The great medieval scholar Nevill Coghill was once walking along the grounds of Magdalene College when he ran into a very pleased C.S. Lewis. When Coghill stopped him and asked him why he was so happy, Lewis replied, “I believe I have proved the Renaissance never happened in England”. Coghil–l -  looking rather stunned - didn't have time to say anything before Lewis concluded by saying, “Alternatively, even if it did it had no importance”. 
 
The recent news surrounding Valeant (VRX) and Turing Pharmaceuticals have many investors wondering - much like Professor Coghill - whether the biopharma is in the midst of a great crisis or alternatively all of this noise is of “no importance”.
 
It would certainly seem the past several months have seen a distinct deflation in one segment of the BioPharma market. The performance of the SPDR S&P Biotech ETF (XBI) has provides an overview of the wreckage in the biotech sector in the past year – down 60% in the last year. Its top five holdings have demonstrated the volatility of the space. 
 
Five Prime:                          +128%
Orexigen:                            -54%
Juno Therapeutics:              +52%
Dyax:                                  +165%
Infinity Pharmaceuticals:     -46%
 
But we should remember all this Stürm and Drang has been relatively isolated in the Biotech space. Is the shoe going to drop on the larger integrated BioPharmas of  the world? Before investors make investment decisions in the space, they should take some issues into consideration.
 
PE BioPharma and Integrated BioPharma
 
Perhaps the largest factor in investing in the BioPharma space is making the distinction between what I refer to as PE BioPharma and Integrated BioPharma. PE BioPharma are smaller private equity backed firms that operate on the idea of either developing a single molecule/compound or are publicly traded companies that adopt the “asset light” model made popular by Fred Hassan and/or Valeant. These companies (particularly the latter) have a tendency to veer far from the traditional business model. They generally shed employees, infrastructure such as overseas facilities, and research and development. They see themselves more as IP and distribution companies. Integrated BioPharma can include what we used to refer to as both biotechnology and the larger pharmaceuticals. These are companies that use the more traditional sales/promotional models and spend significant dollars on research and development (usually through a strategic agreement with the larger CROs). I’m aware this paints the industry with a very wide brush, but I think for investors it’s one of the first real investment decisions that need to be made.
 
Industry Characteristics
 
In addition, there are some salient facts about the BioPharma space that investors should always bear in mind as they think about long-term growth, profitability, and calculating value versus price.
 
Drug Costs As Percent of Total Healthcare: Roughly 10% of all healthcare costs are outpatient drug related[1].  This number is expected to rise modestly as new specialty products come online and drive aggregate drug prices higher. As newer drug therapy classes such as TKI’s in leukemia are launched, the median costs will be driving these numbers upwards.
 
Generic versus Branded Drugs: Branded products have extended patent protected lives ranging from 15-20 years. As those drugs come off patent, it has been the nature of the industry that generic drug companies jump in to manufacture these products and offer them at vastly lower prices. Roughly 80% of all prescriptions written in the US are for generic drugs. Generic drugs are roughly 80-85% cheaper than branded drugs[2]. Some of the newer specialty drug classes are simply not going to able to be manufactured at that traditional discount.  
 
This Isn’t a Free Market:  Currently Medicare pays for roughly 30% of all prescription drugs but has no ability to negotiate prices on those drugs. With Republicans holding the US House and Senate, it is extremely unlikely we are going to see any difference in this policy. This obviously has a huge impact on how drugs are priced across the board.
 
Blockbuster versus Specialty Products:  This inability to negotiate is only going to get worse with the focus on specialty drugs in oncology, immunotherapies, and orphan drugs. It is expected that specialty drugs will grow from 25% in 2000 to nearly 70% in 2020. Twenty years blockbuster medicines in cardio care were expected to treat tens of millions of patients at $3/pill. New specialty products might treat an orphan disease such as CML with only 3,000 new patients a year but cost roughly $125,000 annually.
 
Price Increases are a Core Business Model….for Everyone: For all the talk of the PE BioPharma rebranding generic drugs through the Orphan Drug Act and raising prices at an exhorbitant rate, raising prices is a core part of all of BioPharma’s business models. Growth in large biopharma has come almost exclusively from price increases. Amazingly, 80% of the earnings growth last year came from price increases in branded products[3]. While not at the rate of a company like Turing, these increases need to be borne by some payer.
 
So What Does This All Mean?
 
