You may not have come across the low-profile Mesoblast (ASX: MSB) yet, even though it is one of the better-performing stocks in the S&P ASX 200 Index (ASX: XJO). Its anonymity potentially represents an opportunity, as it often results in the mispricing of a stock.
Biotechnology stocks present difficulties in forming a valuation, because of uncertain future earnings and the inherently risky outcomes from ongoing clinical trials. So when risks are overcome there is very significant upside potential.
Mesoblast is a medical research and development company, working on therapies that use stem cells extracted from bone marrow. It is targeting markets that include heart failure patients, bone-marrow regeneration in cancer patients and orthopaedic remedies such as intervertebral disc repair. Should its well-advanced clinical trials prove successful, a highly lucrative licensing deal with Teva Pharmaceutical Industries (NYSE: TEVA) awaits.
Mesoblast is a very successful company. It listed in 2004 at 50 cents, and has risen to today's price of $5.92. This rise is largely due to the 2010 licensing deal, one of the largest in the world that year, with a U.S. pharma company called Cephalon (now owned by Teva Pharmaceuticals). The deal included $150 million upfront, $1.7 billion in milestone payments and Cephalon took a large stake in the company. This not only provided funding for upcoming trials but also created an international profile for Mesoblast.
On the Australian market, considerable value from licensing was created by another biotech in Acrux (ASX: ACR). It developed an alternative means of delivering drugs through the skin rather than via injection.
The industry as a whole is expanding largely because of the aging population and the increasing incidence of chronic health conditions, such as obesity and Type 2 diabetes. As a result, governments are increasing healthcare expenditure. In the U.S. is represents 16% of GDP and around 9% in Australia.
In recent days some jostling for position on Mesoblast's share register is attracting some speculative talk. One of the world's top biotechnology investors, Capital Group, yesterday became a substantial shareholder. It also has a 7.5% stake in Teva, which acquired 17.4% via the abovementioned licensing deal. Teva is the world's largest generic drug manufacturer.
There are three golden rules investors should focus on in the biotech sector. First, identify the size of the market opportunity. Then, ensure the clinical trials have progressed to Phase 2 data, to provide confidence in the product Finally, have a good understanding of the regulatory pathways involved.
Foolish takeaway
In my opinion, Mesoblast is a clear standout in the listed biotechnology sector given the advanced stage of clinical trials, the size of the markets for its products and the potential upside from a very generous licensing deal.
However, given the inherently risky nature of the industry, investors should only allocate a small percentage of their investible funds. Should all go well, that initial small investment may grow into a large weighting in your portfolio.
