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Horizons: Family Office & Investor Magazine

Marc Pentopoulos: Outperforming with Smaller Listed Bio- and Med-tech Stocks

Monday, September 21, 2020

Marc Pentopoulos, CFA, is a bio-tech and med-tech expert with decades of experience in medical technology, drug development, and finance. He is the Managing Partner of Vista Point Capital where he runs the Parallax Biomedical Fund that focuses on opportunities in biotech public equities primarily in the US and in Europe. He has an MBA from the Wharton School as well as the University of California Berkeley BAs in Molecular Biology and Economics.

Marc’s fund has vastly outperformed not only the S&P but also his peers and all applicable indices. Investment Ideas are generated in- house and evaluated in a rigorous bottom-up fundamental analysis style. The fund’s 20 to 25 core positions are growth stocks in nature and are focused upon small capitalization companies with market capitalizations of less than $ 2 billion.

The field is complex, and significant market inefficiencies exist, especially in the valuations of smaller public companies, presenting significant opportunities. In this interview we will be examining how a successful fund manager in public bio-tech and med-tech stocks invests.


Matthias Knab: Marc, as a start, can you sum up for us why investors should look to invest in your sector, so (why) bio-tech, med-tech and healthcare?

Marc Pentopoulos: Healthcare represents a large percentage of the US and global economy. Currently, healthcare represents about 13% of the S&P500 and just under 20% of the US economy. But, more importantly, humans cannot function well without good health and often treatments are needed for specific conditions. However, the sector is difficult to understand as there are scientific, government regulatory and economic conditions that can all affect the success of new therapies. At the same time there is tremendous innovation that has taken place in the area over the last 50 years making therapies possible for conditions that were previously untreatable.

The COVID situation has also taught us that as much as our understanding of healthcare has advanced, there are still new issues and situations that come up that we need to tackle scientifically and that presents opportunity for those that know how to tackle these diseases.

So, the broader healthcare sector is one of the few growth areas in the US and in the global economy right now. Obviously with the COVID-19 pandemic, the solutions tend to come out of biotech and this domain will remain an important and innovative part of the world economy. In addition, as the population pyramid inverts as a consequence of an aging population, the sector will continue to grow in size and relevance.

Matthias Knab: You haven’t mentioned your returns, which – while past performance is not necessarily indicative of future results – look really interesting as with 54% net return in 2019 and xx% as of Aug. 31st this year you have outperformed not only the S&P but also your peers and all applicable indices.
What is behind your outperformance, what differentiates you from other healthcare funds?

Marc Pentopoulos:We invest in smaller companies, where there are more inefficiencies. These companies are still in the “show-me” stage of development, but when you look through these companies, you can often find very promising drugs trading at a fraction of what they are worth.

There is far more inefficiency in this segment of the market as Wall Street often ignores or pays junior analysts to track these stocks, and occasionally one can find stocks with promising technology and products trading at close to zero enterprise values. It typically pays to be patient when investing in this industry, especially on new technologies.

There are a lot of challenges to inventing, developing and commercializing a new therapy and there can be a lot of bumps along the way. This path to development can provide for excellent investing opportunities as the sector tends to go in and out of favor and certain missteps by companies can provide for long and short opportunities. When products show good signs of efficacy this can provide for a period of sustained outperformance by the company developing it. We also have both investing and operational experience which helps us better understand what it actually takes to develop a therapy and bring it to market.

Lastly, it’s not only about the technologies but also having insights whether the team that’s in place at a certain company is able to drive the firm to either an exit (being acquired) or to successful product launch.

Matthias Knab: OK, I get the aspect on the opportunities, but how do you deal with the risk that’s inherent in this sector? Events seem so binary.

Marc Pentopoulos: While it is true that the sector is risky, there are ways to invest in the sector that can help mitigate some of the risk. It is true that betting on a particular clinical study carries risk, however, one can look more closely at the drug and study to determine whether there is higher or lower probability of success. In addition, the valuation, pipeline, underlying technology and balance sheet of the company all tie into the downside risk of a negative clinical risk.

For example a company with a $2 billion valuation going into phase 2 clinical data with only $50m on the balance sheet and no other products in the pipeline can potentially pose much more risk than a smaller company with say a $300 million valuation and a pipeline of other promising drugs. One needs to take many factors into consideration when determining whether it is worth carrying the clinical risk and what type of portfolio exposure to take into a clinical event. In addition, a careful study of previous data can give some hints into the likelihood of success. But one way we look to limit downside risk and preserve capital is to find out of favor names with a low enterprise value and solid technology,this usually puts some underpinning on the valuation, especially if there is a strong balance sheet. One additional strategy to preserve capital can be to trim the size of the position if the stock appreciates significantly in expectation of a positive clinical data event, therefore reducing the downside risk in the event that the data doesn’t show good results.

