“The tricky thing about drug prices is that when they are higher, it encourages more innovation, because it’s a very risky industry.“ —Joseph Edelman Sasha Maslov for Barron’

The founder of Perceptive Advisors and its hedge fund, Perceptive Life Sciences, has deftly negotiated the potholes in biotech. Even though the sector fell 20% last year, Joseph Edelman’s fund gained 3.8% after soaring 52% in 2015. His father ran the biochemistry department at Columbia University (Joseph started working at the lab at the age of 13), then started a biotech company that he eventually sold. Edelman majored in psychology as an undergraduate, and then worked as a biotech analyst, launching Perceptive in 1999. Today, the firm manages $2 billion, which Edelman oversees along with his chief investment officer, Adam Stone. Edelman keeps his office near Greenwich Village, far from midtown’s madding crowd. Barron’s caught up with him recently to find out what he learned from last year’s carnage, why President Donald Trump’s tweets won’t ultimately have much effect on the market, and why investors must embrace uncertainty.

Barron’s: Trump has made many critical tweets and statements about drug prices. Is it all rhetoric?

Edelman: It’s mostly perception that won’t be impactful in the end. He talks about Medicare and negotiating drug prices. Essentially, private insurers already negotiate for Medicare. It can’t pay more than the lowest price paid by private insurers. We invest in a lot in small- and mid-cap biotech stocks where the essential questions are: Does the drug work? Will it be approved? Will it sell more or less than expected? If it works and is approved, the stock will go much higher. Price controls are a negative perception that keep people away from the group, not the driving factor in stock prices.

Indulge me for a second. The vote on Proposition 61 in California was particularly important. Why?

The proposition was that Medicare wouldn’t pay any more than the Department of Veterans Affairs. The VA does pay lower prices than Medicare, so it could have been very disruptive. If it had passed, the drug companies would have to lower prices to the VA level. California is the most liberal state in the union. But it didn’t pass. People are a little worried about hurting innovation. The tricky thing about drug prices is that when they are higher, it encourages more innovation, because it’s a very risky industry. I don’t think anybody would invest in some of these smaller companies if prices were kept artificially low.

There’s a lot of talk about ending the Affordable Care Act.

It won’t have a meaningful impact. I don’t see Congress creating a large group of people who can’t buy drugs.

Is this the year biotech beats the Standard & Poor’s 500?

If I had to guess, I’d say yes. These stocks are in general very good value. I’m more confident in the ones we’re invested in, which have major clinical regulatory events that, if they go well, the stocks will almost certainly go higher—companies like Versartis[ticker: VSAR], Global Blood Therapeutics [GBT], Neurocrine Biosciences [NBIX], and Amicus Therapeutics [FOLD]. You have fear—people not wanting to be in the group. Eventually, that washes away.

What are the biggest risks facing this sector?

The drug industry has to out-invent itself to a degree. You have a patent life of 17 years; you can’t live forever on one drug. Smaller companies have an exit strategy not available to big companies: They can be sold. But you need to keep innovating in a meaningful way that makes it worthwhile to use a branded drug. There are areas where generics are pretty good, even if not everyone is adequately treated—say antidepressants or blood pressure. Smaller patient populations present a challenge. We invest a lot in the so-called orphan-disease space, where you’re under 200,000 patients and you can price drugs in the hundreds of thousands of dollars, which makes it worthwhile for companies to pursue.

Why do you call your firm Perceptive Advisors?

The paradigm when looking at these stocks is perception and reality. There are three questions: Does the drug work? Will it be approved? Will it sell more or less in the next couple of years? In between those few days when you find out the answers is perception. It can take a long time from the clinic to approval. We want to remind ourselves when we invest that we have limited information. Once you get to a binary event such as a Phase 3 clinical trial, you have to re-evaluate. You’ve made all this money on perception, and now they will turn over the card. Sometimes, you may not feel the probability of success is so high, but you believe the perception will be strong. So you may want to be long the stock, but out [before] the actual results.

Let’s have some picks.

There is a level of skepticism about Versartis that is unfounded. It has a long-acting growth hormone that you inject every two weeks. A big part of the market is kids who take the daily injections to improve their height. In the original study, there was a question about whether this was less effective than the daily. When Adam analyzed it, it looked roughly equivalent. Versartis has increased the dosage for the Phase 3 trial that finishes this fall. There’s every reason to think that will solidify the performance of the drug. The pediatric market is close to $2 billion worldwide. If Versartis’ long-acting hormone is the first approved for pediatric use, you can see them getting 30% to 50% of sales. Their plan is to price at parity with daily injections. The company has a market cap of $550 million. If they get to 50%, they could get close to $1 billion worldwide. Put a multiple of six times, which is about average for a product like this, and obviously that would make it a $6 billion market cap. Then there is the adult market, for improving lean body mass, which is approximately $1 billion now, and off-label users for anti-aging purposes, which of course the companies don’t encourage. There will still be doubters, but I’m giving you an example about how you might extrapolate. This company basically has one drug. The daily growth-hormone market is very competitive. Most of the companies who make and sell it don’t have anything long-acting in their pipeline. It’s more than likely a big company will want to sell this drug, say Teva Pharmaceuticals, NovoNordisk, Pfizer, or Roche.