So what does all this mean for the general biopharma market? Is this an area where investors can expect to find value relative to price over the next 5 – 10 years? At Nintai, we think investors should look very carefully at the business model first (PE versus Integrated), product mix (branded versus generic), and growth stories (growth through acquisition/price versus drug development).
 
One thing is certain. There will be winners and losers in the space over the next ten years. It’s simply not possible for both government run healthcare (CMS) and the privately insured to absorb rapidly increasing drug costs like we’ve seen in some parts of the industry. We believe companies that identify with the PE BioPharma model are most at risk if they solely base their model on acquisitions and price increases. We believe this for two reasons. First, the cost of capital is going to rise at some point. Companies with growth models predicated on obtaining cheap debt to grow earnings are simply going to hit a wall at some point. Second, at some point we believe there will be limited government action on pricing. If nothing else, Congressional efforts will create a wall of worry that will make valuation a very tricky proposition.
 
Does that mean the larger BioPharma will win out in the long term? We can’t say that for sure but we do think investors should keep several things in mind. First, somebody has to do drug discovery and development. At some point, there simply won’t be enough products to rebrand and grow simply on price. Second, many of these companies are in far better financial conditions than some of the PE BioPharma. One look at Valeant’s (VRX) balance sheet versus Novo Nordisk (NVO a company we have a long position in) tells a vastly different story.
 
Conclusions
 
We think there will be clear winners versus losers in the BioPharma space over the next 5 – 10 years. Investors who spend the time asking the appropriate questions and delving into the company’s business model and operations will be best situated to making an accurate assessment of value versus price. In the final analysis, it’s a space that requires an enormous circle of competence. Investors need knowledge in a vast amount of variables ranging from national drug pricing policy to clinical development models. We are certain about one thing – we think events over the past 6 months are unlike C.S. Lewis’ thoughts on the Renaissance – they happened and they will be of great importance for the future of the industry.


[1] http://www.drugchannels.net/2015/08/new-cms-forecast-drug-spending-grows.html

[2]http://www.fda.gov/drugs/resourcesforyou/consumers/buyingusingmedicinesafely/understandinggenericdrugs/ucm167991.htm

[3] http://www.wsj.com/articles/for-prescription-drug-makers-price-increases-drive-revenue-1444096750
 

"I have made it a rule," said he, "whenever in my power, to avoid becoming the draughtsman of papers to be reviewed by a public body. I took my lesson from an incident which I will relate to you. When I was a journeyman printer, one of my companions, an apprentice hatter, having served out his time, was about to open shop for himself. His first concern was to have a handsome sign-board, with a proper inscription. He composed it in these words, 'John Thompson, Hatter, makes and sells hats for ready money,' with a figure of a hat subjoined; but he thought he would submit it to his friends for their amendments. 
The first he showed it to thought the word 'Hatter' tautologous, because followed by the words 'makes hats,' which show he was a hatter. It was struck out. The next observed that the word 'makes' might as well be omitted, because his customers would not care who made the hats. If good and to their mind, they would buy, by whomsoever made. He struck it out. A third said he thought the words 'for ready money' were useless as it was not the custom of the place to sell on credit. Every one who purchased expected to pay. They were parted with, and the inscription now stood, 'John Thompson sells hats.' 'Sells hats,' says his next friend! Why nobody will expect you to give them away, what then is the use of that word? It was stricken out, and 'hats' followed it, the rather as there was one painted on the board. So the inscription was reduced ultimately to 'John Thompson' with the figure of a hat subjoined."