Matthias Knab: What areas of healthcare do you invest in? Do you focus on any subsector of biotech?

Marc Pentopoulos: We focus on companies that have novel treatments, devices or diagnostics that improve the outcomes of care. Either a diagnostic to improve detection of diseases, or a therapy or device that improves the delivery or outcomes of disease. In addition, we focus on smaller companies, usually less than $1 billion in market cap where see concrete events that will demonstrate the value of the therapy in development over the coming years. While we look for opportunities globally, we do focus most of our investments in the US and in Europe. We look for undiscovered names where there is significant potential for upside in the coming years.

We are not focusing on specific subsectors but rather try to be as opportunistic as possible. There are times when there are a lot of compelling opportunities in oncology and there are times when the opportunities lie more in metabolic or psychiatric therapies. The important thing is to make sure that there is a large unmet need and that the therapy in development has a good signal of efficacy and is something that treating physicians will have an interest in once it gets to market.

Matthias Knab: How does your bio and your professional experience come into play when you invest?

Marc Pentopoulos: I have over 23 years of experience in this area, both on the investing side as well as on the drug development side. This means I have seen a lot and been through different cycles, and so while we look to discover these out of favor but promising bio and med-tech companies, we also take a view towards protection of capital. As you have referred to, this is a very volatile space and so we will make sure that we are selecting ideas where we think the downside is quantifiable and where we see a lot of upside. We try to position the portfolio in a way to attempt of minimize the downside volatility but allow for the significant upside.

So, our investment process starts with idea generation and then comes due diligence of these ideas, the determination of sizing of the positions, and an analysis of overall portfolio construction. Then of course there is ongoing risk management and assessment of each of the positions in the portfolio.

Apart from my own 20+ years of evaluating technologies and companies, I have a significant network of industry professionals, doctors, scientists, and other industry and academic groups as well as a number of buy-side contacts that I consider intelligent investors to share and discuss ideas from time to time.

Matthias Knab: What are the key criteria that make a good company in your sector?

Marc Pentopoulos: We really like three factors to line up if possible:

  1. good management,
  2. good technology,
  3. large market potential for the products and an ability to sell them for a high margin.

Then the trick is to get to know the company well and have the opportunity to buy the stock when the company is trading at a significant value to what we believe they are worth.

Sometimes two out of three factors can be an opportunity if the company is selling at a low enough value, but ideally all three line up. Drug development is quite difficult, so you really need good underlying technology, evidence from preclinical models that the treatment really solves the issue it is trying to solve, and then the human clinical studies need to show that it works in humans. Obviously over time, the human experience can further perfect the therapy and how it is administered by the patient or physician. The company also needs to figure out which people will respond best to the therapy and determine a regulatory strategy to get it to market and then a sound commercial strategy to get the drug into the hands of physicians so they can prescribe it or use it in surgery if it is a medical device.

Given the many moving pieces you need a solid management team that can pull together the right team to make all this happen, and so one of the most important things is to really get to know management and understand the quality of the management team at a specific company. This is an industry which requires multiple different skill sets and so you need a high quality management team that can attract the right team to actually be successful in this industry.

We are also careful when it comes to timing. When we are evaluating the upside potential, we obviously also look at the current market cap, how strong is the balance sheet and does it makes sense to get involved now or to wait? Sometimes, for example, if it’s a new management team that I have never met before, it really makes sense for me to follow them for some period of time. From time to time we will follow a company for two or three years before we invest in it.

Matthias Knab: What about short opportunities, how do you pick shorts?

Marc Pentopoulos: Short positions can be more tricky than longer term value investments on the long side, given that the timing has to be much more specific than waiting for an investment to play out on the long side. Typically, what we are looking for is a company that has achieved a significant valuation, often way more than even the most optimistic scenario can justify, starts to have issues either clinically or in their selling efforts. It’s quite difficult to time the top of overvalued companies, so we often wait for the troubles to show up, with the bet that the troubles will continue for some time and the company will lose value in its share price over that time.

