as the baby boomers continue to age and experience vision loss due to wet AMD. But these products are administered via injections into the eye, because they are large molecule antibodies.
"You want to see management buying stock consistently when the window is open, and you want to see them very hesitant to dilute shareholders."
Ohr, with just an $81M market cap, is developing a small molecule eye drop with similar and additional properties. Thinking of this from the patient's perspective, would you rather have an injection in the eye, administered by a physician in a clinic on a periodic basis, or an eye drop you can administer at home? I would speculate that most would think the choice is fairly obvious.
Ohr just initiated a phase 2 clinical trial with its squalamine drops, in which a patient is injected with Lucentis initially and continues on a maintenance program of Ohr's eye drops. This could be very exciting. There is also the possibility that squalamine could be a standalone therapy, thereby displacing Eylea, as well as Lucentis, as the market leader.
TLSR: You have discussed the importance of management in detail. What about management at Ohr?
RS: Management has, from my point of view, funded the company smartly since its inception using a group of insiders, and today Ohr has a solid balance sheet. It also has some of the best physicians and scientists in the ophthalmic space on its scientific advisory board.
TLSR: What's your next idea?
RS: We're very fond of Auxilio Inc. (AUXO:OTCBB), which has just a $19-20M market cap. There have been an incredible number of mergers in the hospital space because the Patient Protection and Affordable Care Act (Obamacare) is forcing hospitals to drive down costs. Auxilio manages an area that happens to be an incredible cost center for hospitals: printing.
TLSR: They do it at the hospital, correct?
RS: Right at the hospital. Auxilio's onsite staff is integrated within particular hospitals and hospital systems. They wrap their "arms" around the whole hospital system's printing issues, from top to bottom. If a copier breaks, they handle it. If there's an issue with a printer, an Auxilio staff member will repair it. The company also consults with and educates the entire hospital system on a more environmentally friendly approach to printing, while simultaneously taking a vendor-independent approach, paring down contracts to reduce costs and realize economies of scale during what are typically three- to five-year contracts. I believe the company is compelling and has a competitive advantage versus the larger print companies out there.
TLSR: Will the company meet its goal of more than 50% revenue growth for this fiscal year?
RS: We believe that they are on track to do so. That's what management has officially stated.
TLSR: Your next idea?
RS: Our next idea is Algae.Tec (ALGXY:OTCBB; AEB:ASX), which is focused on the development and commercialization of innovative and leading-edge technology for the production of algae, capture of solar energy and sequestration of carbon dioxide. The company targets the substitution of fossil fuels with sustainable algae biofuels that can be used in transportation and energy production, among other applications. There has been a lot of talk and interest around this area. Algae.Tec is now in the process of commercializing its technology. It has entered into a contract with the airline company Lufthansa. Algae.Tec has other agreements in place, including one with Holcim Lanka Ltd., one of the largest cement makers in the world. Now it's a matter of continued validation in the form of new partnerships. We think other deals could come down the line particularly in the U.S in the near term.
TLSR: When the company announced the collaboration with Lufthansa back on Sept. 19, Algae.Tec's shares spiked. But now they're near a 52-week low, with an approximate $71M market cap. Institutional investors can't really get near this stock at that valuation. What is the catalyst that's going to drive these shares up?
RS: I believe the company needs additional capital to continue product development and speed up integration with some of its partners. Given that it has some important partners right now, we believe the balance sheet issue could be shored up fairly quickly, possibly by institutions, especially upon the announcement of another partner equivalent in size to Lufthansa.
TLSR: Can I get you to talk about one more idea?
RS: I have a last one: Oculus Innovative Sciences Inc. (OCLS:NASDAQ). It has two segments to its business. The first is a commercial portion, whereby it sells wound care products via its partners to both the veterinary market and the human market. It has had a level of success with some of its partners. Its non-antibiotic, anti-infective product Microcyn (hypochlorous acid + sodium hypochlorite) has utility in a number of different areas, including wound care and dermatology. The company signs on partners within each of those verticals, and the partners market the product, with Oculus getting a percentage of revenues. Partners have launched some of Oculus' products, which are relatively new to the market space, and some of the products are still in the process of being launched. We anticipate that revenues will continue to grow over time as additional adoption occurs.
The company also has a surgical side, a business it decided to spin out into a separate company. Basically, the company is addressing wound-care treatment in a surgical suite, so we're talking about an FDA-approved compound that will help with wound healing, scarring and other issues as well.
TLSR: It's a wonderful idea to displace antibiotics, when you can, for these various indications-infections of the eye, skin, ear, urinary tract, etc. We are facing an epidemic of antibiotic resistance today. Oculus' market cap is just $25M. How big do you imagine this market to be?
RS: It's a multibillion-dollar market. You hit the nail on the head about displacing antibiotics. A lot of people just put Neosporin (bacitracin + neomycin + polymyxin B) on a cut and a Band-Aid on top of it. But the utility of Neosporin is likely to decrease over time because of resistance formation. Oculus has an alternative to antibiotics, and it won't cause resistant bacteria to evolve. That's what's so exciting. It's a massive market. Treatment of diabetic foot ulcers alone is a multibillion-dollar market. You saw Shire Plc (SHPGY:NASDAQ; SHP:LSE) do a huge acquisition late last year in the space when they acquired Dermagraft. There is no question large pharma is very well aware of the wound care market, and the space is massive.
TLSR: Thank you so much for your time. It's been wonderful speaking with you.
RS: Thanks a lot, George.
Ross Silver has been advising, researching and investing in public companies across all industries throughout his career. Prior to founding Vista Partners LLC in 2005, Silver served as a research analyst for a San Francisco-based hedge fund. From 2000 to 2003, Silver served as a research associate covering consumer discretionary and consumer staple companies at Dresdner RCM (now Allianz). Prior to joining Dresdner RCM, Silver was a member of CIBC's Technology, Media, and Telecom Investment Banking group, where he assisted with equity and debt offerings. Silver holds a bachelor's degree in business economics from the University of California, Santa Barbara. He has served as a consultant for government agencies including the National Institutes of Health (NIH). He holds a Series 65 Securities license.
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1) George S. Mack of The Life Sciences Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Life Sciences Report: Oculus Innovative Sciences Inc., Acorn Energy Inc. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) Ross Silver: I was not paid by Streetwise Reports for participating in this interview.
4) Vista Partners LLC's disclosures are listed on the company website. View the disclosures here. View Vista Partners' coverage list here. Vista Partners is a registered investment advisor in California and Oregon. View terms and conditions here.
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