his return.”“And what did he get for it, Daddy? Not much.”“Yes. He ended up penniless and homeless. And one day when he returned to look at the Argo once more . . .”“The prow fell on his head and he died. Thank goodness we don’t have todo such hard things today. When you do want to do something heroic you getrewarded, not killed.”“On the contrary. There is one thing even harder than Jason’s quest for theGolden Fleece. That is for a biotech company to get a product approved by thegovernment. It is very sad, because biologists know more now about the effectiveness of molecules and their side effects than they ever did before. Theyspend a good $50 billion a year researching new ones, and they have filedpatent applications for 30,000 of them. If they win a patent, then they have toshow that the inventors are qualified, search the literature, and do some preliminary studies. About 1,500 to 2,000 of these new drugs make it through thatprocess each year, and then they are ready to be tested on humans. At thatstage, they are called I-N-Ds, Investigative New Drugs.”“Sounds pretty hard, sort of what Jason had to do to get to Colchis,” Kirasaid.“Good point. That’s when the Phase 1, Phase 2, and Phase 3 studies thatyou’re always hearing about start.”“How much does it cost?”“Well, Tufts, in Boston, where your dentist went to school, has a centerfor studying this. Their current estimate is that it takes 18 years and $800 million to get one drug approved by the FDA.”“Daddy, I have a question. If they come up with 2,000 new INDs a year totest, how many of them reach the final destination?”“Great question. Fewer than one in 100. About 15 or 20 each year. Notvery good odds.”“And when they do get approved, is the Golden Fleece very valuable?”“Oh, yes. They get 17 years without any competition from the same molecule, and the nice warm feeling that they don’t have to worry much about
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others going through the same journey they took, because they won’t have thetime or the money.”
I Know This Crazy Guy . . .Roger Longman: You wouldn’t believe it, but I know this guy. Rich traderin Connecticut. Went to Harvard, got a PhD in economics from University of Chicago. But he thinks the FDA should be abolished.Drug company big: You’re killin’ me.Longman: Yeah. He goes around saying that. He runs some kinda fringegroup. Meetings. Slogans. You know. Buzz words. “The FDA stiflesinnovation.” “Big Pharma is keeping out little companies.” “Eachyear the FDA’s failure to approve drugs costs 100,000 lives.” “TheFDA would never have allowed Windows to be approved if softwarewere under its jurisdiction.” Stuff like that.Drug company big: People like that, nobody pays attention. Everybodyknows the FDA is there to protect people from stuff that makes babies get born with flippers instead of arms.Longman: He talks to a bunch of business school kids over the Internet.Wrote a book on trading that has sort of a cult following.Drug company big: Well. Maybe he’ll convince Chile to fire its drugregulators. What do guys like that say when you bring up thalidomide babies?Longman: He came right back and said no way would the FDA approveaspirin today, since it causes deformities too. And then he said theFDA wouldn’t let anybody advertise that taking aspirin brings heartdisease down by 40 percent. I didn’t want to go there. Thing is, people like him exist. They’re out there, you know what I’m saying?
The Old Phase 2Despite irreconcilable differences on the subject of drug regulation, Rogerand Vic are good friends and have tremendous admiration for one another.Whenever the two of them meet, Vic takes his arm. “Roger, let’s do the amiable idiot routine,” he says, doing a bit of soft-shoe. “Have you had occasion tomention me in any of your talks with Big Pharma lately?”Roger falls into step. “Oh, it’s not that, Vic,” he always says. “It’s just thatyou need to realize that there’s no requirement for approvals to take 20 years.The drug companies and regulators do it to make sure the drugs are safe.”
304 Practical SpeculationIt is all too typical of those totally immersed in a milieu, be it an industry,a political culture, or a profession, to defend its norms. Roger is editor andmanaging partner of Windhover Information Inc., publisher of a respectedgroup of magazines that are must reading for drug industry venture capitalists. The “drug company big” in the preceding dialogue is an actual person, atop executive at a major pharmaceutical firm. We withhold his name in the interest of diplomacy.