There is often a mismatch in the market capitalization value of our (longs) versus our shorts. We prefer to short higher market capitalization companies for two reasons, the first being that we are looking for overvalued shorts and undervalued longs and the other is that it can be very painful if one is short a $300 million market cap company and all of a sudden it comes up with positive data. If a short position already has a $2 billion market cap, the upside potential on positive data is usually lower. And given the inefficiencies in the smaller names, even if the smaller company has data that is a bit ambiguous, the company can spin the data in a way that drives the valuation higher, so one has to be quite careful in shorting smaller companies. Usually the safer smaller companies to short are ones where there will be little potential for their commercial products once approved by the FDA or EMA and the company has to demonstrate sales growth to meet the analysts’ optimistic forecasts.

To be a bit more specific, we have a smaller number of short positions in what we believe are overvalued companies where there’s also a significant catalyst in the near term. Maybe investors have priced in a product growing at 40% to 50% for the next few years, however competition is going to moderate that growth to maybe 20% to 30% and that should lead to a significant decline in valuation. Or there is going to be some regulatory risks and you are already realizing that the company isn’t really communicating what the issues are with getting the product through the FDA. Those kind of issues can also lead to significant downside moves in the company and so we are targeting overvalued names where there is defined catalyst that will push the valuation down over the next say 12 months.

Matthias Knab: Tell us more about your position sizes and your typical holding period for an investment?

Marc Pentopoulos: Ideally, we will hold a long position for a number of years, and participate in a significant appreciation in value of the company. I would say on average we hold a long position for about 2-3 years, but sometimes it is much shorter, and other times much longer. A lot depends on the execution of the team and the valuation of the company and how the prospects for the company develop over time. If a company is able to successfully develop a pipeline of products, it can end up being worth a lot more than perhaps the original investment thesis. On the short side, the holding period is typically shorter, and usually ranges from 6 to 18 months. If it hasn’t worked in 18 months, the thesis probably hasn’t worked out.

Long positions typically get initiated between 2% and 8% and the position sizing really comes down to the conviction that’s driven by those factors I have mentioned earlier, quality and potential for the technology, the quality of the management team, and the evaluation of the company relative to what it could become down the road. On the short side, they tend to be between 2% and 4% of the portfolio depending on these catalysts that will drive significant downside in the stock in the near term.

Matthias Knab: What other factors drive your overall portfolio construction?

Marc Pentopoulos:One aspect is of course the number of names that really fit our criteria, but we also need to be conscious about the outlook for the sector and subsectors. Sometimes there are all kinds of macro factors like political headwinds that we need to be cautious about.

There are also times with great enthusiasm about the biotech sector. Then, everybody wants to own biotech, there are 20 deals happening every night, or you see quick overnight deals being priced at almost no discount. Those tend to be times when you need to be a little more cautious.

On top of that, you also need to know what the insiders are doing at these companies. Are they buying stock? Or is it difficult to get a deal done, in which case you need a lot of the insider participation with some outside funds – those tend to be pretty good deals to participate in.

Once we are in a position, we constantly monitor them, looking at their upside and making that the management teams are executing on their game plan.

Matthias Knab: You said you need to be cautious about political headwinds – what do you think of the current political environment when it comes to healthcare costs?

Marc Pentopoulos: We think many would agree that healthcare costs have gotten out of hand in recent years, especially in the US. The political factor is probably more a risk now than it has been in the past given the large number of layoffs and the huge budget deficits. The question is will this play into pressure to lower drug prices and will it be across the board cuts or focused cuts in particular areas? We don’t think the government wants to cut off pharmaceutical innovation as it is one of the growth areas in the economy, so we don’t think they will do any dramatic in the near terms to dramatically cut the pricing of innovative new drugs. But the current administration is certainly signaling that Americans shouldn’t be paying more for drugs that people in other countries, and that may change the pricing structure of new therapies both here and abroad.

Matthias Knab: From the perspective of an investor, how has the COVID pandemic affected your space?

Marc Pentopoulos: The COVID pandemic has certainly created interest in certain areas of the biotech sector, as evidenced by the big rise in stocks that have vaccine and therapeutic candidates. The other driver has been M&A which seems to continue as larger pharma companies look to expand their pipelines. These two factors on top of the current thinking that biotech is recession proof has really driven biotech’s outperformance this year.

Matthias Knab: What do you think of the COVID companies at their current valuations?

Marc Pentopoulos: I think there is quite a bit of risk in investing in these companies at their current valuations. There is not only the clinical risk but also the competitive risk as there are a few companies with programs out there. I think given the large run they have had it would make sense to wait for more data before trying to pick a winner in this field.

Marc was also speaking at a recent Opalesque Corona Fighters webinar, you can watch his presentation in a video replay here https:// www.opalesque.com/webinar/#pw8 (scroll the video forward to 46:20 (min:sec).
To contact Marc Pentopoulos and his team, email: managerinfo@opalesque.com.



 
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