This may prove a challenging year for small-cap biotechs, but the five analysts who selected companies for inclusion on The Life Sciences Report’s 2016 Small-Cap Biotech Watchlist believe these companies have a good shot at producing innovative products in a variety of indications and producing value for investors. Discovery, it turns out, is not just about finding the cure for a particular disease; it’s also about finding the companies best poised to reach that goal.

The panelists who selected the 2016 Small-Cap Biotech Watchlist are George Zavoico of JonesTrading International Services, Mara Goldstein of Cantor Fitzgerald, Reni Benjamin of Raymond James, Raghuram (Ram) Selvaraju of Rodman and Renshaw, and Mike King of JMP Securities. They discussed their selections, as well as some of the forces they expect will drive the biotech and pharma markets in the new year, at the 2016 Biotech Showcase in San Francisco.

The Big Picture

Reflecting on how biotech will shape up in 2016, most of the analysts were cautiously optimistic. The long-running biotech bull has shown some vulnerability, especially to macroeconomic forces that present headwinds to investment markets as a whole. But the sector’s fundamentals, the analysts maintain, remain solid.

Though Benjamin believes “we’re seeing what could be the beginnings of a sector rotation,” he observed that, “the science is better than ever. The capital flow has been really good. The clinical trials and the regulatory environment are the best that we’ve ever seen. . .[but] that’s only one part of the equation. The other part is, of course, sentiment.”

One of the biggest issues affecting sentiment in 2016, the panelists agreed, will be drug pricing. After all, the issue of consumer shock and election year rhetoric with regard to the costs of drugs—think Gilead’s Sovaldi for hepatitis C and the Turing Pharmaceuticals price-hike debacle—”led to significant volatility last year,” Benjamin said.

“We expect to see reports on safety and efficacy from  Asterias Biotherapeutics Inc.’s cervical spinal cord injury trial sometime in Q2/16.”—George Zavoico

“We’re all aware of drug pricing issues. We’ve heard the candidates talk about this issue,” Zavoico observed. That “headline risk” is what affects sentiment, and that, in turn, produces volatility and pressure on biotech and pharma valuations. It also “begs the question: What is the upper limit for drug prices? And how are insurance companies going to deal with reimbursing huge sums all at once? Will they come up with creative alternatives?”

Zavoico also underscored that this year, “nobody knows what’s going to happen. Who knows what else Donald Trump is going to say? Who knows what issues will come up with Hillary Clinton? There is more uncertainty this election year than usual. . .To keep the industry going forward, I think all the candidates need to understand that incentives for innovation should be retained,” Zavoico said.

The bigger issue for investors, as Goldstein put it, is “if we are in an environment where macro issues outweigh fundamentals for the sector, then all information, in our view, is treated similarly. That means bad news, such as an unsuccessful clinical trial, is treated as bad news, and good news, while positive, gives investors an opportunity to take profits and/or minimize losses rather than build positions. This has occurred in the past, and it makes for a very challenging environment for biotech investors.”

For his part, King is “sick and tired of hearing about the pricing issue. People ignore or forget about the whole good that this industry does.” The analyst believes the industry needs to do a better job letting the public know the benefits of what Zavoico calls “lifesaving drugs” like Sovaldi.

“I don’t know if that makes things go away in 2016, but at least we have a very strong counterargument,” King said.

Positive themes for 2016 include mergers and acquisitions, which the analysts forecast will continue to be a driver. The regulatory environment remains favorable as well, and was also cited as a positive. In addition, King noted a number of “high quality” private companies are poised for initial public offerings in the new year.

“CorMedix Inc. has one of the few programs that deals conclusively with multidrug-resistant bacterial infections.”—Ram Selvaraju

The experts also expect 2016 to bring a number of “big Phase 3 trial outcomes,” both for bigger biotechs like Incyte Corp. (INCY:NASDAQ), Vertex Pharmaceuticals Inc. (VRTX:NASDAQ) and Regeneron Pharmaceuticals Inc. (REGN:NASDAQ), as well as for small-cap companies. “This is the grist for the mill for biotech,” Benjamin observed. “The binary nature of clinical trials is a huge driver, both positive and negative, in our space.”

Selvaraju elaborated on that theme. “Investors are very much sensitized to the risks attendant upon deficiencies in clinical trial design and in statistical powering assumptions,” he observed. “We are in an environment today where having a successful clinical trial and even getting regulatory approval is not a guarantee of success. We’ve seen several companies that went through the clinical trial development process successfully, then went through the approval process successfully, reach the market and fall flat on their faces. . .this new concept that companies can actually get to the finish line and still not be in a safe zone [weighs] on investors’ minds tremendously these days.”

But clinical trials that work are a boon to the industry, individual companies and, of course, patients and physicians. “I feel like we’re in an era where the hard stuff is really working,” King said, citing the new drugs that cure hepatitis C and the rapidly developing field of immuno-oncology. “I feel that’s part of what’s pushed up valuations. . .You can actually make a bet on some of these better companies, and the bet will go your way.”

“There is no more efficient way to address chronic and debilitating conditions than to target them with drugs. There is a lot of leeway still in the pricing of drugs as long as they provide significant and tangible, clinically meaningful benefit,” Selvaraju added.

The 2016 Biotech Watchlist Companies Explained

[Editor’s note: The five analysts submitted commentary on some of their Watchlist companies earlier. For more, read Panelists Select 19 Companies for the 2016 Small-Cap Biotech Watchlist]

Mara Goldstein’s selections include Ignyta Inc. (RXDX:NASDAQ), a targeted oncology company.

“Ignyta is focused on in-licensing clinical assets that target specific oncogenic drivers, using its proprietary next-generation sequencing infrastructure to aid in both the selection of assets as well as selection of patients in clinical trials,” Goldstein said. “Ignyta is moving forward in a Phase 2 trial with a big basket design, which we think is a smart approach to developing drugs that have implications in a variety of indications. The basket trial, called STARTRK-2, is enrolling patients, and the company should be able to evaluate signs of activity as the arms are enrolling, and continue to enroll or discontinue an arm if a signal is not observed. We think this trial makes a lot of sense, and believe it can create efficiency and expediency around oncology trials.”

“The biotech bull has shown vulnerability, especially to macroeconomic forces that present headwinds to investment markets as a whole.”

The company has a “very prolific business development effort, bringing in candidates from Teva and Lilly, along with equity investments from these companies, which I think diversifies the risk profile,” Goldstein continued. “The company has a captive next-generation diagnostic arm that helps it identify patients with particular alterations or rearrangements that are thought to be responsible for their disease. For us, we like that Ignyta checks some of the boxes around derisking clinical trials and diversity of portfolio, and has a good cash runway at this point in time.”

Goldstein also likes gene therapy company Applied Genetic Technologies Corp. (AGTC:NASDAQ), which is focused on monogenic eye diseases. “What we like about AGTC is it’s somewhat under the radar with strong technology underpinnings. AGTC has honed its development strategy to focus on monogenic eye diseases that are largely stable. We expect some data from the lead program, for X-linked retinoschisis (XLRS), in 2016, which could inform the clinical development program and focus investors on the company. We really like the meticulous way in which the company has built out its clinical program, its transformative deal with Biogen, and its long cash runway.”