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My Biotech Watch List

June 19, 2018, 11:16 am

It’s been a good year for growth stocks, with the Russell 3000 Growth index up over 8%. In addition, the best-performing names have been the most aggressive. This is a bit surprising given the rise in interest rates, which theoretically should not be in favor of growth stocks. However, the mantra of this bull market has been that as long as earnings are rising, stocks will be okay. Given this, investors are comfortable paying significant premiums for highly visible growth.

Biotech, on the other hand, has underperformed meaningfully so far this year, with the iShares Nasdaq Biotechnology ETF (IBB) up less than 1%. This makes sense since the top 10 components of the IBB, which make up 52% of the ETF, are mostly large companies that have maturing products or are facing competition or patent expirations. Due to patents, the life cycle of a new drug is only about 12 years, forcing the companies to replace and surpass these products if they want to grow. This becomes increasingly hard as they get bigger, which is why many of the giants of IBB have such low PEs as there is the risk of a meaningful decline in earnings down the road. For example, Biogen (BIIB, 8% of the index) has a PE of 11.5X 2019 EPS estimates, Amgen (AMGN, 8%) has a PE of 13, Gilead Pharmaceuticals (GILD, 7%) has a PE of 11 and Celgene (CELG, 7%) has a PE of 8.

So while IBB has underperformed most growth stocks, it’s a little unfair to call it a growth index as its performance is in line with many value benchmarks. To be clear, though, I am not saying that biotech is dead or that there are no game-changing opportunities here. Instead, you need to look at the smaller companies that are in developmental stages with little to no sales or earnings. There is certainly no shortage of these types of companies. In fact, of the 147 biotech companies with capitalizations of at least $500 million, only 29 earn money. There is tremendous potential in these smaller biotechs, but there’s also considerable risk as a high percentage of these companies will not be strong long-term performers. However, the ones that can successfully develop the right products will have a bright future.

With that in mind, I want to share three of the developmental stage names that are on my watch list right now.

LOXO Oncology (LOXO) wowed investors for the second straight year earlier this month at the important American Society of Clinical Oncology (ASCO) meeting. The company is potentially revolutionizing treatments for certain cancers by focusing on their genetic mutations instead of where they exist in the bodies. In 2017, it presented data on its lead drug, larotrectinib, which had a 76% response rate in patients whose tumors had specific genetic markets. This year, LOXO-292, a drug earlier in the pipeline, showed a 77% response rate in treating solid tumors with RET (the gene that produces a protein for signaling between cells) and a 45% response rate in mutated thyroid cancers. Both of these drugs are still in Phase I and II trials, so it will be a few years before they are approved and the company realizes revenues. The stock has been a strong performer but has corrected a little off its recent high of $208.95, and any period of potential broader market weakness could be a good opening.

Xencor (XNCR) is a developmental stage company that makes monoclonal antibodies for the treatment of autoimmune diseases. Its lead drug candidate is XmAB5871. It’s currently in Phase II testing for IgG4-related diseases, which is a chronic inflammatory condition characterized by tissue infiltration with lymphocytes. In November 2017, all 12 patients in the Phase II study achieved their primary endpoints of a two-point reduction in the IgG4 responder index, with eight achieving remission. The company’s pipeline goes well beyond IgG4, as it has an oncology program that focuses on activating T-cells to kill malignant cells. XNCR partners with larger companies, including Alexion Pharmaceuticals (ALXN), whose ALXN 1210 drug candidate makes use of its technology. The broad pipeline of Xencor makes it more attractive, and I would consider adding it on a pullback.

Atara Biotherapeutics (ATRA) is developing T-cell immunotherapy treatments for patients with cancer and autoimmune and viral diseases. The company is in its pivotal Phase III trials of tab-cell in patients with Epstein-Barr virus, which causes mononucleosis (also known as the “kissing disease”). Management is optimistic about approval and hopes to file a New Drug Application (NDA) with the European Union (EU) in the first half of next year. ATRA is also working with the Sloan Kettering Cancer Center to develop the next era of genetically modified T-cells. The stock has dipped after running up sharply in May in anticipation of the ASCO meeting, so a buying opportunity may not be far away.

To drive superior returns, investors need to turn more to developmental stage companies with greater risks. Some of these companies have already had nice runs in the “risk-on” environment for growth, but by practicing patience and waiting for the best entry points in strong stocks, there is good money to be made in this sector.

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