Hitch a Biotech Rocket Ride, Without Blowing Up

Biotechnology companies live or die by the strength of their innovation. As patents expire on highly profitable medicines, they must replace the lost income by inventing new drugs or acquiring companies that already possess breakthrough therapies.

This dynamic favors small-cap biotechs, which can richly reward (or punish) early investors. One secret to biotech investing is finding companies that emphasize unmet medical needs. Below, I spotlight promising small-cap plays with pioneering products and outsized potential.

Biotech companies as a whole are benefiting from increasing drug approvals, new product launches, and muted disruption so far from Obamacare. The U.S. Food and Drug Administration (FDA) has approved roughly 30 new drugs so far in 2017 and remains on pace to approve even more in 2018.

Biotech is an “event driven” sector, whereby clinical trial data and FDA decisions can cause a biotech stock to soar (or plunge). That’s another investment appeal of biotech right now, because the broader markets are overvalued and in need of earnings catalysts that can justify sky-high multiples.

Meanwhile, political risk for biotech has waned considerably. Wall Street has belatedly come to the conclusion that political grandstanding about controlling drug prices will come to nothing, especially in a Trump administration that’s shaping up to be fiercely anti-regulatory.

The collapse this week in the U.S. Senate of the latest iteration of Trumpcare is another long-term advantage for biotech, largely because it removes uncertainty from the health services industry.

Finding the pioneers…

The trick in making money from these trends is pinpointing the biotech firms with the greatest research and development (R&D) prowess and the most distinctive products, which is what the following ETF does for you.

ALPS Medical Breakthroughs ETF (NSDQ: SBIO) is an exchange-traded fund that specializes in small-cap biotechs that heavily invest in R&D.

With net assets of $126.78 million, SBIO seeks results that correspond to the performance of its underlying index, the Poliwogg Medical Breakthroughs Index, which is comprised of small- and mid-cap stocks of biotech companies that have one or more drugs in either Phase II or Phase III FDA clinical trials.

The fund’s holdings include the biotech sector’s most compelling innovators. The earlier-stage firms in the SBIO’s underlying index, the Poliwogg Medical Breakthroughs Index, devote about 2.7% of market cap on research and development, 29% higher than the R&D spent by components of the NASDAQ Biotech Index.

SBIO has racked up a robust year-to-date total return of 34.7%, compared to the S&P’s YTD gain of 11.7%. Over the past 12 months, SBIO has generated a return of 28.1%.

SBIO’s top five holdings are Kite Pharma (NSDQ: KITE), Exelixis (NSDQ: EXEL), bluebird bio (NSDQ: BLUE), Galapagos (NSDQ: GLPG), and ACADIA Pharmaceuticals (NSDQ: ACAD). The expense ratio is a reasonable 0.50%.

A major impetus behind biotech growth is the accelerating race to cure rare and hard-to-treat diseases. Among ALPS’ holdings, an individual stock that particularly interests me is ACADIA (market cap: $4.5 billion), which develops and markets pharmaceutical treatments for unmet needs in central nervous system illnesses that have resisted conventional treatment.

In an increasingly crowded biopharmaceutical industry, breakthrough products that address chronic needs that have been unresponsive to existing remedies offer the strongest possibilities for investors.

ACADIA’s lead product candidate is NUPLAZID, which has made substantial progress under FDA scrutiny. The small molecule drug has successfully finished Phase III trials for the treatment of Parkinson’s disease psychosis, as well as Phase II trials for the treatment of schizophrenia and Alzheimer’s disease psychosis.

The average analyst expectation is that ACADIA’s earnings growth will reach 28.9% over the next five years on an annualized basis.

Targeting unmet needs…

Another intriguing biotech small cap is Citius Pharmaceuticals (NSDQ: CTXR), which also develops and markets therapeutic treatments for unmet needs.

One of the company’s most promising products in the developmental pipeline is Mino-Lok, which has successfully completed Phase IIb clinical trials for the treatment of catheter related bloodstream infections. These infections can be life threatening and have resisted treatment. Mino-Lok is currently advancing to Phase 3 clinical studies, for which Citius is recruiting sites in the U.S.

Mino-Lok is designed to salvage central venous catheters, preventing the need to remove and replace the catheter. As such, Mino-Lok would address a widespread problem for which there has been no effective drug treatment.

Citius has a partnership and licensing agreement with Alpex Pharma to develop and commercialize orally disintegrating tablet formulations of drugs in the U.S., Canada, and Mexico. These orally dispersible treatments, known as “fast melt tablets,” are a hot area in drug development.

Citius also is developing a proprietary topical formulation of hydrocortisone and lidocaine to provide relief for hemorrhoids. This area actually constitutes a big growth opportunity: by age 50, about half of all adults must contend with the pain and bleeding of hemorrhoids.

When screening small-cap biotech companies, I’m always heartened when top management is seasoned and has put “skin in the game.” Citius Pharmaceuticals CEO Myron Holubiak previously served as president of Roche Laboratories. More than 67% of CTXR stock is held by insiders, another good sign. According to Securities and Exchange Commission documents, Chairman of the Board and Director Leonard Mazur has personally invested $10.5 million in the company’s shares.

Unlike many small-cap biotechs, Citius has a strong balance sheet, with a total debt-to-equity ratio (most recent quarter) of only 46.72. The market cap is $26.4 million, so this biotech is only suitable for aggressive investors willing to shoulder risk. However, if Mino-Lok survives the regulatory gauntlet, as increasingly appears likely, shares could skyrocket.

That said, given the inherent riskiness of investing in single small-cap stocks in the biotech sector, more cautious investors seeking hefty (albeit less exciting) gains should consider ALPS Medical Breakthroughs ETF.