Resources

Monday, October 29, 2018

Monday, April 2, 2018

The Choreographed Trade War


The list is out.  So China will put tariffs on American fruit, wine, and pork.

Clearly, China is showing some real restraint here. If they really wanted to go after agriculture (a major American export), they would have went after corn and soybeans. Instead we have:
  • Fruit and wine. These are major California produces. California is clearly on Trump’s shit list, so China is almost doing Trump a favor.
  • As for pork, a Chinese company WH Group owns America’s largest exporter in Smithfield. So this is China offering to tax themselves.

It's starting to look like Trump and Xi had some sort of handshake deal, because this is looking very much choreographed. Talk tough, slap some non-punitive tariff on each other, then take some victory laps with political constituents.

Ironically, Emporer Xi’s total grip on power allows him more flexibility to extend concessions in the face of US demands. “Xi for life” is bad for democracy, but so far good for U.S. commercial interest.

If Trump is smart, he will take this olive branch from China, claim victory and call it a day.

The best case for markets is if Trump keeps his strategy of speaking loudly and carrying a small stick. The economy would hum along with little damage.  Meanwhile, the Fed can use this trade war thing as an excuse to get dovish and delay rate hikes.


Sunday, April 1, 2018

Notes from 1Q18


I was 100% allocated to stocks coming into 2018, had an ecstatic January, then a crappy February that led me to cut exposure. I continued to cut exposure in March and now sitting on more than 30% cash.

The low volatility regime has decisively ended, which means all sorts of previously overvalued stocks can come down on the slightest negative news. Fundamental based investors need to watch out for value traps! 

Often these negative news are laughable and are just an excuses to sell stocks. The problem is “value investors” have a tendency to confusing these negative news as the actual cause of stock drop, find reasons to say it doesn’t matter (which it doesn’t), then proceed to buy. But often the negative news is just a catalyst for a hibernating bear case to resurface, and NOT the real reason, so these investors are led completely off track.

The Facebook/Cambridge Analytica scandal is one such example. Bulls are attacking a non-existent bear case that people will somehow stop using Facebook. This line of reasoning dominates the market today, and will likely prop up the stock for now. But I do not think that is the reason for the price drop! There are other legit, but dormant bear cases that runs much deeper.  But I will save this for another time..


Some notes on a few stocks I’ve been involved in recently:

Digital Realty Trust (DLR) – bought at around $105/share
Very simple thesis: 1) Positive industry trends, 2) valuation/dividend coverage/leverage all check out fine, and 3) timely technicals

  • Positive industry trends. 1) Datacenters have plenty of runway from ever-expanding cloud adoption. 2) The race toward over-the-top video means companies will want their content physically closer to consumer locations, so the Google, Facebook, and Netflix of the world will need the physical proximities that DLR can offer. 3) Edge computing is the future (required by internet of things, autonomous cars, 5G…etc), and again that raises the value of physical proximity to end consumers
  • Numbers check out fine. About $18.5bn of market cap versus ~$1bn of cash flows from operations. That CFFO is growing rapidly. $1bn of CFFO easily covers ~700mm of dividends. Debt to EBITDA is high at > 6x , but comparing debt to value of investment properties shows a manageable ~50% loan to value ratio.
  • Timely technicals. 10 year U.S. treasury yields got close to 3% resistance and backing off. DLR stock seem to bounce of $100 support level.


Arena Pharmaceuticals (ARNA) – bought around $41.5/share
I bought ARNA right after their March 21st secondary offering. ARNA has market cap of about $2bn, but it has two phase 3 assets that are potentially best in class, targeting multi-billion dollar markets. You really don’t need to be that smart to see this is good risk and reward here.

The 2 drugs are different mechanism targeting different indications. So success probabilities are uncorrelated. Etrasimod is an S1P modulator that is targeting ulcerative colitis, a $4-5bn market. Ralinepag is an IP receptor agonist going for the pulmonary arterial hypertension (PAH) indication, a $10bn market.

Phase 3 trials have about 50% chance of success, so that means only about 25% chance of failing both. I think the distribution of outcomes are follows:

  • 50% chance they have 1 indication with peak sales 1-1.5bn; at 3x revenue, this thing is worth 3-4.5bn enterprise value; stock doubles 
  • 25% chance that both Etrasimod & Ralinepag scores, then peak sales would be like $2-3bn. Again at 3x EV/revenue this thing is worth 6-9bn. Stock triples or more.
  • 25% chance that both fail, so stock trades down to cash value, or down something like 80-90%.. But realistically they still have other early stage pipelines and that’s worth something. 
There’s actually more upside than this. First, another asset, APD-371, has its phase 2 readout coming in 2Q18. If successful we have not two, but THREE phase 3 assets. 

Second, Etrasimod’s real value is that it’s an S1P modulator, which has applications beyond ulcerative colitis. Novartis’ Gilenya and Celgene’s ozanimod are both S1Ps and can be used to treat rheumatoid arthritis, a much bigger market. 

The risk is time to market (will take at least a couple years) and cash burn before we get there. But ARNA just raised a ton of cash so we're somewhat de-risked.


A big loss in Melinta (MLNT), and lessons

I’m taking a big loss here. It was never a big position, but a 55% loss on a ~2% position still hurts.

I bought at about $17.2/share. Originally, my thesis was that at that price, MLNT has ~$500-550mm market cap. They have 4 FDA approved drugs hitting the market, and I estimated $250mm peak sales. So this is a great bargain given established pharma regularly trade at 4-5x EV/revenue.

So what went wrong? 1) too slow to adjust fundamental outlook, 2) failure to see that future fund raises are a form of leverage.

First, I was too slow to adjust my fundamental outlook. I watched happily as MLNT stock collapsed. Small cap biotech/pharma is notoriously volatile, so there’s nothing out of the ordinary. The company has a big pile of cash, so net debt is low, and I’m not worried. “This is the sort of stuff I can double down on!” Management talked about $1bn peak sales, so my $250mm peak sales is quite conservative. I cheered as the stock went down so I can buy more at lower prices.

It’s pure negligence. If I never believed management’s $1bn peak sales numbers, why should I think my much lower estimate is conservative? That's straight up anchoring bias. Only after the latest earning call did I revise my estimates. I dug deeper into competitor revenues and downgraded my estimate of peak sales to $200mm, then $150mm. Now I’m not even so sure about that.

Second, I failed to realize that future fund raises are a form of leverage. I falsely thought of MLNT as a low net debt kind of company, the sort I can double down on. The truth is that MLNT is burning cash, meaning at some point they will need to raise equity or debt. This means MLNT is way more leveraged, and stock valuation is way more sensitive to peak sales than I realized. I underestimated modeling error, and that led to overconfidence and negligence.