Biotech Lottery Tickets

Small biotech stocks are often considered "binary" lottery-ticket type events, with either a small chance of big upside, or a much greater probability of nothing at all. I call them "bipolar" because around FDA clinical trials and approval events, these stocks can soar to heights of euphoria and crash to depths of depression -- sometimes all in the same week.

Intermune (ITMN - Snapshot Report) is an example from last year that stands out. The stock soared from $15 to nearly $50 last spring on positive expectations from FDA trials for its drug pirfenidone to treat idiopathic pulmonary fibrosis (IPF). IPF is a rare and fatal lung disease affecting more than 200,000 patients in Europe and the United States combined, with a survival rate of only 20 percent after five years.

But then subsequent findings of an FDA advisory panel were not as rosy and the stock plummeted back down to the teens within two months. Investors were taken for a while ride in a very short time and many probably swore they would never touch another small cap biotech with unproven medicine again. A few months later in December, ITMN launched back up to $40 on progress at meeting FDA hurdles for the drug.

Small Cap Biotechs to Watch: Raptor and Transcept

To give you an idea of how early and wrong you can be in these names sometimes, I bought Raptor Pharmaceutical Corp (RPTP - Snapshot Report) in 2007 (before I became a Zacks Rank student) when it fell from $8 to $3. As its patented human receptor-associated protein (RAP) therapies designed to target cancer, neurodegenerative disorders and infectious diseases were still proving their science, the stock subsequently fell below 50 cents for most of 2009.

Then the fourth quarter of 2009 brought some good news and an instant spike back up to $4. Great, we're off to the races for riches, right? Not so fast. Over the next six months Raptor drifted back below $2 and I think I finally threw in the towel, selling my 500 shares at a loss when I consolidated some trading accounts last year.

I really wish I had held on for the measly $1,000 I had a risk. The past year has been steadily good to Raptor shares, and the past two months have seen a big move from below $4 up to nearly $6.50 on positive reactions from analysts about the company's strategy to focus on so-called "orphan" disease treatments.

Orphan diseases are generally defined as those afflicting less than 200,000 patients and both the US and EU grant special incentives for orphan drug development, often lessening time to market, development costs, and risks. Raptor's lead orphan drug is DR Cysteamine for the treatment of nephropathic cystinosis, a genetic disease marked by abnormal buildup of cysteine in the cells which can result in organ and brain damage.

As David Miller and Alan Leong of Biotech Stock Research suggest, investors don't pay enough attention to companies focused on orphan diseases because they tend to seek the "grand slam" block buster drug successes. Orphan diseases may offer less reward, but they also carry less risk and may lead to a steadier, more-predictable stream of sales.

Early on in the 80% move higher in Raptor shares in the past month was a boost in the Zacks Rank to a #2 position (buy) on May 17. The stock has received this #2 Rank only one other time since January 2009, when #3 Rank (hold) and #4 Rank (sell) ratings have dominated.

Though analysts still don't see the company being profitable in 2012, the outlook is for increased revenues coming from its drug pipeline and business strategies. Some larger investors must like the news too as the stock was on the receiving end of three 2-million share upside trading days during this time.

Currently, the Zacks target price for RPTP shares is only $6.50 as the revenue and earnings picture doesn't hold significant upside from what has already been quickly priced into the stock. The company is currently in Phase 3 clinical trials for DR Cysteamine and expects to report the data from this trial by the end of July 2011. Keep an eye on this name around late July to see how analysts react to the research outcomes and what corresponding shifts take place in the Zacks Rank.

Getting Back to Sleep Could Be Big Business

Transcept Pharmaceuticals, Inc. (TSPT - Analyst Report) has an insomnia drug that looks poised to wake up revenues pretty quickly over the next few years if they pass muster with the FDA in July. Intermezzo is a crucial alternative to drugs like Ambien and Lunesta, which require at least seven hours for sleep, because it is designed to treat middle-of-the-night (MOTN) waking.

Those two extremely popular prescriptions have been found being used by patients at their doctors' recommendation during the MOTN and this poses serious threats to safety in early morning commutes. An FDA approval of Intermezzo could provide physicians a safer alternative, especially as early testing in actual highway driving studies is very encouraging.

Transcept shares became a Zacks #1 Rank on May 19 for the first time in our coverage as the two analysts on this name raised their earnings estimates from consensus EPS of $0.49 for this year to $0.95. They also boosted their consensus to $0.32 from a loss of 2 cents for 2012.

As Bill Wilton reported for Zacks on May 23, "They currently have $63.3 million left in cash and are averaging about $1.6 million per month in spending. Transcept brought in $3.1 million in revenue for the period from a license fee. That 24-month non-refundable fee has been coming in since August 2009 and will total $25 million when completed."

The drop-off in 2012 earnings is due to the end of that licensing fee. But analysts expect that FDA approval of Intermezzo will give Transcept a new valuation level to fit with strong growth into 2013 where full-year EPS estimates are as high as $0.97.

Investors should stay tuned to July 14 for the FDA announcement and watch the Zacks Rank as well. Expect new analysts to initiate coverage as this company and its science gain more attention.

Sifting and Sorting for the Winners

Raptor and Transcept belong to the Zacks Medical-Biomedical/Genetics Industry classification, a large group which currently has 170 companies in it. But they are two of only 21 names with a Zacks #2 Rank buy rating. And most of those top 21 stocks are small cap as you might expect.

Big biotech names like Amgen (AMGN - Analyst Report) and Gilead (GILD - Analyst Report) find themselves further down the list, each with a Zacks #3 Rank. Again, as your intuition might tell you, the aggressive growth potential is in the smaller biotech companies because they can ramp up earnings momentum quickly once they hit the market with a successful drug.

Just be sure to use the Zacks Rank as a short-term timing indicator and be ready to take advantage of the early warning buying opportunities it signals, because it can get you in before the institutions move into a given earnings star.

And then be ready to take profits when the market hands them to you. In other words, don’t copy my example with Raptor.

Kevin Cook is a Senior Stock Strategist for

Zacks.com.

The information supplied above by Zacks Investment Research Inc. contains opinions based on factual research which may or may not be accurate. Neither Zacks or Intellisphere will assume any liability for losses from investment decisions based on this information.