2 Tiny Biotechs That Could Have Blockbuster Opportunity

Smaller health care stocks are not for the faint of heart. When it comes to developing and testing new drugs, the success rate is tiny but the rewards can be huge. How can the risk-tolerant Fool spot the next Amgen (AMGN -1.33%) or Biogen (BIIB 0.23%)?

This health care edition of Industry Focus looks at two currently small biotechs with promising drugs under development. One is better situated in terms of cash, but has a longer time horizon, while the other is burning through its resources but could have its drug on the market as soon as next year.

A full transcript follows the video.

Michael Douglass: Two small biotechs with blockbuster potential; this is Industry Focus.

Hi Fools, health care analyst Michael Douglass here for our health care edition of Industry Focus. I'm on the phone with our contributor, Todd Campbell, from New Hampshire. Todd, how has your week been thus far?

Todd Campbell: Hey Michael, how are you? I think New Hampshire is just about to enter mud season, because it's warming up and all these 18 feet worth of snow that we got is starting to melt.

Douglass: Oh, lucky you! That sounds like a lot of fun. Virginia is actually about to refreeze, because why not?

Campbell: Break out your ice skates!

Douglass: Yes, and of course we'll all feel very different at Duke Street, where The Motley Fool is headquartered, in Alexandria, when it becomes a frying pan in July and it's 105° and 300% humidity. That'll be a lot of fun -- something to look forward to, I guess!

But in the meantime, we wanted to take a little bit of time today and talk about small cap biotech investing.

It's interesting I think, because you and I spend a lot of time talking about the big caps; your Johnson & Johnsons (JNJ -1.15%), your Celgenes (CELG), many, many multi-billion dollar stocks. We don't take that much time to talk about your smaller health care stocks.

I think that's in part because they're riskier and I think you and I are both maybe a little bit conservative of investors for them. But let's go ahead and talk about a pair. Let's start with Ophthotech (ISEE).

Campbell: Absolutely. I think small cap -- especially small cap biotech -- they're risky bets, but at the same time for the right kind of investor, who's maybe a little bit younger, has a little bit longer of a timeframe, that can take on a little bit of risk, sometimes looking at some of these companies and putting a couple here and there into a portfolio can work out.

After all, the Biogens and the Amgens and the Celgenes, they were all small cap companies at one point along the way.

Douglass: Right.

Campbell: The trick, though, as you just alluded to, is trying to find small cap stocks where the odds aren't as stacked against them as they might otherwise be.

Douglass: And let's be clear about this; in health care, when you have a drug going from preclinical to phase 1, the odds are just tremendously stacked against it actually making it through phase 2, phase 3, the FDA, and then finally marketing.

I think the number we've cited in the past is about a 90% failure rate, from phase 1. Is that about right?

Campbell: Yes, 90% of the drugs that enter human trials in phase 1 never make it to commercialization. What's really interesting is that, of those that make it to phase 2, you're still talking about a coin-flip success rate. Of those that make it to phase 3, you're talking about a third to 40% of them are going to fail there, too.

Clinical stage companies, it's very hard to be able to say with any high degree of conviction, "This drug absolutely will make it to market." You can't do it.

You basically, as an investor, have to approach it and say, "I want as much information in front of me as I possibly can, so that I can make the best educated guess on the likelihood of this happening, recognizing that I could lose everything if it doesn't pan out."

When I went through and I looked at my small cap universe and I said, "What kind of stocks maybe would be attractive to a small cap investor in this space?" two popped up, and one of them was Ophthotech.

Ophthotech is intriguing to me because it does have late-stage trials that are ongoing, and the results that were reported for its mid-stage studies were good enough to prompt Novartis (NVS 0.72%), one of the biggest drug makers out there, to license Ophthotech's drug, Fovista, so that if it does pass approval someday they've got a huge marketing partner alongside of them.

