Generally speaking, small-cap stocks tend to be considerably more volatile than their larger peers, mainly because they lack a time-tested business model. But what they lack in experience, they make up for in long-term growth potential. While not all small-cap stocks will succeed, those that do can provide robust gains to investors over the long run.
With this in mind, we asked three of our Fool.com contributors to name one small-cap stock that they believe is worth buying right now. Rising to the top of the list were diabetes drug developer Lexicon Pharmaceuticals (NASDAQ:LXRX), chronic kidney disease and pruritus drugmaker Cara Therapeutics (NASDAQ:CARA), and software-as-a-service provider to the mortgage industry Ellie Mae (NYSE:ELLI).
A small-cap drug developer with a blockbuster in the making
Sean Williams (Lexicon Pharmaceuticals): Following a roughly 40% decline since June, a small-cap stock with an above-average risk-versus-reward profile at the moment is drug developer Lexicon Pharmaceuticals. Although Lexicon has one approved therapy -- Xermelo, a treatment for carcinoid syndrome diarrhea -- all eyes are clearly on experimental type 1 and 2 diabetes drug sotagliflozin.
Most next-generation type 2 diabetes drugs are SGLT2 inhibitors. Operating in the kidneys, these inhibitors work by suppressing glucose absorption, thereby allowing the body to excrete excess glucose through the urine, regulating glycemic balance. Sotagliflozin is an SGLT1 and SGLT2 inhibitor, meaning it does what numerous existing SGLT2 therapies already do but adds the ability to reduce glucose absorption in the intestines, as well as via SGLT1 inhibition. The goal is to reduce A1C levels and improve glycemic balance.
So far, we've seen sotagliflozin shine in treating type 1 diabetes patients. This is the rarer type of diabetes that's genetic rather than the one that occurs over time. As published in the New England Journal of Medicine, Lexicon's lead drug led to an A1C reduction of 0.79% in a pivotal-stage trial, which was more than double the 0.33% A1C reduction seen in patients taking the placebo. Presumably, if this success translates into type 2 diabetes patients, Lexicon could have a blockbuster on its hands.
There has been some concern about the potential for adverse events in patients -- namely, diabetic ketoacidosis, which tends to be more common with SGLT2 inhibitors, as well. Although it doesn't appear as if this will stop Lexicon's lead drug from gaining type 1 diabetes approval in March 2019, it's something to monitor.
Just as important is the fact that Lexicon snagged a successful partner in Sanofi. With Sanofi heading up the type 2 diabetes trials and ready to help with marketing, sotagliflozin could be just a few years way from hitting $1 billion (or more) in annual sales. That makes Lexicon and its $880 million market cap look like a steal.
Scratching an itch
Keith Speights (Cara Therapeutics): Over 450,000 patients in the U.S. with chronic kidney disease (CKD) are on dialysis. Roughly 60% of these patients experience an internal itching known as CKD-associated pruritis (CKD-aP), and there's currently no Food and Drug Administration (FDA)-approved treatment for the condition.
Enter Cara Therapeutics. The biotech doesn't have any products approved yet, which explains why its market cap remains below $750 million. However, Cara could become the first company to win FDA approval for treating CKD-aP if late-stage clinical studies for Korsuva go well. Cara expects to announce the results from those studies next year.
Cara already has lined up one big partner for Korsuva. Vifor Fresenius Medical Care Renal Pharma, a joint venture between Swiss drugmaker Vifor Pharma Group and Fresenius Medical Care, licensed Korsuva for the CKD-aP indication in markets outside of the U.S., Japan, and South Korea. And Fresenius, which ranks as the largest dialysis provider in the world, plans to promote Korsuva in all of its U.S. dialysis clinics.
At least one analyst projects peak annual sales of Korsuva of more than $570 million. However, that's only for treating patients with CKD-aP who are on dialysis. Cara also is evaluating an oral version of the drug in treating CKD-aP patients who aren't on dialysis and in patients with chronic liver disease-associated pruritis.
A beaten-down market leader
Brian Feroldi (Ellie Mae): The recent spike in interest rates is lowering the demand for mortgages. That backdrop is causing investors to flee from companies with any exposure to the industry, which includes market leaders like Ellie Mae.
Ellie Mae is a software-as-a-service business that helps mortgage providers to automate the origination process. Customers pay Ellie Mae both a monthly subscription fee and loan origination fees each time they close a loan or transaction on the platform. Most mortgage providers are happy with this trade-off because Ellie Mae's software makes their job much easier and ensures that they remain compliant with local laws.
Ellie Mae's value proposition has convinced hundreds of thousands of mortgage originators to sign up. That's allowed the company to crank out consistent profit growth for years. However, Ellie Mae's revenue and adjusted profits "only" grew by 15% and 22%, respectively, in the most recent quarter, as loan volumes declined in the face of rising interest rates. That caused management to dial back its expectations for the full year, causing the share price to crash.
Management did their best to point out that this situation is temporary and that the company continues to grab market share. However, their plea is falling on deaf ears at the moment, which is why shares currently trade at the lowest valuation that we've seen in years. That makes right now a great time to buy a great company that I'd argue is trading for a fair price.
Brian Feroldi owns shares of Ellie Mae. Keith Speights has no position in any of the stocks mentioned. Sean Williams has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Ellie Mae. The Motley Fool has a disclosure policy.