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Rise in small-cap biotech signals return to fundamentals, says Next Edge's Eden Rahim

Next Edge Bio-Tech Plus Fund portfolio manager and options strategist Eden Rahim appeared on BNN this morning, explaining how, despite the collapse of the sector’s two headline-grabbing titans, Concordia Healthcare (TSX:CXR, Nasdaq:CXRX) and Valeant Pharmaceuticals (TSX:VRX), the Canadian biotech sector remains aloft, driven by its less famous, under-the-radar small-cap biotech companies.
Rahim singled out sterilizer specialist TSO3 (TSX:TOS) and Promis Neurosciences Inc (TSE:PMN) for particular attention as under-loved “green shoot” biotech stocks.
TSO3 just reported its Q2 2016 results, which saw the company losing US$1.48 million on revenue of $3 million, nonetheless beating estimates and projecting solid growth for their product.
TSO3 is up 75.90% over the past year, settling in today at $3.43. “I think it has a bright long-term future,” says Rahim.
Promis Neurosciences Inc. is also up 68.75% over the past year, at $0.14.
Rahim’s deep knowledge of the biotech sector obviously helps him pick through small-caps that most analysts might neglect, but there’s a common theme to these companies that separates them from the soap opera that has dragged down the value of Concordia and Valeant recently.
Concordia has just announced that its strategic review is ongoing, and that the rejigging of the formulary by CVS Health Corp. excluding two of its drugs, Nilandron and Dutoprol, will not be harmful to the company’s fundamentals.

“The last couple of years of the healthcare rally, that peaked out a year ago, it was those sort of companies, those large-cap pharma companies, with easy access to cheap credit, they led. That’s done.” – Next Edge portfolio manager Eden Rahim

Speaking of the company’s fundamentals, Concordia has dropped 81.18%, down to a $19.69 share price, while the other “headline grabber”, as Rahim calls them, Valeant Pharmaceuticals, has dropped 91.63% in value, settling in since April into the high-20s, now sitting at $28.26.
“They’re in a ‘show me’ mode,” says Rahim of Concordia. “They’re in a ‘prove it’ mode right now. And while you’ve got other companies, and the sector recovering to six-month highs, you’ve got this company breaking multi-year lows.”
The threat by Concordia CEO Mark Thompson to sue former short-selling hedge fund employee and now full-time chicken farmer Marc Cohodes for libel hasn’t helped to calm the general atmosphere of chaos accompanying the company’s lack of fortune.
So what explains the inability of the simultaneous collapse of two of the biotech sector’s biggest names to sink the entire index?
According to Rahim, it’s a shift away from the M&A era, in which companies grew through acquisition, fueled by debt, in favour of smaller, more agile companies that innovate, invest in R&D, and develop necessary solutions to actual problems faced by the healthcare industry.
Rahim believes that the pain suffered by Concordia and Valeant, a pain shared by investors in those companies, actually masks an underlying strength in the healthcare sector.
“The Canadian healthcare sector has been bifurcated this year, in the sense that there are two divergent stories,” he says, with one narrative focusing on the “futility” of these legacy companies that have achieved their status on a growth-by-acquisition model, and the debt that they’ve incurred.

“What these companies do, they innovate. They use R&D, and they innovate and they create original technology, original products, original therapeutics.”

“But out of sight, beneath the surface, is another story,” he says. “You’ve seen a lot of these small-cap Canadian companies really start to emerge. We have several positions that have doubled this year so far.”
Rahim describes companies such as TOS3 and Promis as “green shoots” rising from the scorched forest floor in the biotech sector, helped along by the fact that so few investors and analysts are seeing what he’s seeing.
“It’s an uncrowded trade, and they’re just emerging,” he says of those companies. “Many of these companies don’t even have analyst coverage.”
But Rahim not only evaluates companies in his portfolio on the basis of their business fundamentals, but also on intangibles like the excitement they create at medical trade shows.
“Toronto hosted the AAIC, which is a renowned Alzheimer’s conference, last week,” he says. “Five thousand neurological experts from 75 countries gathered in Toronto to review the latest Alzheimer’s disease research. One of the small Canadian companies, such as Promis, they presented two papers that showed a breakthrough mechanism in understanding Alzheimer’s disease. All of this stuff is very exciting, but it’s occurring beneath the surface. No one knows.”
As exciting as that low-key hype is for Alzheimer’s sufferers, it should also be encouraging to investors.
When BNN anchor Amber Kirwan, who also hosts the start-up friendly The Disruptors with Bruce Croxon, asks Rahim to explain the rise of these agile, innovative small-caps while their older sector-mates languish, it rings a familiar sounding bell.
“What’s the playbook here?” asks Kirwan. “If the old playbook was growth-by acquisition, debt-fueled, how did those two companies that you just named differ?”
Rahim replies, “What these companies do, they innovate. They use R&D, and they innovate and they create original technology, original products, original therapeutics.”
“How novel,” observes Kirwan, to which Rahim smilingly affirms, “Exactly!”

“These are exciting companies that have a bright future, and they will be able to grow. It doesn’t really matter what the economy does. And that’s the opportunity that’s unfolding.”

So the logic of disruption has finally arrived in biotech if Rahim’s analysis is correct, much to the relief of investors who prefer putting their money into fundamentals such as agility and innovation and solving actual problems, rather than debt-fueled growth and speculation.
“The TSX healthcare index is almost rudderless right now, because you’ve got the old legacy leaders that are languishing,” says Rahim. “New, small leaders, that have no weight in it, are emerging. But I think more than anything else, it’s telling you that it’s a return to R&D-based companies, companies that can create products that can make obsolete existing products.”
And how did it come to this rudderless situation?
“For years we had Canadian healthcare investors piled in to large-cap pharma, because of the allure of earnings momentum and sales momentum that was acquired,” says Rahim. “To handicap what an R&D pipeline would turn into is a different skill set altogether. But it’s also why you’re seeing the M&A wave. Why is it that there are bidding wars for all these biotech companies? Because large-cap biopharma is looking at this and saying, ‘We can build a product portfolio out of these companies,’ when their topline growth is languishing.”
Best of all, companies that are supplying solutions to the problems set out by TSO3 and Promis appear to be more or less recession-proof.
“You’ve got a whole new generation of investors in Canada that are perhaps not tarred and feathered by their experience with the former cycle leaders. And they’re discovering these companies,” says Rahim. “These are exciting companies that have a bright future, and they will be able to grow. It doesn’t really matter what the economy does. And that’s the opportunity that’s unfolding.”
Rahim is as definitive as a cold shower in describing the turn away from the old M&A era of growth-by-acquisition in favour of companies that can grow through innovation, R&D and attention to fundamentals.
“The last couple of years of the healthcare rally, that peaked out a year ago, it was those sort of companies, those large-cap pharma companies, with easy access to cheap credit, they led. That’s done.”
Watch Eden Rahim on BNN here.

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