At its core, Rule Breaker investing is about finding dominant companies with the potential for superb growth over a long period. These companies can manifest as top-dog consumer brands, such as eBay (Nasdaq: EBAY ) and Netflix (Nasdaq: NFLX ) , whose first-mover advantage and brilliant execution stamp out the competition. Or they might turn up in the drug industry, where a company such as Genentech (NYSE: DNA ) can deliver annual earnings growth of more than 20% for years by developing and acquiring great drugs.
First-mover status and cutting-edge innovation are hallmark characteristics of a Rule Breaker. If you are diligent and find companies with paradigm-shifting technologies or business models early, you will ride a massive wave of profit. However, such a beast is quite rare.
The Rule Breaker approach to investing is not a dogmatic ideology whereby we must invest only in world-changing companies. Yes, those companies are a great fit for us. But taking such a strict view would miss the bigger picture. What we really want are companies with great, sustainable growth potential because of a moat of competitive advantage surrounding the core business. If I think a company can increase earnings 15% to 20% annually for an extended period, I really don't care how fancy the technology is.
To find this type of growth in the drug sector, we don't necessarily need to be at the forefront of high-profile innovation. Instead, we can find phenomenal growth potential in a more obscure corner of the drug universe: the specialty pharmaceutical companies. I gave a broad overview of this business model last week. Today, I'll highlight a few companies that I find interesting.
Four criteria to consider
I used a few general criteria to select two high-quality specialty pharmaceutical companies to highlight. If you are interested in exploring this segment further, these are good benchmarks to keep in mind.
(1) Profitability: If the company is not yet in the black, it should have a clear path to profitability within a reasonable amount of time.
(2) Competitive advantage: Look for a broad platform technology that can be applied to many drugs. That will ensure the company can expand its portfolio of marketed products. For drug delivery companies, make sure the proprietary drug delivery technology will have a competitive advantage over branded, second-generation drugs marketed by large pharma, as well as over generic versions of the original drug. Look for partnerships with large pharmaceutical companies that are applying the technology to their own drugs.
(3) Niche marketing: Determine how well the company is filling niche markets where it won't have to compete with big pharma.
(4) Seasoned management: Specialty pharmaceutical companies can face difficult market environments, with competition from both branded and generic drugs. We need management teams that know how to differentiate the company's products from its competitors' and capture market share.
Company 1: SkyePharma
For those of us living in the U.S., there can be a tendency to think the biotech industry starts and ends between San Francisco and Boston. I am guilty of that parochial view at times, despite knowing of great companies in Europe. One I like a lot is SkyePharma (Nasdaq: SKYE ) , based in London.
SkyePharma has broad expertise in the drug delivery field, which it has successfully leveraged to create a deep pipeline and form partnerships with some of the world's leading pharmaceutical companies. As one example, SkyePharma receives royalties on sales of the controlled-release version of GlaxoSmithKline's (NYSE: GSK ) antidepressant, Paxil.
As a result of its stocked internal pipeline and collaborative agreements, SkyePharma will participate in the economics of numerous drug launches in coming years. The company has indicated that it expects three drugs using its technology to launch in 2005. Two more drugs will be filed for approval. With all this commercial activity, the long-term growth picture looks solid.
Company 2: DepoMed
Another drug delivery company I find interesting is DepoMed (Nasdaq: DEPO ) . DepoMed's proprietary technology is its gastric-retention drug formulation. The technology keeps drugs in the stomach longer, providing more convenient drug dosing and better absorption of the drug into the bloodstream.
DepoMed's business model carries minimal technical risk compared with the development of new drugs. The company works with approved drugs known to work and improves them with its delivery technology. DepoMed has two products, Glumetza and Proquin, that have already been filed with the Food and Drug Administration and could be on the market in 2005 for treatment of diabetes and urinary tract infections, respectively.
Glumetza and Proquin have the same active ingredient as the market leaders for their target diseases. So we already know the drugs work, which makes them low-risk from a research and development standpoint. As with all drugs, what remains to be seen is how much market share they will capture. That risk is always difficult to quantify. My view is that the drugs will do well enough that approval would likely move the company toward profitability and lay the foundation for years of earnings growth.
Break your own rules
For investors interested in holding shares of good companies for a long time, earnings matter more than anything else. Proprietary technology is just the means to deliver profit to the company's investors. With that in mind, Rule Breaker investors would do well to break some of their own rules by looking outside the universe of companies with disruptive technologies. The specialty pharmaceutical segment is very likely to see a higher return on R&D investment and deliver more consistent earnings than the highflying fad companies of today.
For additional articles on the drug industry, see:
- Genetics of a Rule Breaker
- Spin the Medicine Bottle
- Picking Biotech's Winners
- Don't Be Afraid of Biotech