The best place to find undervalued stocks is undoubtedly with small-cap companies with less than $1 billion in market capitalization. Small-cap companies are often so small, though, because they always face the threat of going out of business or having a larger competitor come in and take over their market. If you want to ratchet up the rewards and risks even more, then look no further than small-cap pharmaceutical stocks, whose existence is often riding on the clinical and commercial success of one drug.

This situation perfectly describes Rule Breakers pick and small-cap wonder Encysive Pharmaceuticals (NASDAQ:ENCY). Its fortunes rise and fall on the prospects of its one drug, Thelin, which is used to treat a rare disease called pulmonary arterial hypertension (PAH).

Thelin is awaiting approval in the U.S. (more on that later) and has already been approved in the European Union. It is currently coming to market in the individual countries of the EU as fast as Encysive can set up sales and marketing forces and negotiate reimbursement rates in each EU country.

To get an idea of what sort of sales Thelin will bring in, one only has to look at the level of sales that a competing but inferior treatment for PAH marketed by Swiss-based Actelion (OTC: ALIOF.PK) has enjoyed. After more than five years on the market in both the EU and U.S., Actelion's Tracleer has ramped up sales to more than $500 million in just the first nine months of 2006. Even after being on the market for so long, the drug's sales are still climbing, with 2006's sales up more than 40% compared to 2005.

Based on the growth in Tracleer sales in its first years after EU approval, and the fact that Thelin will be the second PAH drug on the market, sales of Thelin should be around $30 million for 2007, assuming it is only approved in the EU. In 2008 and beyond, sales should continue to ramp up, thanks to its superior side-effect profile and easier dosing regimen compared to Tracleer.

Thelin's route to approval in the U.S. has been much rockier than in the EU, though. The drug has already been turned down twice by the FDA, and a third decision is forthcoming either within the next several weeks or in about five months, depending on how the FDA decides to handle Encysive's response to its approvable letter.

The knock on companies developing drugs to treat PAH has always been that the disease is so rare that it will be too difficult to hammer out profits selling drugs for this indication. For niche diseases like PAH, though, it doesn't take a large sales force to cover all the physicians treating the disease (which keeps overhead low). And since drugs to treat PAH typically cost more than $30,000 annually, it doesn't take a lot of patients on the drug to bring a company in this space to profitability. Pharmas like Gilead Sciences (NASDAQ:GILD) and Actelion seem to agree with me, since they've both acquired companies developing drugs to treat PAH at healthy premiums this year.

Whether Encysive is fated to be the one stock you must buy depends partially on whether it can get U.S. approval to market Thelin before Gilead's competing drug starts to take over some of the market. Even if this U.S. approval doesn't happen in a timely fashion, though, investors in shares of Encysive can at least wait for EU sales to start ramping up to meaningful levels in 2008.

Based on the risk-reward profile for Encysive and the possibility of U.S. approval in the upcoming months, Encysive has the potential to be one of the best small-cap investments of 2007. If you agree with me -- or if you want to tell the rest of the world why I'm wrong -- come join the Fool's brand-new community-intelligence database, Motley Fool CAPS, and rate the stock as an "outperform" or an "underperform." CAPS is free to join and play, and is a great way to check in on what investors think about the stocks you're interested in. Based on what you have to say, we'll declare the best small cap for 2007 early next week -- so come on out and vote for Encysive.

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Fool contributor Brian Lawler does not own shares of any company mentioned in this article. The Fool has a disclosure policy .