The Trader’s Apprentice“Registered letter here, Vic.”“Not another garnishing from the Infernal ones regarding that $40 dispute on our 1970 returns.”Rob, my office manager, hands me the letter. “No. It’s from that Chineseguy you turned down for a job because you didn’t think he understood American markets well enough to help.”“What does he want, reimbursement for a first-class ticket?”“He says he read in those nineteenth-century investment books in your library that old-time speculators started out on Wall Street as apprentices. Theydid menial work for free and after they’d proved themselves, they’d be given achance to trade. He wants to do that for you. He sent his e-mail address.”I tap out the address on my computer monitor. “Let’s go,” I write, andpush the send button to Shi Zhang.Shi appears at the trading room door a few days later. He calls me “Sir.”The traders in my office, unaccustomed to such displays of deference, nickname him “Mr.”For Mr.’s first project, I ask him to classify five years of monthly prices forthe 150 companies in the Russell 2000 Health Care Index according to thelevel of insider trading in the preceding two months.Shi proved himself a worthy apprentice. His biotech study and manyother contributions appear throughout this book. Moreover, several weeksafter his arrival, after Shi had racked up a 46-trade win record with his first 48forays into the German bund market, my other traders formed a line, bowedin unison, and called him “Master,” over his outraged protests.
The Invisible VictimJim Lorie, one of the original directors of the Center for Research in SecuritiesPrices, talking to the Friends School at Chicago 35 years ago; Vic audited theclass before their first squash match together.
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“Kids, there is not one economist who has ever studied the FDA whohasn’t concluded that they’d do much better if they speeded up the approvalprocess. As George Stigler says, industry co-opts regulations to make surethey are designed and operated primarily for its benefit. By driving up the costof pharmaceutical research and delaying drug approvals, the FDA reduces thesupply of new, effective drugs.”“But what about safety, consumer protection, and imperfect information?” asks a student.“Yes, but at what price?” says Lorie. “You have to balance the costs againstthe benefits. Let’s look at this diagram of what happens if the FDA allows orrejects a drug, classified by whether it’s beneficial or harmful.He chalks Table 16.1 on a blackboard.“FDA officials know they’ll be punished for approving a harmful drug(Type I error), but not for failing to let a good one go on the market (Type IIerror),” Lorie says. “If a harmful drug is inadvertently allowed to go tomarket, the victims are identifiable and might appear on Oprah. But if abeneficial drug is rejected, the victims are faceless, nameless, and rarely acknowledged even in the abstract. Is it any wonder, then, that the FDA placestoo much emphasis on avoiding Type 1 errors and not enough on avoidingType 2 errors?“Although many lives are lost because of FDA delays and failure to approvegood drugs, from the agency’s standpoint it’s much worse to let a bad drug slipthrough. They always say that economists can never agree on anything. Butevery economist who has studied the FDA has concluded the same thing: TheFDA needs to approve drugs faster. The economists also agree as to the reasonsfor erroneous decision making at agencies like the FDA.“You have to balance disasters like thalidomide, which by the way wasnever approved in the United States, against things like aspirin and penicillinwhich could never make it by the FDA at all today under the current setup,”Lorie concludes. “The net result of all this misplaced emphasis on minimizing the Type 1 errors at the expense of the Type 2 errors is 50,000 extra deathsa year, according to the best estimates.”With just three minutes left before our game, Jim winds up his talk. “FromAdam Smith to Sam Peltzman—who first studied the lives lost by delays inTable 16.1
FDA reviewers . . .
FDA Decision Making
Allow the drug.Reject the drug.
Drug IsBeneficial
Drug IsHarmful
Correct decisionType 2 error
Type 1 errorCorrect decision
306 Practical Speculationapproval—to Milton Friedman, every economist who studies this has concluded that the cures for the market’s woes are often worse than the disease.Nowhere is this more harmful, nowhere is this more tragic, than in the case ofour current system for deciding which drugs get approved.”Things have not improved since Lorie’s talk. I found numerous examplesof deadly FDA delays:Septra: The FDA delayed approval of the antibacterial drug Septra for fiveyears, taking three years longer than European regulators. NobelPrize winner George Hitchings estimated that the five-year delay cost80,000 lives.Beta Blockers: Beta blockers regulate hypertension and heart problems.The FDA held up approval for eight years because it believed theycaused cancer. In the meantime, according to Dr. Louis Lasagna ofTufts University, 119,000 people died who might have been helpedby the medication.Clozaril: Clozaril is effective in treating 30 percent to 50 percent of schizophrenics who don’t respond to other medicines, according to The NewEngland Journal of Medicine. The effect was discovered in 1979, butClozaril was not approved in the United States until 1990. Companiesbelieved the FDA would reject it on the grounds that 1 percent of patients who take the drug develop a blood ailment. As a result, some250,000 patients suffered needlessly.Mevacor: A cholesterol-lowering drug that reduces heart disease deathsby about 55 percent, Mevacor was available in Europe in 1989. It wasnot approved in the United States until 1992. As many as 1,000 people died from heart disease because of the FDA’s delay.Havrix: The first vaccine to prevent hepatitis A, Havrix was available inEurope and 40 other countries three years before being approved inthe United States.Interleukin-2: European regulators approved Interleukin-2 in 1989 forthe treatment of kidney cancer. Three years later, it won approval forthat use in the United States. In the interim, 3,500 people died whomight have been saved.
