And before this stock hit it big, it gave off three signals to investors that you need to know to find the next mover and shaker in the small-cap drug market…

Most of you probably recall the column I wrote a couple of weeks ago about a real small-cap success story — proving that a lot of money can be made by investing in solid small-cap pharmaceutical and biotech outfits.

I wrote about a unique indicator that sends your chances of hitting a home run in the biotech and pharmaceutical industries from 1 in 1,000 to a whopping 62%. And I mentioned small-cap legend Amgen (AMGN:NASDAQ), which makes drugs that treat rheumatoid arthritis, infection and anemia in cancer patients. If you missed it, you can catch up by clicking the link below:

Investing in Prescription Drugs: A Fast Track Indicator

Coincidentally, in Worth’s Greatest Stock Picks of All Time: Lessons on Buying the Right Stock at the Right Time, W. Randall Jones includes Amgen in his list of the 25 best stock picks of all time. Jones — the founder of Worth magazine — devised a list of what he considers the 25 best picks of all time. He details the best years for investors to have owned some of Wall Street’s most legendary companies, like IBM, General Motors and Intel.

And it’s no wonder Amgen made the cut — the stock was trading for $15 in the summer of 1998. Today, it’s trading for around $73. On top of that, the stock posted two separate 2-for-1 splits in 1999.

Strategies for Small-Cap Investing: Why Is Amgen Such a Good Pick?

But more important than Amgen’s rise are the lessons you can learn about how to spot these companies before they make their moves — and buy in with a chance at huge gains.

As Jones says, some of his picks are based on companies that were stellar long-term investments, while others were selected based on bigger short-term gains — where investors would have needed to time the market well to see the larger profits. His goal was to select times in history when companies began displaying signs of strength and growth that would be visible to the average investor — not just a small group of insiders.

So you should be able to apply the same criteria to your own picks. Then you will see how some of your prospective “buys” stack up against history…

Since Amgen was a fledgling small-cap biotech, it was susceptible to big price changes after even small news regarding the company was released. In the late 1980s, “most of the news was good, lifting Amgen’s stock price, giving it a market capitalization of more than $700 million,” Jones writes. And this is before Amgen even had any products out in the marketplace.

The company’s early investors had to look beyond its high price-to-earnings ratio in the late 1980s (this number gives investors an idea of how much they’re paying for a company’s earning power).

Strategies for Small-Cap Investing: How a Small Biotech Made Big Profits

Jones writes that in 1987, Amgen’s P/E was 400 — while the S&P 500 averaged a P/E of 15. Naturally, this high P/E repelled a lot of potential investors. But some saw beyond the high multiple, realizing Amgen’s potential before it began to show the signs of a fast-rising stock.

With an incredibly high P/E ratio, investors were expecting a lot from Amgen. But in 1989, the company saw its drug EPO, used to treat anemia, win FDA approval. It had a patent and was ready to make money. In July 1990, earnings at Amgen were up to 57 cents per share, from 5 cents per share in the same quarter of the previous year.

Amgen stock doubled in 1990 and remained strong through the decade. Here’s how the company did it:

– Big profit gains: After Amgen reported these earnings, Jones writes that the company consistently reported increased profits that beat out sales. While sales grew at more than 100% per year, profits grew an average of 184%

– Keeping the market saturated with the products: The company was ready almost immediately with a follow-up product, Neupogen, used to fight infection in chemotherapy patients. This drug, like EPO, had no competition from any other drug, Jones writes, and did not put the company under any pricing pressure

– Productive partnerships: EPO is a delicate product, Jones said, and Amgen needed help to mass-produce it. So Amgen partnered with Kirin Brewery in Japan to help with custom-made bottles and special handling equipment. In return, Kirin was given future rights to make and manufacture EPO in Japan.

Finding smaller biotechs that share these three characteristics is a whole lot easier than just putting your money on a whim, such as on a company with a lot of buzz but not the numbers to back it up — and it could be a lot more profitable in the long run.

Biotech stocks can be a tricky business, but when you find a company like Amgen, which offered products for a big market with virtually no competition, the money usually follows. Jones’ lesson on big market demand and low competition: “[You] can’t beat these two for a successful company. But don’t expect the stock to be cheap, and don’t shy away just because it isn’t.”

Until next week,

Gunner
February 8, 2006

Strategies for Small-Cap Investing: Long-Term Profits vs. Short-Term Gains was originally featured in the Penny Sleuth.