Promising Bargains in Biotech Stocks

Back in the old days, stocks of small biotech companies virtually defined investment risk. News about the results of a drug in trials could cause a stock to soar or crater. There was no middle ground. So value investors ignored biotech. But with a seemingly endless flow of new drugs emerging from biotech labs, that has changed. The Baupost Group's Seth Klarman, one of the sharpest value investors around, regularly invests in biotech stocks. He recently made a killing in Idenix, when Merck said that it would buy the developer of hepatitis C drugs at a 240% premium to the preannouncement share price.

I, too, have warmed to biotech over the past year. One of my largest holdings is Gilead Sciences (symbol GILD), whose hepatitis C drug Sovaldi generated more revenue ($2.3 billion) in its first quarter on the market than any other drug ever. At $105, Gilead, which also has the world's top HIV drugs, trades at just 12 times estimated year-ahead earnings.

I think BioDelivery Sciences International (BDSI) is also a terrific value, and I have made it one of my biggest holdings. The firm already has approval from the Food and Drug Administration for a drug with big potential. It has another drug that just produced excellent results in late-stage trials, and it has a third in early trials that could be a huge winner. The stock trades for just under $16 and boasts a market capitalization of $805 million.

BioDelivery Sciences has a lot going for it. In June, the FDA approved Bunavail, a treatment for dependence on opiates. The annual market for these kinds of drugs is $1.4 billion. "We expect peak sales of Bunavail will be 20% to 25% of the market," says Al Medwar, a vice-president at BioDelivery. Based on the way investors value biotech stocks, if Bunavail generates annual sales of $300 million, that should be worth $900 million in stock market value, or 12% more than BioDelivery's current market cap.

In August, the company announced outstanding late-stage trial results for BEMA buprenorphine, its treatment for chronic pain. BioDelivery and its partner, Endo International (ENDP), plan to seek FDA approval for the drug late this year or early in 2015. When the application is filed, Endo will give BioDelivery $10 million, and it will hand over $50 million if the drug wins approval. Those would be significant chunks of change for such a small company. "There is a 90% chance of approval," says analyst Jim Molloy, of Summer Street Research, an institutional research firm. "BEMA buprenorphine could be the next Vicodin."

Big potential. The drug in early trials is Clonidine, a topical gel for treating diabetic neuropathy pain. In August, BioDelivery doubled the number of participants in its Clonidine trial and said the analysis thus far was "very encouraging." About 20% of the millions of diabetics in the U.S. suffer nerve-related pain. If Clonidine works, it could produce $300 million in annual sales. But millions of non-diabetics also suffer neuropathic pain, and current treatments are fairly ineffective. So annual Clonidine sales could conceivably hit $600 million.

As a value investor, what I really like about BioDelivery Sciences is not so much that there are many ways to win as that there are almost no ways to lose. If initial sales of Bunavail prove disappointing, the stock could fall to $10. But it often takes time for a new drug to get traction, so that shouldn't scare people out of the stock, especially given the high likelihood that BEMA buprenorphine will be approved and the reasonable chance that Clonidine will be as well. "With BDSI, you get tremendous downside protection," says Molloy, whose one-year price target for the stock is $20. "My estimates are conservative. The stock could hit $40."

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Andrew Feinberg, a contributing columnist for Kiplinger's Personal Finance, manages a New York City-based hedge fund called CJA Partners.