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Small Companies, Big Returns

December 7, 2012
The broader biotech indices are up more than 30 percent this year and have reached levels not seen since the peak of March 2000. Larger biotechs account for much of the index returns, as we have described previously, and have helped the sector outperform the S&P 500 by two fold. But how have smaller biotech companies been performing?

As of Nov 30, 27 companies that started the year under $1 billion in market capitalization have jumped 100 percent or more.  That is a little more than the top decile for the category. When compared to the small cap returns across other industries, only 72 of 1730 (4.2 percent) had 2x returns.

Consider the returns this year for the top 20 performing companies under $1B:  (source: Factset)

Finding positive outliers, with 2x, 3x, or even 5x returns can have a big effect on a concentrated portfolio. A small 1 percent position with a 5x return can move an entire portfolio 4 percent.

Of course, in biotech, picking these winners requires more than a glance at burn rates and cash on hand. It takes a detailed understanding of the company’s leading pipeline assets - a drug’s market potential, its competition (on the market and in the pipeline), likelihood of clinical success (which in turn depends on safety profile, modality and novelty of mechanism of action), the potential regulatory scrutiny, and the drug’s probability of achieving reimbursement – just to name a few items.

But the hard work can pay off. Small cap biotech is one segment of the overall market where skilled investors with deep industry knowledge can outperform equal weight and market cap weighted baskets of securities. Specialist hedge fund managers have been able to spot small cap winners and beat the average returns listed above.

One fund manager that has been able to do to just that is Peter Kolchinsky whose fund RA Capital has been able to beat the average returns by a wide margin over the last ten yearsIn his words: "Smaller, development-stage companies cannot be understood through their financial statements the way larger profitable companies can be. You have to differentiate between good and bad science, data, trial design, and target markets, all on borrowed time as cash burns down.  We have a great team dedicated to dissecting the fundamental basis for everything these companies do and we try to anticipate the chess game that companies play in competitive fields. That's helped us make some good investments. But we always appreciate a little luck."

Kolchinsky is one of hundreds of biotech investors that will be attending BIO's next investor event, the BIO CEO Conference in February. As the world’s only independent conference focused on publically traded biotechs, it is the essential event for scouting next year’s winners at therapeutic panels, business roundtables, and company presentations.

To illustrate the importance of detailed research in small cap biotech investing, consider that the small cap biotech universe has been lagging large caps. When we break annual performance into two groups, companies above $1B in market cap and those below $1B at the start of the year, we find larger companies standing out as performance leaders in the sector. In fact, for the last six years, the average stock performance for small biotechs has underperformed larger biotechs every year except 2009 (see table below).

(In the table above, we break down the average performance for companies above $1 Billion in market valuation and those below at the start of each calendar year. This is similar to the performance of an equal weight position taken in each stock on Jan 1st. The number of publically traded biotechs is listed for each category. Companies under $10M market cap are excluded. Median results generated the same outcome. Source: Factset, Blackrock, BIO)

But is this a market-wide or a sector-specific phenomenon? Using the same methodology as above, we sorted the companies currently listed in the Russell Large, Small, and Micro Cap indices by market cap range at the start of each year.* The table below shows the mean return per year in the same format as above, but includes all sectors of the US economy, excluding biotech: (Source: Factset, Blackrock, BIO)

It turns out that smaller companies across a wider range of industries have held up well against the returns of bigger companies. Small companies outperformed in four out of the six years. This compares to just one year for small biotechs. Thus, outperformance from billion dollar plus companies seems to be more specific to the biotech sector. Furthermore, the above data should knock holes in the belief that small biotechs are simply a beta play on the market.

The lower average returns for small biotech stocks could mean more homework is required in this sector to keep up with the major indices. One way to stay on top of the news, catalysts, and recent trends for these companies is to hear directly from senior management. At the upcoming BIO CEO Conference, where institutional investors receive complementary registration, these conversations and updates can be held in private meetings powered by BIO’s One-on-One Partnering System, accessable here.

*Note that if we use the popular index returns for large and small caps, such as the Russell 1000 and Russell 2000, we would be comparing apples to oranges: 1) these indices are market cap weighted and use a different methodology, and 2) have widely different definitions of Large and Small. For example, the Russell 2000 Small Cap index has 450 companies over $1 Billion.