Watchlist Analysts Forecast Continued Blue Sky for Biotech Industry

While the focus of the 2015 Small-Cap Biotech Watchlist panel was on names that made the cut, the five analysts also highlighted factors playing into the vigor of the space that investors should be on the lookout for, including the need for ongoing scientific innovation and changes in the pricing and regulatory environments. The panelists asked to select the 2015 Small-Cap Biotech Watchlist were George Zavoico of MLV & Co., Joe Pantginis of ROTH Capital Partners, Bert Hazlett of Ladenburg Thalmann & Co., Reni Benjamin of H.C. Wainwright & Co., and moderator Mara Goldstein of Cantor Fitzgerald.

1. Signs the Biotech Market Will Continue to Grow

Overall, the biotech market looks like it will remain robust for the foreseeable future, according to Benjamin. This should last until "some sort of sea change, whether it's macro, pricing pressure, or something else that causes generalists to come out of the sector. But there are several factors that should power this market for at least the next several years."

First up, according to Benjamin: a scarcity of innovation in big pharma. "Pharma companies continue to jettison their research and development (R&D) divisions left and right," he said, and instead look to biotechs for innovations that will power future growth. "The funding cycle over the last couple of years has left many small-cap companies in a much, much better financial position than they ever have been in. That's very good from a development point of view, because a lot of the small-cap companies we cover are running the right-size trials. . .Small-cap biotechs are running randomized Phase 2 studies that allow us to make much more educated and confident bets on products going forward."

Benjamin also pointed to M&A. "If pharma doesn't have an R&D division, it has to acquire or merge with other companies. . .there is really a significant push to acquire assets in development. Biotech is the only game in town for these bigger players that don't have R&D divisions."

Watch the 2015 Small-Cap Biotech Watchlist Panel Discussion

Then, there is pricing. "Pricing so far has not been an issue," Benjamin said. But "It definitely could derail the train at one point. It's something that all investors should keep an eye on because once that sort of shot is fired across the bow, you may see—and this might be an interesting point for us to discuss—something like what happened back in the 2000 genomic bubble. . .The second some sort of significant clampdown occurs, let's say, at the government level or the insurance level, that's going to cause a lot of investors to take some pause, because right now, the sky is the limit."

2. Is the Price Right?

The subject of pricing sparked comment from other analysts on the panel as well.

When a company has "an opportunity to position a novel drug in an otherwise commoditized environment, it can take price on it," Goldstein observed. And "for products that are truly novel, that's where we think you will tend to see the premium pricing be maintained."

But pharmacoeconomics—determining whether the price of the drug is worth the social and economic benefit—will be the deciding factor. Benjamin noted that currently, a gene therapy in Europe sells for $1.4M, and that remains acceptable.

"Everybody is looking at what the United Kingdom is doing," said Zavoico. "The National Institute for Health and Care Excellence (NICE) doesn't add drugs to its formulary when it thinks the clinical and societal benefit is not sufficient to justify the cost to the healthcare system." He doesn't think that kind of action will happen in the States, but advised investors to bear in mind that some variation on the European model could take hold here, adding that the political climate for major policy change just isn't there, but that third-party payers may act on their own to rein in costs.

"There's a coming problem in oncology," observed Pantginis, recounting how the topic of pricing came up at a major cancer conference in 2014. Expensive targeted drugs—and combinations of expensive targeted drugs—are being used more often in lieu of traditional chemotherapies. "Right now, the blanket statement is if you garner a survival benefit, you're going to get reimbursed," he said. Then he noted that a doctor from MD Anderson told a panel at the conference that "the rising drug costs violate the Hippocratic oath of not causing harm to your patients."

3. Get a Grip on Risk/Reward

The analysts also took on the issue of how and when companies should abandon drug candidates.

"I'm a big believer that if a drug fails the primary endpoint, the trial has failed," said Benjamin. "A lot of biotech companies love to talk about going to the FDA with positive secondary endpoints—that the FDA is much friendlier right now." But this is not necessarily true, and "from a valuation perspective, it's easy for us to just take that revenue line right out of the model. The next step is to look at the rest of the pipeline. A lot of these companies are not one-trick ponies. They have a pipeline. They have other assets that could generate value."

"We do have companies that have very binary endpoints," Goldstein said. "Those have a very different risk/reward profile. You have to go in with eyes wide open and understand that irrespective of what you think of the data, it's a very long road to redemption once a trial has failed for a company. I look at the universe in two different ways: stocks that have binary endpoints but offsets. . .and then those that exclusively fit this binary endpoint model."

"Let's face it, every compound that's being developed is a billion-dollar compound, right?" Benjamin added. "If you're not developing a billion-dollar compound, you're not a biotech company. But if you're in Phase 1 and you have a $1B market potential, there's no investor on God's green earth who's going to value your company anywhere near that market potential. It's all risk-adjusted. That's something that we would definitely do after a Phase 3 failure."

4. Consider Select Immunotherapy Companies for Future Growth

With all the focus on immuno-oncology, the analysts were optimistic about the prospects for sustainable valuations among companies working in this field. As Goldstein observed, "We have seen this subsector of oncology gyrate through various levels of investor enthusiasm, from wildly interested to unapologetically uninterested. Many will point to Dendreon Corp.'s (DNDN:NASDAQ) Provenge (sipuleucel-T) as a reason to believe that the overall commercial opportunity is limited. But we think that the argument is product-specific, rather than all encompassing."

"It really first comes down to, again, clinical data," said Pantginis. "In the vaccine space, we need another win, because it's been sullied by what happened with Dendreon. Investors and others throw these things into the same basket, even though different companies have different approaches with regard to immunotherapy. We need another Phase 3 win. We need another approval. Celldex Therapeutics Inc. (CLDX:NASDAQ) had some very good data with rindopepimut in recurrent glioblastoma. That could potentially be the next cancer vaccine win in the U.S., but it's really going to come down to the clinical data."

"Valuations for these small molecule checkpoint inhibitors are pretty solid," said Benjamin. "You have compelling data, you have approved products and you have big pharma licensing with small-cap biotechs. . .those are sustainable activities that are planting a foundational valuation on this entire class. We're hopeful that it's only up from here."

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