“It is the highest form of self-respect to admit our errors and mistakes and make amends for them. To make a mistake is only an error in judgment, but to adhere to it when it is discovered shows infirmity of character.”
- Dale Turner
Over the course of my investing career I’ve made some terrible investments. I’ve written about them before. In one I talk about the general concept of looking like an idiot (“The Fine Art of looking Stupid” here), in another I talked about education through ignorance (“Learning from My Mistakes” here), and I’ve even discussed a specific case of ineptitude (“Anatomy of a Failed Investment” here). In this article, I thought I’d address an investment failure (so far) from the perspective that several readers have asked about – when do you know enough to stop being uncertain? Or put in a different way - how do you know you’ve reduced risk to a reasonable level?
Biosyent: An Investment Gone Awry
In October 2017, Nintai purchased shares in Biosyent (OTC: BIOYF or TSXV: RX), a specialty pharmaceutical company based in Mississauga, Canada. The company through its subsidiaries sources, acquires or in-licenses pharmaceutical products and markets them. In May 2018, I compared the company’s business model against that of then Valeant (now Bausch Health Companies: BHC) in an article entitled “Opposites Don’t Attract” (it can be found here). In the article I pointed out that Biosyent’s model was the opposite of Valeant’s – the company had no debt, it generated high return on equity, assets, and capital, and high free cash flow margins. Most importantly, while it in-licenses new products (similar to Valeant) its business model did not require increasing prices by 6,000% to survive. My overall thesis as stated in the article was Biosyent could take a great deal of pressure in a business downturn and still work out as an investment, whereas Valeant had little margin of error.
With all that research and industry expertise, you might ask how the companies have done over the past year? Well, talk about being hoisted on your own petard! BIOYF is down 38% versus BHC’s -10% return. BIOYF’s free cash flow is down -31% versus BHC’s drop of 1.5%. BIOYF’s revenue is down 15.8% versus BHC’s increase of 3.1%. Not a pretty picture. In just about every measure, Bausch has outperformed Biosyent.
So what happened? How did I get my investment thesis so wrong? Before I get into that, let me quickly review how Nintai generally deals with such a debacle. First - and before anything else - I will generally pick out some classical music, pour a glass of whisky, and roll up my sleeves at my desk. This is no time for hasty action. I will pull out my previous investment case and valuation spread sheet and begin to pull it apart piece by piece and assumption by
assumption. I will also review everything we had broken out as both a risk and an uncertainty. What I’m most interested in is whether there as a risk (where we could ascertain a percent chance 0f happening) we either overlooked or underestimated, or was it an uncertainty (an event we could not apply a reasonable percent chance of happening) that did my estimates in. One thing I find most helpful is writing to our investment partners about the investment and giving an overview of the investment and what’s happened since our initial investment. This process is very helpful in removing the emotions from the investment. The following is a letter that was sent to all our investment partners late last week discussing our investment in Biosyent.
To Our Investment Partners:
Biosyent (BIOYF) released its Q2 and H1 2019 results today and they were as ugly as we expected. Q2 2019 net revenues were $5,156,476 which is 13% decrease versus Q2 2018. H1 2019 net revenues of $9,635,290 which is 7% decrease versus H1 2018. Q2 2019 Canadian pharmaceutical net revenues of $4,844,090 decreased by 4% versus Q2 2018. H1 2019 Canadian pharmaceutical net revenues of $9,114,230 increased by 4% versus H1 2018. This was a pleasant surprise. However, the international numbers simply couldn’t be worse. Q2 2019 International pharmaceutical net revenues were $0 (yes, that’s nil) as compared to $511,483 for Q2 2018. H1 2019 International pharmaceutical net revenues were $0 as compared to $1,077,324 for H1 2018. Ongoing import restrictions on FeraMAX® meant that no international shipments were made at all in H1 2019. Finally, it appears the decision to cancel regulatory submissions to Health Canada for two new cardiovascular products is final. The company took a one-time impairment loss on intangible assets of $424,941 with this decision.
With today’s losses our position currently stands at a roughly 31% loss on our initial investment. Over the coming week, we will be revisiting our investment case. We intend to speak with corporate management, strategic partners, customers, Health Canada officials, and industry thought leaders. On the positive side (if one can be found here), Biosyent has no short or long-term debt, still generates free cash flow, and is ready to launch a new product next year. We believe the value of our investment methodology is being proven in this case. A rock solid balance sheet, high returns on capital, and generous free cash flow as a percent of revenue gives us a significant leeway in terms of damage the company can withstand. It also dramatically reduces the chances of a permanent impairment of our invested capital.
That said, it’s not the drop in Biosyent’s price (in fact we like to see that in most cases) but the drop in our estimated intrinsic value that bothers us. A drop of 50% in our estimated value means we missed something significant in our due diligence. As Count Ciano said, “Success has many parents but failure is an orphan". At Nintai, failure is openly acknowledged and discussed. There will be no investing
Ospedale della Pietàins in our shop. We intend to go back and find out what went wrong and what we can learn from this. We will update you over the next 30 days and discuss these findings. Should you have any questions or comments before that, please do not hesitate to contact me at email@example.com or at 603.512.5358.
These types of letters aren’t the easiest to write. Opening up your books and revealing a flawed process is difficult on the investor’s ego. But I think over time, writing this type of update can get your mind thinking more clearly and helps you become a better investment manager.