What Ophthotech is doing is developing Fovista for something called wet stage AMD, or Age-Related Macular Dengeneration; basically, vision loss in elderly people. It's a big population. Obviously, baby boomers are getting older, so more people are suffering this condition. The CDC estimates that there could be as many as 3 million people with wet AMD by 2020.

What's interesting about Fovista is that it's not being designed to replace existing therapies. It's being designed to make the existing therapies work better. Those existing therapies are Lucentis and Eylea, and those are both blockbuster drugs.

Lucentis does $4 billion in sales, and Eylea does about $3 billion a year in sales, so you're talking about blockbuster drugs, and this drug is not trying to displace them, but simply make them work better.

Based on that, that's one name that -- again, risky -- but educated guess is that things are looking pretty good for it.

Douglass: I will say, when I look at Ophthotech, a couple of good signs make themselves heard. The first is, as you mentioned, this big pharma partner. Now, it's not like a big pharma partner guarantees success, because it doesn't.

But when the people who have been in the business for a very long time and have very deep pockets, like these big pharma companies, when they choose to go ahead and jump in and say, "You know what? We're willing to take some of the risk of this drug because we think it can prove out," that usually indicates that they see an opportunity in the data that this could potentially be a drug that really moves the needle.

For something to move the needle for a Novartis or a J&J, there has to be a fair amount of potential upside, I think.

Campbell: Yes, and I'll take that one step further and say that it's especially intriguing when the person that's partnering with you is actually the dominant player in that disease.

Lucentis is the largest, top-selling mediation for this disease, so it's not like they're trying to branch out into new areas. They could be doing this because they're looking at it and saying, "Based on all the research that we've done internally, this looks like it could be something that could move the needle."

Douglass: Yes. The other bump for a clinical-stage biotech is when one of those big pharma marketing commercialization partners come in, usually -- and it depends on the agreement that's signed -- but usually there's some up-front cash, there's some opportunity to earn milestone payments.

That means that when you're looking at cash burn, which is always a real big concern with small cap biotechs that are at clinical stage, that helps smooth out that cash burn and give them a longer cash runway before they have to, as is usually the case, dilute -- issue new shares and dilute current investors -- which is, as you can imagine, not really a great thing for investors to see happen.

Actually, Ophthotech says in their 10-K that they believe their cash, cash equivalents, marketable securities, etc., as well as the potential from those milestone payments with Novartis could be sufficient, and I'm quoting here, "to fund our operations and capital expenditure requirements [...] through the end of 2017."

That gives you some runway and some potential to really see how much opportunity there is with this data, and that's definitely a nice thing to see.

Campbell: Right, and the thing that investors have to be watching for is the phase 3 data. Obviously, this drug is being studied alongside both Eylea and Lucentis, and in 2016 we should have the final phase 3 data that will show whether or not this drug does effectively help these other drugs work better.

This is not something that's going to happen right away, because obviously the phase 3 data has to come out, then they have to do the filing, and then you have to wait for the FDA to get around to making a decision on it, so investors may not see anything, in the form of revenue, in the best case scenario until 2017.

Douglass: Right, exactly. Let's talk about Portola Pharmaceuticals (PTLA), then.

Oh, and (unclear), Ophthotech, that's ticker symbol OPHT. All right, Portola, ticker symbol PTLA. What's your bull thesis here?

Campbell: That's another intriguing stock. The reason I found it so intriguing was the drug that they're working on, where Ophthotech's trying to develop a drug that makes drugs work better, Portola's drug is trying to make them not work better!

It's a reversal agent. As a reversal agent, what it's trying to do is stop the anticoagulant activity of a new class of blood thinners, if you will, called Factor Xa inhibitors.

Those drugs, J&J's Xarelto, Pfizer (PFE -3.85%) and Bristol-Myers (BMY -8.51%) Eliquis, are growing sales dramatically because they're replacing warfarin, which has been around for decades and decades and decades.

