Why is This Biotech Company Baker Bros.’ Top Stock Pick?

Baker Bros. Advisors, managed by – you guessed it – Julian and Felix Baker, had quite the second quarter this year. As seen on our list of best performing hedge funds, Baker Bros. Advisors was the second most successful hedge fund over this time period, at least in terms of total returns. The fund’s 13F portfolio, which is reported to the SEC, returned a whopping 15.8% between March 31st and June 30th, and is currently valued to be worth a little over $4.2 billion. With a focus on biotechnology companies, it is understandable how the New York-based hedge fund was able to generate such significant value for its investors over such a little period of time, but it’s also possible for individuals to have this kind of success. Without further ado, here is the top stock pick in Baker Bros.’ 13F portfolio.

Pharmacyclics, Inc. (NASDAQ:PCYC)

Pharmacyclics, Inc. (NASDAQ:PCYC)

Accounting for a 14.7% stake in the hedge fund, Pharmacyclics has returned 325.9% since the start of 2012, and with a market capitalization above $4 billion, this isn’t your typical small-fry biotech stock. The company develops drugs that can be used to treat a variety of ailments including cardiovascular disease and certain cancers. Pharmacyclics’s ace in the hole, however, is its work with texaphyrin-based technology, which is molecular in nature, and can be manipulated by x-ray light to remove cancerous tissue in a patient’s body.

The company also has a solid amount of products in its drug pipeline that have yet to be approved by the FDA, but have enormous potential. The most important is Ibrutinib, a collaborative effort with Janssen Pharmaceuticals, which is a subsidiary of Johnson & Johnson (NYSE:JNJ). The drug is a BTK inhibitor that can be used to treat a variety of cancers, including chronic lymphocytic leukemia, multiple myeloma, mantle cell lymphoma, and diffuse large B-cell lymphoma.

Last year, Ibrutinib was moderately successful in its phase II trials for the treatment of chronic lymphocytic leukemia (CLL), with 7 out of every 10 patients reporting a positive response to the drug. More importantly, Pharmacyclics also announced in August that Ibrutinib was moving in the right direction with regards to its usage to treat mantle cell lymphoma (MCL). The company added its fifth patient to its trial group, automatically prompting a $50 million payment from Johnson & Johnson’s Janssen Pharmaceuticals.

As of this writing, however, Pharmacyclics still has exactly zero FDA-approved products, and its stock price is being propped up by the potential of Ibrutinib’s successful completion of phase III trials. From a valuation standpoint, the company’s shares look to be overbought nearly anyway you look at it. Pharmacyclics has a Price-to-Earnings ratio of 446.1X, far above peers like Cell Therapeutics Inc. (NASDAQ:CTIC), Merck & Co., Inc. (NYSE:MRK), and Valeant Pharmaceuticals Int. (NYSE:VRX). Even when growth is factored into the equation – EPS has grown by 129.2% over the past 12 months – the stock still looks to be overvalued, as it trades at a ridiculous PEG ratio of over 2,000, compared to others in the industry: Merck (4.4), Valeant Pharmaceuticals (16.7), and Cell Therapeutics (n/a). The latter is not expected to generate any significant earnings over the next five years.

While these metrics are measurements of how investors are valuing Pharmacyclics based on its past and foreseeable earnings, they do not take into account the entirety of profit windfalls that could occur from an FDA approval of Ibrutinib in both its CLL and MCL forms.

It appears that many in the hedge fund industry are buying Pharmacyclics based on Ibrutinib’s potential alone, as 15 hedge funds held shares of the company at the end of the second quarter. The most notable bulls were Cliff Asness, Richard Driehaus, and D.E. Shaw. A few fund managers, including Israel Englander and George Soros, closed out their positions in the stock during this time as well, likely because Pharmacyclics’s hypothetical profits were trading at levels much too expensive for their tastes. For a complete look at the hedge fund industry’s sentiment toward this stock, continue reading here

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