Small-cap biotechs showing new signs of strength

Innovative therapies, an improving environment for potential merger activity and low stock valuations are a prescription for success among small-cap biotech stocks, says Fidelity's Eirene Kontopoulos.

• The stocks of small-cap biotech firms are newly invigorated following a period of tight lending conditions and other factors that crimped their ability to raise capital to conduct the research needed to advance innovative treatments, according to Fidelity Portfolio Manager Eirene Kontopoulos.
• "Promising new product discoveries and therapies, along with low valuations and richer prospects for mergers and acquisitions, provide a compelling opportunity to invest in small-cap biotechs," says Kontopoulos, who manages Fidelity Advisor^® Biotechnology Fund.
• In helming the industry-based, equity-focused strategy since 2018, Kontopoulos, who holds a doctorate in neuroscience from Harvard Medical School, believes that successfully investing in biotechnology requires a competitive edge on the science behind the drugs, the likelihood of clinical success and the size of the total addressable market. She favors companies that can help develop what she considers to be the most innovative therapies.
• Historically, small biotechnology firms have been in the vanguard of new product discoveries and treatments, including innovation in oncology therapies, gene editing and vaccines, Kontopoulos says. But in recent years, small-caps in the industry have lagged the performance of their larger-cap counterparts, partly due to higher interest rates and tight lending conditions, which she says, "crimped the ability of many small firms to raise capital to conduct the research needed to advance innovative medicines."
• Now, a reversal is taking hold, with Kontopoulos and Fidelity's biotech team believing the opportunity for smaller-cap biotechs is ripe, given their low valuations relative to large-cap biotech companies. "In 2024, aggregate clinical trial results among small-cap biotechs added considerable market value, although it wasn't fully reflected in stock prices, by our calculation," she explains.
• At the same time, she notes, earnings margins among the biotech components in the S&P SmallCap 600^® Index are expected to potentially return to positive territory in 2025, after a difficult 2024.
• Additionally, she thinks merger-and-acquisition activity could rebound. Large-cap biotechs and major pharmaceutical companies have accumulated near-record cash of late, and many need to replace drugs set to lose patent protection, she says.
• "More deals could be coming if lower interest rates spur risk-taking," according to Kontopoulos. "They could center on smaller-cap firms, as these types of targeted acquisitions are easier to integrate and often face less regulatory scrutiny than large acquisitions."
• Crinetics Pharmaceuticals is a high-quality, small-cap fund holding in the small-cap category that Kontopoulos has particularly liked, describing its focus on small-molecule endocrinology. She believes it may get approval from the Food and Drug Administration in 2025 for an oral treatment for acromegaly, likely recording about $700 million in peak sales, by Fidelity's estimate.
• Another top idea is Xenon Pharmaceuticals, for which the biotech team expects favorable phase 3 epilepsy data later this year. "We estimate roughly $1 billion in peak sales here," she says, adding that the drug also is being studied as a potential treatment for depression.
• Crinetics and Xenon were among the fund's largest overweight positions versus the industry benchmark as of April 30.