The TrialAs I told my daughter, and as Lorie made plain, biotech companies’ quests forthe Golden Fleece are fraught with many dangers. Bringing a product to market
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demands a combination of research, manufacturing, scientists, doctors, consultants, and government affairs people. Forbes ASAP editor Michael S. Malonegave a firsthand report of a few crucial moments of one typical quest in a reportfor ABCNEWS.com:As it happens, two years ago for a magazine story, I followed a biotech companyas it ran the gauntlet of final FDA approval on a new heart drug. Now, in my career as a journalist, I’ve seen new product design teams sweat and fight and breaktheir health trying to get a new model to market. I’ve seen CEOs with bad quarterly numbers get ripped to pieces by packs of howling analysts. And I oncewatched a corporate chairman nearly collapse from a stroke while trying to drive amerger vote through an angry shareholders’ meeting.But nothing prepared me for the FDA Star Chamber. The company I waswatching had spent two years field testing their drug, then weeks preparing itsFDA presentation. Then the entire senior staff of the company moved to a hotelnear Bethesda, Maryland, set up a full communications center in a conferenceroom there, and spent four days running rehearsal after rehearsal, rewriting theentire presentation a half-dozen times.Meanwhile, back home, the company froze, knowing that its stock value andits future sales all depended upon what happened inside the FDA chambers at theNational Institute of Health.The hearing itself had all of the elements of a nightmare: the terrified presenters, the panel of doctors on stage, each with their own prejudices and agendas. Eight hours of misery, until the final vote. . . .The company gained approval by a single vote. General cheering and backslapping. The presenters went home to a gigantic company party—only to learn acouple days later that one of the approving doctors had changed his mind.The company stock collapsed, morale imploded, and the company reeledunder the shock for months. It is only now regaining its footing.2
Who would be foolish enough to buy stocks in a company subjected tothese perils? Amazingly, numerous investors are willing to share in the risks.These hardy souls may be likened to the Dutch entrepreneurs who bravedsimilar odds to finance a new company in America some 350 years ago. Certainly the incentive for buying such stocks is the spectacular profit that may berealized by those who pick the products that make biotech the likely choice forthe breakthrough industry of the twenty-first century.Even more surprising, however, is that executives in such ventures oftentake bullish positions by buying their own company’s stock. Presumably,these purchases are engendered by something more than pure optimism thatthe quest will end by capturing the prize. One such motivation must be information. Executives have to know by the time they spend 10 years of effort and$800 million of expense whether Big Pharma is likely to help them get
308 Practical Speculationthrough the final rocks. They have to know from their scientists and their doctors how the treatments are going. Their well-connected consultants mustgive them feedback as to how the winds are blowing with their current or former colleagues at the FDA.Human nature being what it is, the wheels of commerce have a way of lubricating the flow of information. There are meetings, studies, and letters. Consultants are hired, often those who will eventually opine on the product’seffectiveness. No matter how blind the double-blind study, somewhere along thepath a company may chance to come by some knowledge as to the likelihood ofsuccess, however tenuous the approval process.
