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Small Biotechs May Offer Big Value
Barron's/June 1, 1998
(Mike - thanks for your notes, great report. Though not mentioned
by name, Gliatech definitely fits the investment profile in
following article. )
By Corinna Barnard
Biotechnology has grabbed the limelight in recent weeks since Pfizer
released Viagra and reports surfaced of EntreMed's success in treating tumors
in laboratory mice.
Just last Friday, Icos stock soared 30% after a newsletter reported that its
anti-impotence pill IC351, still in early clinical tests, has fewer side effects than
Viagra does. The shares gave back some of those gains Monday, closing at
20 7/16, down a little over 3%.
Yet investors often find it hard to play the smaller biotechnology companies
that make these kinds of breakthrough discoveries. Small biotech stocks remain
notorious for their volatility and the "bio-bombs" that cause share prices to
collapse when promising drug trials or marketing alliances with major
pharmaceutical partners go sour. And the 300 or so small-cap biotech
companies are much more likely to burn capital than turn a profit.
That's probably why the Nasdaq Biotechnology Index is lagging the market
badly -- up by just over 1% from a year ago, compared with a nearly 28%
advance for the Nasdaq Composite Index, although they have gained almost
6% so far in 1998. As with the overall market, small-cap biotechs have lagged
their larger peers.
But some champions of the group are beginning to notice signs of life after five
or six miserable years. In a late April report for Hambrecht & Quist, "The
Case for Biotech: A Rally Approaches," industry analyst Richard van den
Broek declares: "The biotech wave is building quietly, but steadily, and will
have gained significant momentum before its strength becomes apparent to a
wider audience." The biotech industry should begin verging on profitability in
the "next 12 to 18 months," he predicts.
Kurt von Emster, fund manager of the $80-million Franklin Biotechnology
Discover Fund, also sees some light ahead. "I think it's a good time to be
involved in the group," von Emster told Barron's Online, adding that this is the
first time he's been comfortable investing in the sector this decade.
Why the change in sentiment? Primarily for two reasons: valuations and
technology. "This is a group that has underperformed the broad market for the
last five years," says von Emster. In the meantime, he says, their technologies
have progressed and the companies are closer to delivering products that can
make money.
In his report, analyst van den Broek says that "about 40 new therapies being
developed by biotech companies . . . have the potential to reach the market
during the 18 months between early 1998 [and] mid-1999 . . . Even if only
some successfully meet commercial expectations, the universe of biotech
companies with revenues and profits will be significantly broadened."
How to tell which ones will reward shareholders? The key signposts are
clinical tests and regulatory approvals. Phase III trials are the most important
of all the clinical tests of human subjects. If the test drug fares well in Phase III,
the company will file for regulatory approval. An advisory panel of the Food
and Drug Administration decides whether to recommend the drug for
marketing, and the FDA usually abides by the panel's judgment. Most drugs
are launched on the market almost immediately upon approval.
With many drugs now going through this process, David Stone, an industry
analyst at Cowen & Co. in Boston, sees strong potential growth ahead. He
says it's better "to invest in a group that is lagging, but where the fundamentals
are very strong, than when the cover of every news magazine has an article
about how well they are doing."
What's more, Stone points out, years of underperformance have caused the
price/earnings ratios of many biotechnology stocks to be either in line with or
below their expected earnings growth rates. By contrast, stocks of the major
pharmaceutical companies trade at P/Es that are roughly twice their growth
rates.
Which stocks should investors look at? Most advisors prefer companies that
have been around for a while, have a diversified product line and have struck
alliances with larger pharmaceutical companies that can provide marketing
muscle. Most important: look at companies with products that have already
gone through clinical trials and have gotten FDA approval, leaving earlier,
development-phase investing to venture capitalists. Investors, says van den
Broek, "are best served by investing in companies after they have successfully
crossed these hurdles."
Dr. Charles B. Engelberg of AmeriCal Securities, a San Francisco-based
investment advisor to fund managers, also suggests focusing on companies
whose products fill large, unmet medical needs and that will enjoy a favorably
reception among practicing physicians, who can make or break a new drug.
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