Tom Jacobs

When a long shot is worth a shot

Biotech speculators crave newer, productless and profitless companies with exciting latestage, high-potential product candidates. But with information today so easy to come by, no candidate remains hidden for long. That’s why it’s both a mystery and a delight to find an unknown biotech speculation. Indeed, Northfield Laboratories (Northfield, IL, USA; Nasdaq:NFLD) has received scant attention. Despite its potential billion-dollar-a-year blood substitute in pivotal phase 3 trials in the United States, the company is valued at a paltry

The margin of safety

260 million. It’s a speculation for sure—everything depends on regulatory approval—but the possible payoff from Northfield’s success is so great that this is one of those rare times when a careful speculation may be worth the risk of loss.

When your stock takes a nosedive.

www.nature.com/naturebiotechnology • DECEMBER 2002 • VOLUME 20 • nature biotechnology If there is one precept about which most successful investors agree, it is to invest only when you have a margin of safety. We all want to be successful investors, and a margin of safety—whatever it means—sure sounds good in the third year of a bear market. The term originated for modern investors in Benjamin Graham’s classic, The Intelligent Investor. Graham wrote,“The margin of safety is always dependent on the price paid.” Meaning that buying the best company’s stock returns nothing if it is overvalued or priced beyond its capability to earn. It is always best to buy shares of good businesses at prices that allow room for future gains. The larger the upside potential, the greater the margin of safety between the current price and huge losses. Sounds good, but if only it were so easy! The trick—or test—is valuation, determining the current value relative to future prospects, and that is what makes the entire investing world go round. From the beginning investor’s first brush with the venerable P/E (or price-to-earnings ratio) to a finance guru’s advanced computer modeling, it’s all about valuation. In March (Nat. Biotechnol. 20, 219, 2002), I used one such measure— enterprise value to free cash flow measured against free cash flow growth—to make the point that by at least one yardstick, two superb companies, Amgen and Genentech, were at late-winter prices lousy stocks. But an investor can buy with a margin of safety without becoming a valuation expert, through buying shares periodically—socalled dollar-cost averaging. It’s a brilliant strategy that quite conveniently corresponds to how most people are able to invest. We don’t usually have pots of money all at once, but instead with small amounts we budget each paycheck or month. And, with low commission discount brokers available, or dividend reinvestment plans (DRIP) offered directly from companies who pay dividends, we can invest a little each month or quarter without commissions eating us up. How does this approach provide a margin of safety? Let’s take Amgen or Genentech, companies that consistently generate the most cash flow from operations of any biotech drug maker. If their futures appear bright, you may decide to buy and hold long enough that there valuations mattered less. Maybe, but not always. If you won’t need the money from your stocks for at least five years, and preferably for ten or more (see the July and August 2002 Fool’s Corners; Nat. Biotechnol. 20, 653, 771, 2002), and if you don’t mind a few years of little or no return, then dollar-cost averaging may offer you the desired margin of safety—a better shot that you are buying at the right prices—even for a stock that is richly priced today. To illustrate, Table 1 shows ten equal investments made at the same intervals, while the stock price varies but ends up in the same place. In this example, the company’s price doesn’t change. If you invested all your money at purchase #1, your return would be zero, and you could have earned more on a fixed-interest investment. But with dollarcost averaging, you average your purchase prices, buying more shares when the price declines and fewer when it rises. Your gain— current value (

A special biotech speculation.

1,278) minus amount invested (

My worst biotech investment.

1,000)—is

Paying over the odds

278, or 28%. Sure, you could have done better (or worse) by investing a lump sum at various points, but in that case you would be clairvoyant, not read-

Great company, bad stock

Tom Jacobs is cofounder of Complete Growth Investor, http://www.completegrowth.com/, a stock service for individual investors. Tom owned shares of QLT at time of writing. He welcomes your comments at tom@completegrowth.com/. You’ve done your homework, studied a company’s drugs in development and on the market, assessed the risks, checked its finances and arrived at an investment thesis. You estimate good potential returns and buy happily. But later, the stock drops significantly—perhaps 20%. Although you know you can’t catch the low or high on a stock, this shakes you up. But fear not! With this guide, you can take sound action without panic.

Diversify to multiply.

The classic biotech speculation is a small, development-stage company that possesses breakthrough biotech applied to a drug candidate aimed at a large market. With such a company, the bet is typically all or nothing. Yet what I offer you this month is a company that has, as every parent whose child wants to be a movie star/concert pianist/poet advises, something to fall back on. Oncology company YM BioSciences (YM; Mississauga, ON, Canada; AMEX:YMI) is not a potential one-hit wonder, but rather has several more tricks up its sleeve. It has not one breakthrough biotech product, but three: tesmilifene, which is being tested in breast cancer and prostate cancer; TheraCIM h-R3 (nimotuzumab), which is in trials for head and neck cancer and for glioma; and AeroLEF (aerosolized liposome-encapsulated fentanyl), which is being tested as a treatment for chronic pain, most commonly from cancer. In short, YM has one drug that clearly addresses large potential markets, and two others that are no slackers.

Bugs or drugs, tortoises or hares?

No one enjoys investing losses, but no investor picks only winners. Even Warren Buffett had his US Airways and Peter Lynch the fraudulent Belgian car exporter ACLN. To deny losers is to pretend you can avoid losing money in the stock market. You can’t. Every successful investor’s record is an average of winners and losers, and losses often teach more than profits. On this happy note, today I stand first in the confessional line, inviting all schadenfreude. My worst biotech investment, drug maker QLT (Vancouver, BC, Canada; Nasdaq:QLTI), appeared in this column in October 2004 (Nat. Biotechnol. 22, 1221). Its history illustrates four simple truths. First, every investment is a wager on the chance of potential events, which no matter how certain you are, may not occur. Second, neither you, nor alleged experts, nor professionals have any control over the course of events. Third, because of these two truths, you will have losses. And fourth, as a result, accepting the occasional but inevitable loss ensures a longer, happier and less stressful investing life.

Time to kick that drug habit.

A better valuation Valuation is most often cited as a company’s market value or market capitalization, market cap for short. Market cap is simply stock price times shares outstanding. It assumes that if you had to buy the company, you would pay at least this price. But this is not right. Given the choice between two companies with market caps of