Profit from AsymmetryGeorge Akerlof, Michael Spence, and Joseph Stiglitz won the Nobel Prize in2001 for writing about such situations. In their branch of the dismal science,known as the economics of information, they study how much informationpeople demand in determining what they will buy and sell. Among their areasof focus are situations of asymmetrical information, where the buyer andseller have different degrees of information.Akerlof used the example of the sale of a used car. The seller knowswhether it is good or bad, and consequently the price drops because the buyerfears buying a lemon. Similarly, Stiglitz observed that a person buying insurance knows how sick or how likely he is to avoid calamity much better thanthe company selling policies.Stiglitz, like most economists, is much more concerned about how imperfect and asymmetrical information can lead to violations of the competitivemodel that can only, according to his lights, be fixed by government action tocorrect the asymmetry. Indeed, after the September 11, 2001, attack on theWorld Trade Center, Stiglitz figured prominently in urging the governmentto expand its role in assuring security at airports. We will refrain here from adiscussion of the virtues of competition and innovation that would be stifledby such interference, except to note that we would gladly pay $15 a ticket extrato fly on a plane manned by armed guards should the government ever deignto let airlines compete by offering additional security.Now consider those biotech and pharmaceutical executives who, withfull knowledge of the difficulty of threading their product through the FDAneedle, are courageous enough to buy shares in their own company. Are theydoing so thinking that their product is likely to be rejected? We would hazardthey are not. Moreover, since a substantial part of their own wealth is tied up
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in the options and shares they already own, our guess is that they are not doingit to throw good money after bad. The information that is revealed by their insider purchases and sales contains, to us at least, as much of value as the advertisement that a car is for sale or an individual’s inquiry about buying insurance.That said, we would not use insider sales as a signal to short stocks. Wegenerally don’t believe in shorting individual stocks. It is too difficult for us toovercome that 15,000 percent-a-year arithmetic updraft against the shortsdocumented in Chapter 9. As far as we know or can predict, others sufferfrom this same failing.Trading on insider purchases has risks as well. Some executives might bedeceiving themselves as to their company’s true prospects. Worse still, theymight be buying shares to throw the public off the scent. An executive mightbuy a minimal number of shares as a setup for a huge sale, timing the transactions to take advantage of the lags in required reporting times. He might escapedisclosure altogether, as did CEO Chairman Kenneth Lay, by selling large,equal numbers of shares as part of a “long-term” plan. On balance, however, wehave found insider buying to be a profitable signal.
The Niederhoffer-Kenner-Zhang Drug TrialsInspired by the rather draconian requirements of the FDA, which involvedouble-blind studies by accredited investigators at designated centers, we decided to follow to as great an extent as possible their own standards of proof.However, because we did not have $800 million available to perform a complete double-blind study, nor did we find it appropriate to wait 18 years beforemaking a decision as to our financial health, we took certain shortcuts forwhich we beg the indulgence of all parties.It is common for companies submitting protocols to the FDA to compliment the regulators on their acumen and fairness (need we inquire as to whythis grotesque servility seems to be so prevalent?), and we would similarly compliment the regulatory agency for the high test standards thatthey have set for the companies under their jurisdiction, including therequirements that the drugs be administered in double-blind studieson patients with no other condition besides the ones being tested, and who areavailable to take the full course of treatments at locations approved and monitored by FDA consultants.Although we are firmly convinced that these stringent requirements andothers that we have doubtless left out have added immeasurably to the loss ofhuman life by requiring pseudoscientific results that have no relation to the
310 Practical Speculationway patients actually take medicines in the real world, we have tried to followthe spirit of the FDA’s requirements in our own work to as great an extent asfeasible with our own financial results and proper reporting of those results toour readers.To test our theory that a dose of insider buying leads to healthy profits forbiotech investors, we conducted, with the assistance of Vic’s aforementionedapprentice, Shi Zhang, a comprehensive three-stage study of all subjects enrolled in the Russell 2000 Health Care Index over the six years 1996–2001.The first stage involved a Phase 1 study of the safety of such a procedure. Welooked at the performance of 50 companies in the year 2001. The resultsshowed that these companies displayed healthy returns in excess of 20 percent, greater than the Index’s returns during that year.Consultants who oversee our work pointed out that these results couldwell have been affected by special factors relating to the 2001 cohort, and theysuggested a more complete study involving a six-year period. This led us toroll out a comprehensive Phase 2 trial. In compliance with currently requiredFDA protocols, we enrolled 1,000 healthy subjects who registered positive forinsider trading within a two-month period. We followed their health duringeach of the next 12 months, as measured by their average percentage changein price. While this was not a double-blind study, we did, in accordance withstandard procedure, compare this with a much larger control group of 1,800subjects that were afflicted with insider sales. (Many subjects received thesedosages in separate months, and each administration of a dose of buying orselling in a month was treated as a separate subject.)The results for healthy and unhealthy subjects (i.e., insider buys versusinsider sales) for all six years combined appear in Table 16.2.The results of the Phase 2 studies were highly encouraging, and yet thevariability in the results by years shows that, as for most treatments, there ismuch uncertainty as to the actual outcome. Note, in the years 1998 and 1999,the differentials of 30.2 and 39 percentage points, respectively, between returns for buys and sells. Aside from these two years, the results appear relatively random.In the tradition of early investigators of medical treatments, we decided totry the treatment ourselves on a real-time basis. The results were carried liveon CNBC Money, starting with our October 25, 2001, column, where we reported the enrollment in our portfolio of 10 insider-positives. After just onemonth in the study, they showed improvements in their health, as illustratedin Table 16.3.The 25 percent average improvement was so drastic that we immediatelyclosed out the companies from our portfolio and took profits.
