Street Talk: Small-Cap Biopharmaceutical Stocks

It's the dog days of summer and there isn't too much happening on the larger life sciences financial front. As I write this, second quarter results are just starting to trickle in, with Genentech leading the way. If Genentech is any indication, the quarter should be a mixed bag, with a little something for everyone. Genentech beat analyst expectations, earning $0.78 per share against analyst expectations of $0.72 per share. Particularly encouraging to the South San Francisco-based pharmaceutical giant were sales of its cancer-fighting drug Avastin, which soared 33% for the quarter to $564 million.

Brian O'Connell

Long-range, Genentech raised its full-year profit outlook to a range of $2.85 per share to $2.95 per share, excluding charges. It had expected to earn $2.79 to $2.90 per share. But analysts say that the figures rely on a rosier-than-reality outlook for Avastin for the rest of 2007. Also, sales of other key drugs, like Herceptin and Lucentis, need to remain steady. Genentech's flagship product, the rheumatoid arthritis and non-Hodgkin's lymphoma drug Rituxan, saw $582 million in sales during the quarter, an 11% increase. If Rituxan can keep that up, then Genentech should be a big winner by year-end.

But it is not the big boys like Genentech that I'm focusing on this August. It's the smaller stocks that operate in the bigger life sciences orbit that deserve some scrutiny. That means stocks like Tercica (TRCA), which recently has seen its stock price grow by 25% after an announced agreement with Genentech to pay $53 million to combine its Increlex with Genentech's Nutropin, a growth hormone, to form a once-daily injectable treatment for children who don't grow normally. As a result, Tercica's market cap has skyrocketed to $270 million, even after posting an operating loss of $86 million in 2006.

On the other end of the small-cap spectrum is another biotech firm with a hefty market cap, but with much different prospects than Tercica. The company is Depomed (DEPO) and is trading down under $2 per share, after trading as high as $5.80 per share. As one Internet wag put it, Depomed was a "one trick pony . . . that in this case, the pony died." According to the Associated Press, Depomed's stock suffered after "results of a late-stage clinical trial of its Gabapentin GR extended release tablet for nerve pain didn't show significant effectiveness versus placebo." After losing $42 million in 2006, even with a market cap of $200 million, Depomed looks like it is on its way out.

SMALL-CAP BIOPHARMACEUTICAL STOCKS: PLAIN AND SIMPLE

The dichotomy between the likes of Tercica and Depomed defines the small-cap biopharmaceutical world, where risk is high but so is return.

Few investment asset classes offer both the risk and reward that small-cap stocks provide. While small caps are certainly more volatile than their large-cap brethren, there's little doubt that, historically, small caps offer plenty of benefits to investors of all stripes. That's especially true of small-cap biopharmaceutical stocks, which, as measured by the NASDAQ Biotech Index, have far outpaced the growth rates of their large-cap brethren.

So what are small caps? They are companies with a market capitalization of $1 billion or less. Market capitalization can be calculated by taking the number of outstanding shares and multiplying by the current per share price.

Experts agree that small-cap stocks, especially those with market caps under $500 million, are riskier investments, but have higher profit potential. By and large, the lower the market cap, the more vulnerable the investment. So small-cap stocks with market capitalizations under $500 million represent a much greater investment risk than small cap stocks with market caps twice as large.

So a reality check is in order. Small-cap stocks can be risky. Smaller companies that bring a great idea to the marketplace can find that it's not enough—bigger fish can wade in, take the idea, and beat a smaller competitor into bankruptcy. Economic factors like interest rates, consumer demand, and employment trends are more easily absorbed by larger, more stable companies like Genentech, Amgen, and Johnson & Johnson. Not so small-cap companies: such factors can turn a smaller company's bottom line from black ink to red fairly easily (like Depomed). And small-cap companies are harder to evaluate. They have shorter track records, little historical data, and usually a shortage of good, hard information.

But small caps do offer a wealth of opportunity for investors. Think about Fortune 500 mainstays like Proctor & Gamble, Microsoft, Amazon.com, or Google. All began as small companies. Traders on Wall Street say that they're not sure where the next Microsoft is coming from, but it will most certainly start out as a small company. Growth is another factor—it's much easier to double or triple the sales of a company that does $10 million in sales annually, than a company that does $5 billion in sales.

I particularly favor small-cap growth companies, which flourish in the risk and reward nature of the biopharmaceutical industry. As recent history attests, small-cap growth stocks have packed plenty of portfolio punch in recent years. On an annualized basis, the S&P Small-Cap 600/BARRA Growth Index posted 14.7% gains during the past three years, surpassing the performance of all other small-cap asset classes, as well as mid-cap and large-cap stocks.

Growth stocks are usually defined as companies whose earnings are projected to grow faster than the entire market as a whole. That's good news at times of economic peak performance; growth stocks historically outpace other asset classes in good economic climates. Conversely, when the economy recedes, growth stockholders are often left holding the bag, as smaller, riskier growth stock companies can't absorb the body blows of a tough economy.

But that's the risk you take when you invest in small-cap growth companies, which are traditionally younger and more economically vulnerable. That's simply because younger, smaller companies with an aggressive mindset can grow significantly faster than other companies. Investors adopt that mindset because they believe that growth in earnings and revenues will trigger an accompanying boost in stock price. That's why high-flying, high-risk industries like technology and life sciences are chock full of small-cap growth firms. Usually in such companies, profits are earned through capital gains instead of dividends. When looking for small-cap growth stocks, one of the first things you'll learn is that they don't pay investors a dividend.

How do you judge the merits and the value of a growth company? It's not easy, because there is no one simple formula. Wall Street gurus advise focusing on strong historical earnings growth, based on annual revenues. Another key factor is solid forward earnings growth. Look for a five-year growth rate of about 10–15%. Check for other competitors in the industry. How does your potential small-cap growth company stack up? Also make sure that management has its eyes on the ball financially. If management isn't controlling costs, or doesn't have a lot of cash on hand, it can fall prey to any number of economic and competitive industry events. Lastly, look to the future and evaluate whether the growth company has a realistic shot at doubling its revenues over the next five years. Look for a growth rate of 15% annually. If there are no signs of such growth, you don't have a growth stock on your hands.

THE TAKEAWAY

Stick with familiar territory and focus on real-world issues like debt loads and cash on hand. Don't attempt to time the market with small-cap stocks, either. Pick a few companies that pass your due diligence muster and then be patient. Good stock market stories can often take a long time to develop, and that's been the history of small cap stocks, especially in the life sciences sector. At first, keep your small-cap exposure to no more than 10% of your portfolio, then gradually increase your small cap holdings.

After all, 10 years from now we'll be talking about new life sciences giants that could supplant the Genentechs of the world. When we do have that discussion, the companies in question will likely come from the small-cap universe.

Celebrity author and business/finance commentator for CNN and Fox News, Brian O'Connell has written for The Wall Street Journal and Newsweek, Doylestown, PA, 215.230-3711, brian.oco@verizon.net.