You’re one of the biggest holders of Sarepta Therapeutics [SRPT], whose drug for Duchenne muscular dystrophy the Food and Drug Administration recently approved. Insurers are reluctant to cover it.

It’s good value. We were able to add to it at $10 a share last year. It is around $28 now. They aren’t through the insurance process yet. Sometimes, with an expensive drug like this, you can’t just apply once; you have to come back and appeal a decision. Sarepta is making slow, steady progress at getting insurers on board. It’s all anecdotal, but we see reports, some official ones from payers and some social-media reports from patients who got approved for [Sarepta’s] Exondys 51 [also known as eteplirsen]. Over time, we believe most insurers will reimburse members for this drug if they are eligible, with Duchenne’s muscular dystrophy that is amenable to Exondys 51. There is still some question of whether the drug works, which will be settled in a confirmatory trial. This is an example of perception and reality. That happens in the period after approval, and you need to completely shift gears. How will it sell? Nobody knows. We think eteplirsen will have worldwide sales of $500 million to $800 million, and maybe $400 million in the U.S. The company’s market value is $1.5 billion.

What’s the thesis for Global Blood Therapeutics?

It has a drug for sickle cell anemia, which affects about 100,000 patients in the U.S. There’s always a large market when you talk about an orphan drug, because the drug could be priced at $50,000 to $100,000 per year. At the peak, we think the market would be $3.5 billion.

Sickle cells stick in the capillaries and cause all kinds of problems. That doesn’t happen unless the hemoglobin in the red blood cells releases all four of the molecules of oxygen it can carry. This drug makes the oxygen bind more tightly, resulting in reduced sickle cells. In the past, such drugs were toxic. This drug appears to be very safe. The bears believe it will starve the tissues of oxygen, but the data so far show that patients on Global’s drug have erythropoietin levels that are flat to down from the baseline on average. Usually, the body’s response to lack of oxygen is to increase erythropoietin. The Phase 3 trial has already started. There is a second indication for idiopathic pulmonary fibrosis, in which you are trying to get more oxygen to the tissues.

Global Blood’s market cap is $860 million. We’ve compared it to Vertex Pharmaceuticals [VRTX], which has two approved drugs for cystic fibrosis and is a $22 billion company. You can say realistically that one day this will be a $3 billion drug. And you could ultimately have a $10 billion market cap. Last year, the stock was down 55%, even though the drug generated positive data and got closer to Phase 3.

Are you finding any opportunities in big-cap biotechs?

The group is reasonably valued. The one with the most upside, potentially, is Biogen [BIIB]. It may be the last man standing in Alzheimer’s. Its drug is more potent thanEli Lilly ’s [LLY] in the removal of brain plaques that cause Alzheimer’s, although nobody’s quite sure whether it will work. There’s a lot of risk and potential reward. Celgene [CELG] keeps chugging along. It has a broad pipeline for cancer and autoimmune diseases; it’s in cellular therapy, gene therapy. It has a higher multiple but very stable earnings growth. Gilead Sciences[GILD] is very cheap. If the company can acquire something or give people confidence, there is longer-term value after their cure for hepatitis C. We’ve owned all of them from time to time, but not at the moment. Right now, we’re seeing many opportunities in smaller names, and there are many ways we can diversify the risk.

Any opportunities remaining on the short side?

They are a little harder to find because the stocks have been depressed. We’ve been 70% net long for quite a while now. One area that has been disappointing is cancer vaccines—using antigens to treat cancer by stimulating the immune system. They just aren’t powerful enough. One cancer vaccine was approved—Dendreon’s. That turned out to be a commercial failure. Interestingly, using the immune system to fight cancer is enjoying a renaissance. One company had a seemingly promising drug that stimulated the immune system to attack cancer. But the thing about cancer is that you can be 99% effective, but if there are remaining cells, you still have cancer. I won’t name the company. Some attempts at cancer vaccines that failed last year came from Celldex Therapeutics [CLDX], Aduro BioTech [ADRO], and NewLink Genetics [NLNK].

Thanks, Joe.