There’s a joke among investing circles that early-stage biotech investing is like throwing a big plate of spaghetti on the wall and seeing what sticks.
There’s an element of truth to that. Many early-stage biotech stocks are little more than unproven ideas on shoestring budgets. Some of those “spaghetti noodles” stick after the FDA approves a revolutionary therapy, but most fall to the floor. They either run out of cash, or their ideas end up being unviable.
There’s nothing wrong with playing that game, particularly if you’re a “quant” who can find signals in the price action — and thus are not required to guess which companies will win a big approval. But even then, it’s a low-probability proposition. You have to know that going in.
At the other end of the spectrum, you have the slow-growth pharmaceutical behemoths with large portfolios of patented blockbusters. It’s easier to get a handle on what you’re buying here, as the companies have long operating histories and good visibility into patent lifespans. But most of these companies are beyond their best growth days.
The Power of Size
Ideally, I like to hunt for biotech stocks that fall somewhere in the middle. I want these companies to be established enough to be out of the high-risk start-up phase but small enough to still be in the fast-growth phase.
In Green Zone Fortunes, we have four open positions in the health and biotech sectors. Two of them, including my highest-conviction genomics stock recommendation, fall into this bracket.
When digging into a stock, size matters. A lot. It’s been easy to forget that in recent years, as a handful of tech mega caps have dominated the market. But over time, smaller stocks have enjoyed a size premium, outperforming larger companies even after adjusting for risk. Smaller companies are followed by fewer Wall Street analysts and may be too small for large institutional investors to buy. That explains some of their favorable pricing. They’re also better acquisition candidates (more on that in a moment).
Even University of Chicago professors Eugene Fama and Kenneth French — true believers that the market is “efficient” and that there is no value in doing stock research because all usable information is already factored into current prices — found that small-cap stocks outperformed their larger peers and introduced a “size factor” into their market model.
I, too, incorporated a size factor into my six-factor Green Zone Ratings system, and I tend to focus my research efforts on smaller companies. I’m a lot more likely to find an undiscovered gem that the market has undervalued in that space.
Small-Cap Biotech Stocks Poised to Outperform
Right now, I’m seeing a promising setup in smaller biotech companies. Small-cap biotech stocks will often lag their larger peers in a bull market. That has been the case this year. Driven in part by the outperformance of COVID-19 vaccine makers, large-cap pharma and biotech have pushed higher in 2021, while the small-cap names are negative year to date.
If recent history is any guide, we shouldn’t expect that divergence to continue. In both 2015 and 2018, large caps led the recovery in this space, but small caps quickly followed.
There’s another angle here as well. Faced with long development pipelines, many large pharma companies opt to simply buy growth by acquiring smaller companies with promising new therapies. Just this past week, Pfizer paid a 118% premium over market prices to buy Trillium Therapeutics Inc. The pharma giant wanted access to Trillium’s new oncology treatments.
I don’t buy companies expecting them to be acquired. I consider that a nice bonus. But it stands to reason that a company that excites me would also excite Big Pharma.
Within the biotech space, genomics, or DNA-based science, is the biggest game-changer of our lifetimes. This is an investment opportunity bigger than the internet because it goes far beyond medicine.
With small-cap biotech stocks lagging behind their larger counterparts, this is the perfect buying opportunity. You can get into some of these small- and mid-cap positions as they play catch-up. And the best part is you don’t have to use a “spaghetti on the wall” approach.
If you want access to a curated selection of biotech and health-based plays, including my No. 1 genomics stock, click here to watch my “Imperium” presentation now. You’ll see why I believe DNA science is set to disrupt global industries worth $64 trillion.
My Green Zone Fortunes subscribers already locked in 90% gains on half their position in just over four months. Now they are sitting on 170% gains on the second half of the trade … but here’s the best part: My No. 1 genomics stock is still well below my buy-up-to price. You have time to get in now before this stock runs even higher. Click here for details on how to join us now.
To good profits,
Adam O’Dell
Chief investment strategist, Money & Markets