It’s alarming… It hits you in your very core. One would think such a tremendous downturn in a single day was reserved for movies like Wall Street and Trading Places…images of brokers in white jackets screaming “Sell! Sell! Sell!”…flashing fingers, scribbling numbers on little white pads in a desperate attempt to clear their clients’ positions.

But let me assure you, this is the type of action you can expect to experience once in a very great while in the world of small-cap pharma and biotech stocks.

This industry lives and dies on FDA approvals… There’s no getting around it. Even when you believe the odds of obtaining the FDA’s green light are greater than the probability that the leaves on the trees will bloom come spring, you’re still never 100% sure… Anything can happen. It’s a world of tempered expectations.

Sometimes then highly unlikely happens. And when it does, your investment takes a dramatic turn for the worse. That’s what happened in the Small-Cap Insider portfolio yesterday with one of our holdings, NeoPharm (NEOL: NASDAQ).

But let me start from the beginning…

This past October, we found a very speculative drug company whose insiders were simply snapping up its stock. It had a drug in Phase III trials and, if successful, the stock would either rocket or fall virtually to zero. It was like an option, in a way, and not priced too much more than one.

It was a very “binary” investment opportunity — the company would win or lose, and our fortunes would ride in lock step.

We made the necessary checks, made the appropriate calls to our pharma experts in the field, and we felt comfortable in making a speculative recommendation on this company’s shares. We felt the term “speculation” was appropriate label for this idea — and we made it clear to our readers. After all, for every successful company in the drug world, there is a sea of failures.

But things seemed favorable about this company…

NeoPharm had its lead drug, cintredekin besudotox (CB), in Phase III clinical trials. Their drug was intended to prolong the lives of adults who suffer from particularly aggressive brain tumors.

NeoPharm appeared to be near a breakthrough in a better treatment than the current standard of care, the Gliadel Wafer.

Early on, results looked promising: Patients treated with NeoPharm’s CB lived for an average of 55.6 weeks versus 28 weeks with standard treatments. Because of these early positive results, CB earned orphan drug status in Europe. The FDA fast-tracked it.

And the company’s insiders seemed equally optimistic about NEOL stock.

When we wrote our initial report, company insiders had snapped up over 300,000 NEOL shares at prices ranging from $4.86 to $10.20. The company’s CEO, CFO and chairman of the board were very active buyers.

But the bottom fell out on the morning of December 11.

NeoPharm’s drug didn’t meet the benchmark level of performance, and you know the rest.

We knew the risks, and we made them abundantly clear…

We wrote: “Action to take: If you are a speculator who understands the risks, buy shares of NeoPharm, Inc. (NEOL:NASDAQ) for $7.35 or less. Use a limit order. And only invest money you can afford to lose.”

But I’m not writing this Sleuth as a defense of our recommendation. I want to highlight the fact that — yes — small-caps can be risky. They are more risky by their very nature than large-caps because they are typically younger companies in an earlier phase of their growth cycle. And that phase sometimes means that they’re vulnerable. They might not have other products to fall back on if one fails, or they don’t have the financial flexibility to dig themselves out of trouble.

That said, early-stage pharmaceutical and biotech companies are even more risky than your average small-cap.

In fact, the same day NeoPharm reported its Phase III results, Nuvelo, a development partner of Bayer Healthcare, plummeted 79% in its own failed Phase III trial.

But over time, and using a portfolio approach, small-caps can bring great rewards to investors.

If we look back to the 1920s, small-cap stocks have gained, on average, nearly 13% per year versus 10% for large-cap, “blue chip” stocks. Over many 10-year periods, small-caps have beaten large-caps by as much as 50 to 60 percentage points.

Of course, the risk of small-caps explains, in part, why their returns are superior. With greater risk come greater expected returns.

But if we look back again over the last century, we see that small-caps really shine over large-caps when the U.S. economy is growing. And for the majority of the last 80 years, the U.S. economy has been growing. There was only about a decade-and-a-half from 1926 to the present day when we were officially in recession.

So, loyal readers, the events of this week will not test our resolve.

Until next time,

Craig Walters
December 14, 2006

Pros and Cons of Small-Cap Investing was originally featured in the Penny Sleuth.