Fund manager's favourite small-cap pharma shares

Big funds love big pharma. Drug majors like Glaxosmithkline and Astrazeneca boast strong balance sheets and pay generous dividends, and managers prefer to avoid the smaller healthcare companies. That's understandable, but investors have no such constraints, and could do much better elsewhere.

While Glaxo currently yields over 4%, its shares are worth less now than they were in 2013 and have underperformed the FTSE All-Share index over the past decade. Perennial bid favourite Astra is nudging record highs, although it's been rangebound for the past three years.

Big guys have problems, too, especially when a major product comes off patent, and has to be replaced. It costs money to deliver the next blockbuster drug, and there have been fewer of these in recent years.

"It's a bit like running on a treadmill," says Paul Mumford, fund manager at Cavendish Asset Management. "It's fine if you can do it."

But Mumford argues that there are far better opportunities for investors at the smaller end of the market.

"If a company has a decent product, can acquire new products or has a different angle, it's much easier for them to grow in size than the Astra's or Glaxo's of this world," he says. "There are safe areas where you can make quite a lot of money.

"I'm investing in companies that don't have the risk of R&D spend, and prefer to avoid biotechs where it can take donkey's years to get a product to market. Why risk is when you can buy sensible companies, making sensible profits on sensible ratings?"

Sensible small-caps

In a conversation with Mumford recently, he named the healthcare minnows he likes best and which sit in either his TM Cavendish AIM or Opportunities fund or, in some cases, both.

Mumford likes Consort Medical, which makes devices like asthma pumps able to measure doses. It has little competition and has bought the business that manufactures parts for its inhalers, so it has an all-round solution.

Companies like Alliance Pharma that sell drugs but don't do the R&D also interest Mumford. Alliance buys drugs that have been around for years, but which are too small for the big pharmas. Being a smaller business, any drug it can acquire makes a big difference.

Clinigen is similar, but also supplies drugs to biotech companies, while Ergomed has a slightly novel approach. Rather than take an interest in drug producers, it will finance the drug in return for future licences and royalty payments. It's profitable and makes money without the huge risk attached to R&D," says Mumford.

BTG – British Technology Group - spun out by the government and originally owning lots of patents in electronics and mechanics, is now a pure healthcare company.

It does spend money on R&D, but is more focused on development than research. A new product - beads with chemicals that attack tumours – is expected at end of the year. Others treat varicose veins by injecting foam, which works better than a medical procedure.

"It's growing nicely and has net cash on the balance sheet and there's no risk of major drugs that will fail it," says Mumford.

He also likes specialists including Inspiration Healthcare - supplies products for premature births and devices to help premature babies. "It's a very small company, but one that can grow quite substantially," according to Mumford.

Elsewhere, the manager backs Emis, which supplies half of GP surgeries with software to keep patient records that are more easily sent to pharmacies, improving efficiency.

Ten-baggers and spreading the risk

Of course, there is still plenty of risk at this end of the market, but there are also rich rewards. Mumford bought Advanced Medical Solutions years ago for just 10p. The shares are now worth 278p!

Another 10-bagger for Paul is Tristel, responsible for novel chemistry for wipes used in hospitals. "It's looking to break into the US which could mean significant extra value," says Paul.

To de-risk his portfolios, Mumford has a decent spread of investments, which typically means his funds hold around 70 stocks.

And Mumford won't overpay, either. "I don't like to invest in unprofitable companies. Profit forecasts are often very inaccurate, so I much prefer to have a company that's making money, where profits are growing and that's on a sensible PE. I also avoid negative cash flows."

"PEs tends to be 19-20 which can be relatively high compared to other companies in other areas of the market, but not to a level you'd get uncomfortable about.

"It wouldn't put me off having a highish rating to start with, but I prefer stocks to be on single-figure multiples. However, if they're of sufficient size, I'm happy with high multiples."

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.