You don't necessarily have to sift through microcaps. You do need to focus on the right metrics. Maxx Chatsko offers his perspective.
June 21, 2021
Drug developers make great multi-bagger candidates, but they look almost nothing like a traditional business. An early-stage drug developer doesn’t have recurring revenue, earnings, or operating cash flow. Many keep the lights on through public offerings of common stock, which can take a toll over years of development. Investors can go entire quarters without receiving much of an update on pipeline progress. When updates are provided, they’re usually chalked full of technical and statistical jargon that can be difficult to understand.
That doesn’t change the fact that successful drug developers can often provide disproportionate returns for your portfolio. Although I never research stocks with the explicit intention of finding a 10-bagger, early-stage drug developers that deliver sustainable, outsized gains tend to have several qualities in common.
Technology platforms: A technology platform allows a drug developer to leverage technical prowess across multiple therapeutic areas, spread risk across the pipeline, and recover more easily from failures. Technology platforms are also more attractive for acquisitions, especially considering the recent trend among larger pharmaceutical companies that shuns developing internal platforms in favor of developing single assets with blockbuster potential.
Of course, the technology platform has to actually work. Alnylam Pharmaceuticals (NASDAQ: ALNY) pioneered RNA interference (RNAi) therapeutics, but the therapeutic modality failed to live up to the initial hype after winning a Nobel Prize in 2006. After struggling for years, the company found sustainable success on the heels of two breakthrough inventions: Enhanced stabilization chemistry (ESC) and GalNAc. The first optimized how the therapeutic payload interacted with the body, while the second is simply the name of a sugar attached to the therapeutic payload that safely and efficiently directs it to the liver.
The first RNAi drug was approved in 2018. The fifth could be approved by the end of 2021. Each was developed by Alnylam Pharmaceuticals.
Addressing pain points: This might sound obvious, but sometimes pain points can be difficult to pinpoint. They can be multi-layered and abstract. For example, genetic medicines such as RNAi and CRISPR gene editing address the pain point of having limited tools to effectively treat the root causes of disease, but each therapeutic modality must confront its own drawbacks. RNAi developers are trying to replicate success in the liver with other tissues, such as the central nervous system or lung. Atalanta Therapeutics, a well-funded startup founded by the inventors of RNAi, is developing a technology platform specifically targeting RNAi payloads to the central nervous system.
Meanwhile, CRISPR gene editing relies on mutagenic DNA repair mechanisms, which means the cell might preserve cancer-causing genetic mutations when attempting to stitch the genome back together after being cut by the therapeutic payload. That alone could make more precise gene editing technologies, such as base editing being pioneered by Beam Therapeutics (NASDAQ: BEAM) and Verve Therapeutics (NASDAQ: VERV), a better long-term investment.
Probability of success (POS): Early-stage drug developers don’t have traditional financial fundamentals to interrogate, which means predictive models are mostly trying to determine the probability of success (POS) for each asset in the pipeline. In other words, what are the chances that an asset earns regulatory approval?
The rates of success are quite low even for well-established therapeutic modalities. Historical averages suggest that a drug candidate that advances past a phase 1 clinical trial has a 9.6% chance of reaching the market. The averages are higher (26.1% for hematology) or lower (5.1% for oncology) depending on the therapeutic area. There are differences when it comes to specific therapeutic modalities, too.
This single metric can be a prime hunting ground for biotech stocks with 10-bagger potential. For example, Wall Street might pencil in a very low POS for an unproven therapeutic modality or underestimate the influence of technical advances. When an unknown stock pops onto the radar with a single, huge daily gain — think Rubius Therapeutics (engineered red blood cells), Seres Therapeutics (microbiome), or any company developing an Alzheimer’s treatment — then it’s usually because Wall Street analysts had to quickly adjust the POS in their models.
In the early 2010s, Alnylam Pharmaceuticals couldn’t get a new paint color for the office approved. Today, liver-directed RNAi drug candidates enjoy a nearly 60% POS from phase 1 onward — by far the highest of any therapeutic modality in the industry.
Unfortunately, modeling drug developers requires a deep understanding of the science behind a therapeutic modality, knowledge of the competitive landscape, and a healthy dose of objectivity. Penciling in an unrealistic POS for a pipeline just because you own the stock can be a very dangerous game indeed. Nonetheless, Wall Street can be overly pessimistic (or optimistic), which could signal an opportunity for patient investors.
If you want to find your first (or next) biotech 10-bagger, then you’ll need an abundance of patience. Shares of Alnylam Pharmaceuticals gained only 60% in the company’s first seven years on the market. They’ve gained 1,860% in the decade since. Waiting for a whole decade might sound boring after a YOLO 2020, but time is often one of the biggest advantages for individual investors.
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