Big Pharma gets plenty of hype. But is Little Pharma where investors can make the biggest gains? The answer to that question is a resounding "yes." Those larger gains, though, come with more risks. Here's why.
Defining moment
First, let's define what "Little Pharma" is. Unfortunately, there isn't a hard-and-fast set of criteria to determine which companies should be considered to be Little Pharma.
It seems reasonable, though, to include any drugmaker with a market cap qualifying as a small-cap stock (i.e., with a market cap between $300 million and $2 billion). Because the market caps of Big Pharma companies are really big, I'd also bump the maximum market cap threshold for Little Pharma stocks up to $5 billion.
It's debatable whether pure-play biotechs should be included in the Little Pharma group. I lean toward excluding them -- for the same reason that the larger-cap biotechs aren't typically lumped in with large-cap pharmaceutical firms in the Big Pharma category.
Head-to-head
Using the above criteria and the handy-dandy Yahoo! Finance stock screener, there currently are 20 stocks that belong in the Little Pharma group. Using the same screener, there are 16 stocks that fit into the Big Pharma category. How does Little Pharma compare against Big Pharma in terms of stock performance?
Source: YCharts.
Regardless of whether we look at average performance for component stocks over the past one year, five years, or 10 years, Little Pharma wins handily. Of course, averages can sometimes be misleading. For example, Aegerion Pharmaceuticals (NASDAQ: AEGR) shares soared more than 450% in just the last year and almost 700% over the last 10 years. This one big mover by itself accounted for a quarter of our Little Pharma index's one-year gains.
However, if we use median performance, which helps minimize the effect of an outlier like Aegerion, Little Pharma still trounces Big Pharma in all three time frames. For that matter, we could exclude Aegerion altogether and Little Pharma still comes out way on top.
It is true, though, that the Little Pharma stocks have a much wider range of performance. While there were plenty of highfliers, there were some big losers in the Little Pharma mix as well. Rigel Pharmaceuticals (RIGL -5.41%), for example, was down more than 65% over the past year and over 45% in the five- and 10-year periods. By comparison, the worst-performing Big Pharma stock over the last year, Teva Pharmaceuticals (TEVA -3.04%), was down less than 8%.
Why Little Pharma wins
There is one important factor that helps explain Little Pharma's tremendous performance versus larger companies. Our results only include the smaller drugmakers that are still in the $300 million to $5 billion market cap range. Companies that encountered colossal failure could have dropped below our minimum threshold, leaving only the relative winners left in the group. This is called survivorship bias.
Another driver can be found from looking at a Little Pharma like Astex Pharmaceuticals (NASDAQ: ASTX). A big part of Astex's rise came recently as a result of speculation that the company would be acquired and later confirmation of a buyout. Sure, Big Pharma companies can be bought also, but those deals are less common and tend to push shares up much less than they would for a smaller company.
This brings to mind what is perhaps the most significant advantage for Little Pharma. Any good development, whether it's a buyout rumor, positive clinical results, or regulatory approval, has a more significant impact on the stock of a small company than it does a larger one.
Just look at Isis Pharmaceuticals (IONS -0.24%). In June, Isis announced great results from its triglyceride-lowering drug ISIS-APOCIII. The stock jumped nearly 30% on the news. Big Pharma stocks do often go up on the day after good news is announced, but it's usually by a few percentage points at best.
Little Pharma's big lesson
What's the lesson to be learned?
Whether we're talking about pharmaceuticals or any other industry, it makes sense to include some smaller companies in your investing portfolio. These stocks can have the most room to run, as Aegerion's performance shows.
However, keep in mind that there is considerably more volatility with smaller stocks. Remember Rigel's huge drop. That's why diversification is a must. Also, don't discount the importance of the dividends that many Big Pharma companies pay. None of the Little Pharma stocks currently pay out dividends.
All things considered, though, Foolish investors should consider including some small pharmaceutical companies like Isis on your watchlist. Investing in Little Pharma holds the potential for big gains.