The estimates are that this is a $10 billion market for anticoagulants, and with aging baby boomers, again, there's going to be an increasing need for anticoagulant prescriptions in people with heart disease or in post-operative cases.

There's a tremendous amount of activity going on, and demand for the use of anticoagulants, and currently there is no approved reversal agent for them.

Douglass: Naturally, the question investors are going to ask is, "Why is there an opportunity to reverse a necessary drug like an anticoagulant?"

Campbell: Right, exactly! Think about it. If you're elderly, you could slip. You could fall. You could have any number of bleeding events, or you could require emergency surgery.

If you're on one of these anticoagulants, when you go into the hospital for that emergency surgery, or for that care to stop the bleeding, you want to make sure that that doctor has something that they can give you that can quickly and immediately halt the effects of that anticoagulant.

Currently, there isn't anything. They basically have to do patchwork stuff to hope that they can reverse the activity. This would be a game-changer in that regard.

Now, it doesn't happen to everybody. It's only about 3-5% of the people who take Factor Xa drugs, but that's still enough to make pretty much every hospital in the country need to have to stock this, and at least have it available.

Douglass: Definitely an interesting opportunity there. Of course, on the cash burn side, not as positive as Ophthotech. Portola, when they gave their expectations for 2015 they said, "As of December 31, 2014, we had $464 million in cash, cash equivalents, and marketable securities."

They are guiding for having, I want to say it was about $180 million of that left over as of the end of 2015. That indicates really substantial cash burn, and there are some more difficult questions there, like where's the cash going to come from after that? Are we going to be seeing something like dilution?

Yes, $165-180 million in cash, cash equivalents, and investments. That would indicate that they're planning to burn more than half of their current cash this year, which isn't exactly a great thing to see.

Campbell: No. A lot of that cash burn obviously is coming because they're studying this drug against every one of the Factor Xa drugs.

Douglass: Right.

Campbell: Now granted, some of those development costs are being picked up by J&J and Pfizer and Bristol, because those guys have said, "Listen, if we can help Portola develop this drug, we may be able to increase the number of prescriptions for these drugs," because right now doctors aren't prescribing them in frail patients, they're not prescribing them in patients that have comorbidities.

They're thinking, "We'll go ahead and give some money to Portola to help fund the development," but there is a lot of spending going on in R&D for this company.

The other thing that's interesting about this company is that they have already reported phase 3 results in two different trials, and in both of those trials it did effectively reverse the Factor Xa drugs.

Douglass: Yes. Definitely some really interesting opportunities with these two companies. Gut check, Todd. Which one is your favorite of the two?

Campbell: Of the two, I think it's Portola.

Douglass: Yes, perhaps more upside.

Campbell: The other reason, too, is I think it's got a faster path to commercialization. They're thinking that, Andexanet Alfa, which is this reversal agent, if all things go well -- always the "if all things go well ..."

Douglass: The usual caveat in health care.

Campbell: Exactly. If all things go well, they could have this drug on the market sometime next year.

Douglass: Yes, so definitely a lot of opportunity there. As always, I think it's very important for us to note that with any speculative, relatively small cap company -- these are both sub-$3 billion market caps -- you've got to understand that this has got to be the risky side of your portfolio, should have a really long time horizon, and of course there are these important forks in the road that can happen, and that can really dramatically change that investing thesis.

Whenever you're thinking about investing in those, think about your risk tolerance. Think about whether you've got the stomach for it, because especially when you get into the smaller cap biotech space, even with companies that look like they have a lot of opportunity, data, rumors on data, suspicions on data, can move stocks enormously.

You really have to have that Foolish, locked-in, long-term expectation that you're planning on looking at this and reviewing that investing thesis every time the data comes out so you really understand what you're owning, and whether that opportunity, that ramp, still seems to be there.

Todd, as always, thanks for your thoughts. Folks, check back to Fool.com for all of your investing needs, whether they're health care or otherwise, and have a great day. Fool on!