As the top-performing sector in the S&P/TSX composite index, the health-care space is top of mind for many market watchers.
But investors should be aware that this is a tricky sector to invest in, as many health-care stocks involve clinical trials that have binary events – meaning they can either provide investors with enormous gains or horrendous losses depending on trial results. When looking at health-care stocks, screening for companies that have actual earnings can provide investors with downside protection as a company's valuation can be calculated based on actual, not potential, revenues. In addition, identifying health-care companies that have strong balance sheets and cash available to fund their growth is also important for investors to consider.
Today, we'll focus on one health-care stock that may be a healthy addition to your portfolio given its attractive potential risk/reward profile.
Knight Therapeutics is a company founded in 2014 by Jonathan Goodman, the previous chief executive and co-founder of Paladin Labs, which was acquired by Endo Health Solutions. Prior to being acquired, Paladin's stock price enjoyed a stellar rally owing to its solid fundamentals. The company reported 19 consecutive years of record revenues and the share price climbed from $1.50 to $142 a share. Mr. Goodman's goal with Knight is to replicate his strategy at Paladin of acquiring or working in partnership with other pharmaceutical companies (also known as in-licensing) in order to develop and market new pharmaceuticals products.
The company has a solid pipeline of potential acquisition targets; however, management remains disciplined in not overpaying for any acquisitions – and in making the right ones. When management reviews potential acquisition opportunities, they desire lower risk and lower cost products such as mature or underpromoted products from large pharmaceutical companies, or biotech companies with products in late-stage clinical development – therefore reducing the risk of clinical failures. Another aspect of Knight's growth model is its ability to generate revenue by making loans to health-care companies. Management has charged borrowing firms an interest rate in the 10 per cent to 15-per-cent range.
Solid balance sheet: Cash is king. To date, management has yet to make any large acquisitions and investors are waiting with bated breath. The company has over $300-million of cash on its balance sheet available for acquisitions. In total, it has just under $5 per share of cash. What does this mean to investors? If the stock market were to collapse, this stock price should be well supported at a minimum level of $5.
Management's significant personal ownership in the company is also attractive. The CEO owns over 21 million shares or approximately 23 per cent of the shares outstanding. In other words, Jonathan Goodman has "skin in the game" and his interests are aligned with shareholders, something that is important, in particular, with smaller companies.
Catalyst: What is going to drive the stock price higher? The shares should rally when management finally deploys this cash by making acquisitions. Quarterly earnings are immaterial right now. The key thing investors need to monitor is the company news for product additions.
Analysts' recommendations: This new company already has six analysts covering the stock. Five analysts have "buy" recommendations and one analyst has a "hold" recommendation, according to Bloomberg. The average one-year price target is $9.20, suggesting a potential return 34 per cent. Keep in mind that many analysts have not factored in future revenues from potential acquisitions and this target could be revised higher over time.
Chart watch: This small-cap stock has gone for a round-trip ride year to date, climbing to a record high of $9.91 on Feb. 25, and returning to near when it began the year. However, this pullback in the stock price is an attractive buying opportunity. Should the stock continue to retreat, there is technical support at $6.50, and then $6. Should management be able to successfully identify and acquire a solid line of products, this stock may end up having a stellar second-half of 2015 and early 2016.
The bottom line: Knight has downside protection as it has approximately $450-million on its balance sheet. A few positive acquisition announcements could cause the stock to rally back up to its previous high.
Stay tuned. I'll look at another health-care stock worth owning Thursday.
Jennifer Dowty, CFA, Globe Investor's in-house equities analyst, writes exclusively for our subscribers at Inside the Market.
Jennifer Dowty