                       - Benjamin Franklin to Thomas Jefferson on editing the Declaration of Independence
“When Wall Streeters tout EBITDA as a valuation guide, button your wallet.”
                          - Warren Buffett (Trades, Portfolio)
Many enthusiasts of Occam’s Razor [1] would tell you the simplest solution is most frequently the best solution. Franklin’s milliner was a victim of such thinking in his new business. At the Nintai Charitable Trust, we sometimes think solutions can be found simpler and more plausible after cutting through seemingly insignificant data or arguments. However, we’ve found there have been instances in the financial markets where Sir Occam’s approach – where less is more – is probably not the best approach and serves our investors poorly. An example of this is the use of EBITDA in calculating a corporation’s value and as a tool to assess an investment opportunity.
EBITDA: A (mercifully) brief history
The history of using EBITDA really caught the public attention during the wave of leveraged buyouts and M&A wave in the period from the mid-1980s to the height of the technology bubble in the late-1990s. EBIDTA stands for Earnings Before Interest, Depreciation, and Amortization. The final “duh” (DA) of EBITDA are the platypi of corporate finance. Both depreciation and amortization are non-cash expenses, meaning no cash is exchanged. They are also expenses based solely on subjective estimates by managers and auditors. On the auditing continuum they can be judged by experience, industry standards all the way to other end of the spectrum to what we rank amateurs might call “fraudulent intent.” Since the 1980s, the use of EBITDA has become far more widespread with talking heads on CNBC announcing such-and-such a company is trading 12 times EBITDA. But what exactly does that tell us about the company’s value? Is it a tool value investors should have in their quiver?
EBITDA: Financial alchemy in the modern world
EBITDA has become such a normalized measure in today’s financial world, even companies without high asset and high capital needs are utilizing it on a regular basis for their earnings releases. A prime example of this has been Groupon (NASDAQ:GRPN) – the company that “drives more business though price and discovery.” In 2013 and 2014, the company showed losses of $95 million and $73 million by GAAP standards (see below). By announcing their numbers as EBITDA, the company miraculously turned these years into highly profitable periods earning $165 million and $130 million. We think the usage of EBITDA in these cases is particularly eggregious.[2] Beyond giving the company an entirely false financial façade, it calls in to question the judgment of both the company’s executives and board of directors.

Why this matters
For the Nintai Charitable Trust, EBITDA matters for several reasons. First, we enjoy valuing and investing in companies using a certain percentage of what we refer to as reality. For example, interest matters. Anybody who has seen what leverage can do (and debt is by its very definition leverage) knows that interest is a very real expense. Just ask any investor who saw their investments implode when what looked like free borrowing suddenly was cut off and their company was left in a situation not unlike a large bloated fish 50 feet from the water on an ebbing tide.
Equally important, EBIDTA can tell you a great deal about corporate management. Do these individuals really believe depreciation and interest can be taken “off-budget” as they say in Washington? Does a technology company really believe EBITDA is the best financial representation of their company? I would argue that anybody in the investment world – with the exception of the late Bruce “Bid ‘Em Up” Wasserstein – should and would look closely at any company making its business case with EBIDTA numbers.
Finally, I would argue that EBITDA has zero role in the calculation of value. We think Cody Boyte summed it up well when he said, “EBITDA does not take into account any capital expenditures, working capital requirements, current debt payments, taxes, or other fixed costs which analysts and buyers should not ignore. The cash needed to finance these obligations is a reality if the business wishes to grow, defend its position, and maintain its operating profitability (my emphasis)”. Perhaps Charlie Munger (Trades, Portfolio) put it most succinctly and pungently when he said, “I think that, every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.”
Conclusions
As value investors, we are dependent upon the accurate and timely reporting of financial returns by corporate management. A considerable aspect of this is reporting financial data that is consistent with GAAP standards and gives both investors and the markets a reasonable reflection of a corporation’s financial status. EBIDTA has become a Wall Street proxy for cash flow or as a replacement for GAAP earnings. In doing this, both management and analysts are doing a grave disservice to investors. Much as Franklin’s milliner, investors should be equally disgruntled and leery by management that disposes of numbers in a similar fashion from their financials.
The Nintai Charitable Trust has no positions (long or short) in the companies discussed in this article. 

[1] Occam's razor (Latin: Lex Parsimoniae or 'law of parsimony') is a problem-solving principle devised by William of Ockham (c. 1287–1347), who was an English Franciscan friar and scholastic philosopher and theologian. The thesis posits that among competing hypotheses, the one with the fewest assumptions should be selected.
[2] As was GroupOn claiming marketing was a capital expense thus increasing their EBIDTA returns. This is an example of why Warren Buffett (Trades, Portfolio) said, “References to EBITDA make us shudder”. Other examples include Waste Management’s (NYSE:WM) indestructible garbage trucks and WorldCom’s capitalization of nearly everything that wasn’t bolted down (and more).
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“Marriage is the triumph of imagination over intelligence. Second marriage is the triumph of hope over experience.”
                                                       - Samuel Johnson

In my career in the investment field, Ben Graham sits isolated at the top of the mountain in terms of impact on my thinking and models. That said, a near second has been Jack Bogle, founder of Vanguard. Perhaps no other person in our lifetime has set the standard for ethics, created value through cost savings and brought so much education to the investor class (maybe Warren Buffett(Trades, Portfolio) but I would propose his actual investor reach has been smaller).

