An $8 Billion Hedge Fund Bought This Extremely Risky Stock: Should You?

By Markets Fool.com

The market activity of billionaire investors tends to attract a lot of attention because these billionaires are often perceived as having some kind of special insight into the direction of the broader market or individual stocks.

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In the world of healthcare, the billionaire tandem of Julian and Felix Baker, collectively known as the Baker Brothers, are perhaps the most closely watched superinvestors because their hedge fund has repeatedly generated annual returns in excess of 100%. Moreover, they have shown a penchant for picking the next "home run" biotech stocks, such as Acadia Pharmaceuticals and Pharmacyclics , with both of these stocks exploding higher since the fund took a position:

ACAD Chart

Per the third-quarter 13F filings, we learned that the Baker Brothers have amassed a huge position -- more than 10 million shares -- in the orphan-drug maker Synageva BioPharma Corp. , making them the company's largest shareholders and Synageva the fund's fourth largest holding.

Given the Baker Brothers' stellar record of generating marketing-crushing returns and the considerable size of their stake in Synageva, should average investors consider buying this stock? Let's take a deeper look.

Synageva is looking to become a leader in the orphan-drug space
Drugs for rare diseases have gained favor in the pharmaceutical industry because they offer their manufacturers several key advantages over treatments for more common conditions, such as an extended period of market exclusivity, tax credits, faster review times, and even a waiver of some regulatory fees.

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To top it off, most approved treatments for rare diseases to date have been biologics -- or therapies developed from biological organisms -- making them hard to copy via so-called generic biosimilars. The net result is a group of products that tend to enjoy a long shelf life and high profit margins, which is probably why most orphan-drug makers garner huge premiums in terms of their share price.

Synageva is looking to break into this space with its lead clinical candidate,sebelipase alfa (brand named Kanuma), an enzyme replacement therapy indicated for patients afflicted with the rare disease lysosomal acid lipase, or LAL, deficiency. So far, the company has filed regulatory applications in both the EU and the U.S., with possible approvals coming in the third or fourth quarters of this year.

Although the market size for Kanuma is still up in the air because the disease often goes undiagnosed or misdiagnosed, according to Synageva, the company noted in a recent investor presentation that most enzyme replacement therapies eventually generate several hundred million in annual revenues once the work of identifying patients has begun in earnest:

Source: Synageva corporate presentation.

Synageva isn't without its risks
While Synageva looks like it's on the fast track toward following in the footsteps of rare-disease drugmakers such as BioMarin , the company's rapid ascent and limited revenue opportunities in the near term present some serious risks that should be carefully considered.

First, management is going to have to spend a tremendous amount of money on developing theLAL deficiency market after Kanuma's launch. In short, Kanuma won't be a major revenue source for the company anytime soon, and its launch will more than likely result in an increase in net losses.

Next up, the remainder of Synageva's clinical pipeline is extremely early stage:

Source: Synageva.

What this means in a nutshell is Synageva is years away from becoming cash flow-positive, with most of its resources going into its clinical pipeline and the commercial launch of Kanuma. The company does have a strong balance sheet, with $797 million in cash and zero debt at last count. But its market cap of $4 billion clearly reflects the market's enthusiasm for orphan drugs, more than Synageva's fundamental outlook.

Foolish takeaways
A big part of the Baker Brothers' resounding success in the healthcare sector has been their ability to identify undervalued companies with long-tailed growth prospects. In many ways, Synageva fits this classic profile of a Baker Brothers pick -- i.e., the company is only now transitioning into a commercial operation in a space with a bright future in terms of revenue potential.

And if the truth be told, the same risks inherent in Synageva could have been applied to BioMarin as well, once upon a time. Now that BioMarin's business plan has unfolded more or less as planned, the result has been nothing short of spectacular for early investors who were willing to take on the risk:

BMRN Chart

By the same token, there's no guarantee that Synageva will turn out to be a leader in the orphan-drug space, and its present market cap, in light of its development stage, is off-putting, in my opinion. So I think average investors may want to take a pass on this stock for the time being. That said, it still looks like a good watch list candidate and a potential buy if its shares pull back in a significant way.

The article An $8 Billion Hedge Fund Bought This Extremely Risky Stock: Should You? originally appeared on Fool.com.

George Budwell has no position in any stocks mentioned. The Motley Fool recommends BioMarin Pharmaceuticals. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.