Why small biotech stocks are the best choice for big returns

Each week, a professional investor tells us where he’d put his money. This week: Carl Harald Janson of the International Biotechnology Trust selects three potential acquisition targets in the biotechnology sector.

Sales at larger biotechnology firms are stalling as product growth slows and firms face increasing price pressure. We think better investment opportunities exist in the small- and mid-cap universe.

These smaller companies will drive growth in the biotechnology sector, as they are developing drugs for unmet medical needs, such as dementia or cancer. The increase in efficiency in research and development came to fruition in 2017 with 46 new drug approvals in the US the highest number in 20 years. Many of these new drugs originate from small and medium-sized firms.

There are greater risks attached to these firms than to larger ones, as their cash flows are less stable. To minimise this risk, we favour companies with recently approved drugs. Small and medium-sized companies are also likely to benefit from the appetite for mergers and acquisitions. The recent US tax reforms should provide a boost to this trend. Below, we look at three candidates for acqusition.

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A prime target

Acadia (Nasdaq: ACAD) recently launched Nuplazid, which is the first and only drug approved by the FDA for the treatment of hallucinations and delusions associated with Parkinson's psychosis. It is wholly owned by Acadia and would provide growth for a larger company's drug portfolio. The drug is also in clinical trials for dementia-related psychosis, which, if successful, could expand the label and increase sales considerably.

In 2016, Exelixis (Nasdaq: EXEL) launched the drug cabozantinib for kidney and thyroid cancer. It is expected to achieve sales of more than $500m this year. The drug is also being developed in Europe in partnership with Ipsen Pharmaceuticals. Evidence of efficacy across other tumour types, such as liver cancer, should boost sales further. Analysts' estimates indicate that the drug has a peak sales potential of $1bn-$2bn.

The firm also has another oncology drug called cobimetinib, in partnership with Roche, that is indicated for a subset of melanoma patients. It is also undergoing clinical trials to assess its efficacy in colorectal cancer.

A promising pipeline

Last year, Neurocrine Biosciences (Nasdaq: NBIX) launched a drug called Ingrezza, which minimises the movement disorder tardive dyskinesia, which is a side-effect of antipsychotic medications used to treat schizophrenia and bipolar disorder. Sales have beaten analysts' expectations. Ingrezza is wholly owned by Neurocrine, making an acquisition more likely.

The firm also has a treatment for endometriosis and uterine fibroids called elagolix, in partnership with AbbVie. This drug is currently with the US regulator, the Food and Drug Administration (FDA), and is expected to receive approval in the latter half of this year for endometriosis. Data for the second indication, uterine fibroids, is also expected this half year.

Analysts expect the drug to achieve more than $2bn in sales for endometriosis alone. As elagolix only partially suppresses oestrogen levels, effects on bone mineral density are minimal, and the incidence and severity of menopausal side effects, such as hot flushes, are reduced, in contrast to first-generation drugs of this kind.

Carl Harald Janson is investment manager of the International Biotechnology Trust.