One of Bogle’s top issues is management fees and what he so eloquently refers to as the “tyranny of compounding costs.” Much like Johnson’s eponymous widower, Bogle has been tenacious in his view that investing in any situation with high fees is the triumph of hope over experience.
As an investment adviser, inevitably one of the questions you will be asked is how much you charge for fees. In addition, I’ve had many people ask us how we came up with the number we used at Nintai Partners (which was 0.75% of assets under management). We think this is a topic that doesn't get nearly enough attention. But rather than discuss rates per se, I wanted to use the space in this article to discuss the equity risk premium (ERP) in the context of management fees.
At the Nintai Charitable Trust we see the relationship between the risk premium and management fees as a vital measure in potential returns, management alignment with investors and a component of portfolio risk management.

The equity risk premium
The equity risk premium is simply the extra return required by investors as compensation for owning equities in the place of U.S. Treasuries. Many individuals use both historic (as calculated by the difference between the two over a defined period) and future (estimates of future returns for both classes) measures. Since 1802, the ERP has averaged roughly 3.5%. It has ranged from 0% to 5% in roughly half of all rolling 10-year averages. It has only consistently exceeded the high end during the periods ending between 1947 and 1970[1].

John Graham and Campbell Harvey of Duke’s Fuqua Business School issue a fantastic report on research conducted each quarter on the estimated equity risk premium. In their latest 2015 report[2] the estimated risk premium was 4.5%. Put another way, investors are currently demanding a 4.5% return over the current U.S. Treasury rate.

At the Nintai Charitable Trust we think (perhaps too much) about risk on a daily basis. If the ERP is currently 4.5% we look for any advantage we might have in reducing risk – not increasing it. And let's face it: the higher the amount you pay in fees the more these eat into the risk premium. Which brings us back to management fees, their calculation and their impact on risk for your portfolio.

Fees and investment returns
If an investor demands a 4.5% risk premium to invest in equities, it stands to reason the individual will look to increase the return in any way possible. This includes items that have a negative effect on returns – management fees, trading costs, etc.

Don’t think this makes a difference? Let’s take three funds to show management fees and their impact on the ERP. The first is the Vanguard 500 Index Investor shares. This fund has a total management fee of 0.17% and estimated trading costs of 0.05% for a total rate of 0.22%. The second is the Sequoia Fund with a management fee of 1.0% and estimated trading costs of 0.75% for a total rate of 1.75%. The last is the Gotham Absolute Return Fund with a management fee of 2.15% and estimated trading costs of 2% for a total rate of 4.15%.
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Looking at the data as provided by Graham and Harvey, we can compare management fees and estimated trading costs as a percentage of the equity risk premium for the years 2011 through 2015. For the Vanguard 500 Index costs made up approximately 4% to 5% of each year's ERP. A typical actively managed fund represented by the Sequoia Fund consumed roughly half of each year’s ERP. Finally, the Gotham Absolute Return Fund (a new fund we projected backwards for the years 2011 through 2014), costs would consume an astounding 100% or more of the risk premium.

Conclusions
When investment managers charge higher management fees and create high trading costs, they chew up the risk premium required by investors. Higher costs increase risk. It’s that simple. At Nintai Partners we charged 0.75% for several reasons. First, we didn't have back-end operations we needed to support. Second, we traded so rarely our costs on this front were minimal. Third, we firmly believed the proposed rate was adequate compensation for the value we added to our investors. Last, we saw anything higher as a shifting of risk to our investment partners.
Investors should be rewarded for taking risks. When those rewards are disproportionately shared with investment managers, the investor disproportionately takes on risk - and far too little reward. Much like Johnson’s widower, hope triumphs over experience. An experience that history has taught him – and investors – that the outcome is not likely to be to their advantage.

[1] The numbers here are provided by Jack Bogle in his classic “Common Sense on Mutual Funds,” revised edition, 2010, pp. 92-107.
[2] “The Equity Risk Premium in 2015,” John R. Graham and Campbell R. Harvey, Fuqua School of Business, Duke University, National Bureau of Economic Research (NBER); Duke Innovation & Entrepreneurship Initiative, Oct. 1, 2015
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