Mistakes and Changing Perspectives
Quite a few readers have written asking about how we deal with risk and uncertainty when it comes to making an investment. At Nintai, we try to apply different mental models in decision making. This allows us to tease out different approaches when it comes to making a final choice. We recognize we will never be able to reduce risk to a perfect 0% level. Nor will we be able to reduce uncertainty to a “perfectly acceptable” level. For instance, when it comes to uncertainty in making a final choice, we found we share a similar dilemma to musicians. At what point during a studio recording do musicians say “That’s it. That’s the final take.” What is it about that take which causes the musician to feel they can’t improve the song any more. Why not two takes before? Or three takes into the future? I find that many readers are asking a similar type of question in their emails – at what point can Nintai say “That’s it. I don’t need any more research or run any more numbers. I’m ready to put in the purchase order”. I thought it might be interesting to try to answer that question using Biosyent as a case study. After taking a shot at answering it, I thought I would then use the case to see if there isn’t a way to improve the process.
Looking back to October 2017, I felt confident that I had the right amount of data and research to say “I don’t need any additional work here. I’m ready to invest in Biosyent”. In light of a roughly 30% loss-to-date, however, something clearly wasn’t right. But the question is whether this was a problem in not understanding the risk or was it simply a case of not taking into account the uncertainty of investing in biopharma.
Nintai’s Hierarchy of Risks
Whenever we think of investing, Nintai has a general hierarchy of risks (our apologies to Maslow) ranking from the very worst to those we place as least important. I’ve pointed out in previous articles how we see the difference between risk and uncertainty. For the sake of brevity, I will simply re-quote Nate Silver’s great description in his classic “The Signal and the Noise”.
"Risk, as first articulated by the economist Frank H. Knight in 1921, is something that you can put a price on. Say that you’ll win a poker hand unless your opponent draws to an inside straight: the chances of that happening are exactly 1 chance in 11. This is risk. It is not pleasant when you take a “bad beat” in poker, but at least you know the odds of it and can account for it ahead of time. In the long run, you’ll make a profit from your opponents making desperate draws with insufficient odds. Uncertainty, on the other hand, is risk that is hard to measure. You might have some vague awareness of the demons lurking out there. You might even be acutely concerned about them. But you have no real idea how many of them there are or when they might strike. Your back-of-the-envelope estimate might be off by a factor of 100 or by a factor of 1,000; there is no good way to know. This is uncertainty. Risk greases the wheels of a free-market economy; uncertainty grinds them to a halt.”
As we look to think about risk, we think there several macro-risks that are essential to take into account as an investment manager with fiduciary responsibility to our investment partners. They are listed in rank of significance.
Permanent Impairment of Capital
First, from the highest level of assessment, Nintai’s primary risk is the permanent impairment of our investors’ capital. We believe this mostly falls under risk, but there is certainly some uncertainty that comes into play. To make such an event possible, we have to assume the possibility of several catastrophic events. One could be a massive and widespread case of accounting fraud. With a long history of audited financials that meet both FASB and Canadian regulatory requirements, we believe this is a very low risk. Second, is the complete shutdown of operations due to severe regulatory violations and non-compliance. Again, the company has a long history of meeting FDA, Canadian Food Inspection Agency (CFIA), and Health Canada inspections and we see this type of risk as minimal at best. Last, the company is unable to identify, locate, or purchase new in-license candidates and revenue collapses. While we’ve seen a few instances of product approval failures (such as the two recent cardiovascular products), this in no way has led to a collapse in revenue. Decreases yes. Collapses no. We believe this event would be a blend of risk (e.g. warnings such as audits with material weaknesses) and uncertainties (insider activities hidden by accounting fraud). We still rank this extremely low in as a possible risk.
Significant Reduction in Estimated Intrinsic Value
As an investment manager there is only thing worse than having to slash your intrinsic value (see previous). It happens more often than I like, but it’s bound to happen when you invest in companies that are sometimes going through difficulties. In Biosyent’s case, we didn’t think this was the case at all, and boy did we get that one. If you take a look at the previous 5 year annual growth rates versus the trailing twelve months it’s not a pretty picture.
Revenue Growth 21.2% -2.4%
Operating Income Growth 20.8% -9.2%
EPS Growth 22.5% -15.8%
Free Cash Growth 24.1% -31.0%
Any time you invest in biopharma you run the risk of not getting product approvals from the appropriate regulatory body. In Biosyent’s case, Nintai obviously did a poor job in breaking out the pipeline and assigning risk to each product. An obvious learning is to build out a far more robust evaluation process for an investment’s pipeline and model that against the investment’s valuation.
Risk-Driven Investment Paralysis
One the dangers of building out an outstanding risk-based assessment tool is creating a process that leads to investment paralysis. We know of one case where a firm had built out such an impressive risk assessment process that it became nearly impossible to build a case putting the firm’s capital in play. In the time that it took Nintai to build out a 20 company portfolio, the firm had not chosen a single holding. It is critical to remember that any system that incorporates risk and uncertainty must – by its very nature – be part art and part science. There will always be a human component to value investing. Whether it be that panicky feeling when the markets drop 5% in one day, or the feeling of greed when a portfolio holding jumps 18%, human emotion will always be something to master and take advantage of in investing.
In March 2015, I wrote about the four interwoven factors that are essential to master if you look to be a successful value investor (“The Four Horsemen: Risk, Uncertainty, Price, and Value”, here). Every time an investor makes a decision to buy, sell, or hold they are creating an interplay between these four. What they tell the investor is partially driven by the inputs the investor uses, the questions the investor asks, and the value that is given to each individually. One thing is certain – working with them individually or together is as much art as it is science. As the reader can see, Nintai’s decision to invest in Biosyent - at the price we thought was a significant discount to fair value - was flawed at best. What we thought were clearly defined risks actually had underlying uncertainties. We have been saved from the worst possible consequences (so far) by building in a margin of safety that structurally makes it difficult to permanently impair value. Any process that can produce such results is worth revisiting on a regular basis.