Chapter 16 • An Amiable Idiot in the Biotechnology RevolutionTable 16.2
311
Follow the Insiders in Biotech
Year
Mean %Return forInsider Buys
NumberofBuys
Mean %Return forInsider Sales
NumberofSells
200120001999199819971996Weighted average percent return*
−3.43.1149.050.38.230.949.2
8020919720714015
4.9−6.8109.819.1−5.920.122.6
12448027828024414
Total transactions
848
1,420
* Note the weighted average percent return cannot be calculated by simply averaging the meanannual returns.
We decided to conduct a confirmatory trial in 2002 withtwice as many patients. The patients were fragile to begin with,and it would be impossible at this point to separate the effects of the insider dosages from theGreat Market Virus of 2002, Type “Meme.” However, we haveconcluded that our first study was what they call in the trade “a false positive,”and reluctantly pulled the plug. Our tests resulted in what is called a negativestudy in the medical literature. The patients taking the medicine actually died
Table 16.3
Improvements in Health
Stock
Change (%)(October 25–November 21, 2001)
CorvasDyaxGenelabsGenzyme TransgenicsGuilford PharmaceuticalsInKine PharmaceuticalLarge Scale BiologyThe Medicines Co.3-Dimensional PharmaceuticalsTriangle Pharmaceuticals
−0.464.4−10.11.115.630.445.854.219.9−2.9
Average
25.1
Source: Niederhoffer Investments.
312 Practical Speculationat earlier ages than those with no treatment. Indeed, the authors of this bookenrolled in the study themselves for the purpose of science, financial health,and this book. Suffice it to say that their financial health was injured to thetune of 50 percent by their purchase of these stocks in 2002 (versus an approximately 30 percent decline in the biotech index itself).Which, once again, shows the necessity of counting.
17
EARNINGSIMPOSTORS
To the tune of the Duet of the Captain and Little Buttercup inH.M.S. Pinafore, by W.S. Gilbert and Sir Arthur Sullivan:
Things are seldom what they seemPublic’s wrong at the extremes.Prices climb on Wall Street hypeExecs sell when time is ripeVery trueSo they do.Mergers work accounting gimmicksAnalysts are only sidekicksProfit forecasts are precutCEO has time to putt.Even so,No cash flow.Managed earnings laid on thickInventory hides the trick.Statements obscure bottom linesAccruals shroud cash flow declinesSo they areNever at par313
314 Practical SpeculationHide the debts in towns offshoreThen go out and borrow moreOption costs they don’t deductPublic is the goose they pluckSo they doIn full viewWorst of all is the write-downOfficers they all leave townPay their bonus, then go underOnly bad folks get to plunderFirst they fakeThen they take.Big execs retire like kingsEliot Spitzer has his flingGild the earnings, steal the tillWhat is left is sure to killYes, I know,Dow will go.
P
ictures of corporate executives and accountants in action in the goodold days were more likely to show them hitting a drive at an importantconference at the Greenbrier Resort than taking a perp walk before an indictment for corporate fraud.Lists of those in the Rogues Gallery were more likely to include bank robbers than executives charged with crimes from such companies as AdelphiaCommunications, Arthur Andersen, Enron, HomeStore, ImClone, Tyco, orWorldCom. Security analysts, rather than Attorneys General, were more likelyto be studying financial statements. Income statements were more importantthan balance sheets.
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But in the early years of the twenty-first century, all that has changed. Executives are depicted as impostors. The attractive members of the opposite sexat cocktail parties no longer surround the venture capitalist. The bullish analyst is laughed off the television set. As Gilbert tells us in Pinafore:Highlows pass as patent leathersJackdaws strut as peacock feathers.Yes, indeed, training in detecting the impost0rs is becoming more important for the investor than the study of the principles of scientific management. The study of balance sheets has become more important than the studyof income statements. Within the balance sheet, the “cash and cash equivalents” is king. You can talk, you can bicker, you can boast about the earnings,but when profits don’t show in cash flow from operations, you’ve got to becareful.We found four questions to be helpful in differentiating between the realand the distorted, and the true and the false:1. Has the company announced a stock buyback? Buyback announcements preceded highly superior performance in all periods we tested.2. Does the company pay dividends? Giving cash back to shareholdershas been associated with superior long-term returns for at least thepast century.3. What’s happening with inventory and accounts receivable? Decreases inthese two indicators lead to good performance. Increases are bad news.4. Does the company pay taxes? The bottom line may be a chimera, but ifthe company is so profitable that it has to bite the bullet and pay cash tothe IRS, that’s a good sign that the earnings are real.Not all of these measures are good for all seasons. Companies with highdividend yields have performed significantly better than companies with lowdividend yields over the very long term. But they held no advantage in the1990s, or even in the difficult market year of 2002. Buybacks can signal thata company is willing to back up its good intentions with cash—but sometimes, it works out best for all concerned if the company keeps the money toinvest in the business. Accounts receivable, inventory, and cash taxes paidmay be of more enduring value, particularly combined with the buyback ordividend signals.We discuss each of these findings in this chapter. But first, we will explain the accounting issues in a bit of detail. You don’t need a green eyeshadeto understand this stuff, and an investor who knows a cash profit from an accrued profit will have a meal for a lifetime.
316 Practical Speculation
Cash MoneyCash is the first item on the balance sheet. By looking at a company’s auditedstatement of cash flows from one year to the next, you can tell whether cashincreased or decreased. But where did that cash from, and where was it used?In a nutshell, cash flow from operations is designed to show the cash effects of revenues and expenses. If a business is to survive, it must in the longrun generate such cash flows. If a business constantly loses cash from its operating activities, who would want to own it?The record that keeps track of these increases and decreases is called anaccount. The left side of an account is called a debit, and the right side is calleda credit. The rules for financial bookkeeping are designed so that the debits onany transaction are equal to the credits. That is what is meant as double-entrybookkeeping.The double-entry bookkeeping system, followed by all major companies,is designed to reflect the fact that economic transactions have impact on twoor more than two accounts at the same time. For example, if you go out to buya box of cereal, your cash decreases and your stock of cereal increases. An increase in an asset or expense is a debit, and an increase in a liability or revenue is a credit.The basic equation that keeps the debits and credits equal isAssets = Liabilities + Owners’ equityFor this equation to remain in balance, all changes on the left side mustbe balanced by an equal change on the right side. Also, any increase in an account on the left side must be balanced by either a decrease in an account onthe left side or an increase on the right side.If we divide the left side of the equation into cash and noncash assets, weget the new equation:Cash + Noncash assets = Liabilities + Owners’ equityThen we can see that any increase in noncash assets must be balanced by adecrease in cash assets, or an increase in liabilities. Any decrease in noncash assets must be balanced by an increase in cash, or a decrease in liabilities.By working through the transactions that cause an account to increase ordecrease, an accountant or an educated reader can calculate the difference between the cash flows and the net income of a business. They are all summarized and reported on the statement of cash flows. All public companies havebeen required to report this in their annual reports to shareholders and inSEC filings since 1987.
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Table 17.1 shows some selected financial figures from General Electric forthe calendar years 2001 and 2000 to put this in perspective.Table 17.1 General Electric: Selected Financial ItemsYear Ended
InventoryAccounts receivableSalesNet income
2001(in Millions)
2000(in Millions)
