Ah, Grasshopper, so you are troubled by the changing value of your share in Organovo Holdings, Inc. (ONVO)? You say in June it was worth $10.90 and three weeks later it was worth $1.93. You say that throughout most of December, it was worth little more than $2.00, but Monday of this week it rose to $6.00 before falling Tuesday to as low as $4.00, and now you wonder about tomorrow? Sit down Grasshopper, stop pulling your hair, and listen to how a LTBH Zen Master waits for a butterfly to stop its fluttering and alight.
Transformative Technologies and the LTBH Investor
We are long-term, buy and hold ("LTBH") investors, you and I, and so we hold a mixture of value and growth equities. A subcategory of our growth equities is companies possessed with the potential of a transformative technology.
By transformative technology, we mean a unique, proprietary product with the potential to fundamentally change a significant aspect of the market.
Some of companies with transformative potential are large and established, like International Business Machines Corporation (IBM) with its big data and carbon nanotube technologies or ABB, Ltd. (ABB) with its direct current circuit breaker. These companies lumber across the earth with nary a sideways glance; there are no predators large enough to harm them, only choosing a wrong path leading to a barren landscape threatens their existence.
Others are smaller and fear predators; they scurry through the underbrush, eating smaller creatures but growing in confidence, companies like Nuance Communications, Inc. (NUAN) with voice-recognition technologies or Clean Energy Fuels Corp. (CLNE) providing natural gas fueling to truckers.
And still others are the smallest of all, tiny little companies just emerging from their nests or pupa, companies like Arcam AB (AMAVF.OB) selling a few dozen high end 3D printers annually to aerospace and medical companies, or Organovo Holdings, Inc., developing the 3D printing of human tissue.
It is these babes that cause us such worries, Grasshopper. Like little ONVO, recently emerged and starting to flutter its wings. If we watch it too closely, we become dizzy with its ups and downs. The Zen of LTBH investing, Grasshopper, is to visualize the path and not watch the fluttering.
The LTBH Philosophy
Remember, Grasshopper, why we are LTBH investors and not day traders, mutual fund, or ETF investors:
- Equity markets offer superior returns to many other investing options, so we ask not whether to invest in equities, we ask how to invest in equities
- We know the path of frequent trading costs more in broker fees, capital gains taxes, time and energy
- We know what we cannot know; professional traders have the edge in timeliness of information, speed of execution, and transaction costs
- We know that, with discipline, we can win against mutual funds (because of their burden of fees and expenses and, in some cases, our ability to invest in smaller companies) and we can win against ETFs (because of their expenses and our ability to be more selective).
The LTBH Rationale for Investing in Organovo
Remember, Grasshopper, the reasons why we invested in Organovo. Its transformative technology is the 3D printing of human tissues for drug discovery and development, biological resources, and therapeutic implantation. It is conceivable that one day Organovo machines could print entire human organs like a liver, a kidney or a heart to be therapeutically implanted into a person and save their life. This potential is the very embodiment of a transformative technology.
Yet we also know that Organovo is still a delicate creature. It is a long way from having a proven product and it is incurring substantial operating losses. In the third quarter of 2012, according to its 10Q filing and an excellent Seeking Alpha article by PropThink, it had essentially three sources to its $469,238 operating revenue:
- $298,800 in collaboration fees from United Therapeutics (UTHR)
- $75,000 in collaboration fees from Pfizer (PFE). This collaboration expired in December 31, 2012 and is expected to be replaced with a new agreement, but no such agreement has yet been announced.
- $95,500 from a National Institutes of Health grant
We know its expenses are running at 182% of revenues, comprised of selling, general and administrative expenses at $550,157 and research and development expenses at $304,251. But still the tiny company expresses confidence in its financial position. At September 30, 2012, they report having working capital of $7.2 million, "sufficient to fund our ongoing operations… for at least the next 12 months." In addition, Organovo is in the process of resolving outstanding stock options that will remove a large liability from its balance sheet and position it to move from OTC to the NASDAQ capital markets in 2013.
What is Organovo's Future Value?
We do not know what the future holds for Organovo, only that it lies somewhere on a continuum between nothingness and becoming a multi-billion dollar behemoth. The possibilities are likely distributed on a bell-shaped curve with some outcome towards the middle as the most likely.
But with this knowledge, and some simple probability calculations, we can formulate an estimate of Organovo's long-term value and thus find a Zen-like peace as the market flutters before us. Consider Organovo's future as depending on two key issues: (1) proving great value in the 3D printing of human tissue and (2) establishing exclusivity or dominance with this technology. If both of these issues develop strongly in Organovo's favor, it will become fabulously valuable. But there's a high degree of risk that one or both may not fully occur. There may be as yet undiscovered technical reasons why 3D printing is not feasible, or why it will be supplanted by another, superior method of creating human tissue. Another company may invent an alternative method for 3D printing of human tissue without violating Organovo's intellectual property rights.
Using these two issues, we can project a range of potential outcomes for Organovo and lay the basis for calculating an expected present value of the stock. As an example, I would propose that each of the following five scenarios are potential outcomes for Organovo:
- Scenario #1: Organovo has minimal value (five year target share price $0 to $2). 3D printing of human tissue proves to have little value. Organovo may go out of business, be acquired by someone else, or survive as a small company selling a limited number of 3D printers to research organizations.
- Scenario #2: Organovo has a value of $100 million to $500 million (five year target share price $2 to $10). Organovo has annual earnings of $10 to $25 million a few hundred to a few thousand 3D printers annually, plus supplies and technical support, again to research organizations.
- Scenario #3: Organovo has a value of $500 million to $2 billion (five year target share price $10 to $40). 3D printing of human tissues becomes a standard mainstream research methodology and Organovo is the premier provider of this technology. Many thousands of printers are sold annually. Organovo trends towards annual earnings in the range of $50 to $100 million.
- Scenario #4: Organovo has a value of $2 to $5 billion (five year target share price $40 to $110). 3D printing of human tissues becomes an accepted therapeutic methodology for creating implants. There are competitors who have created alternatives around Organovo's intellectual property protections. Organovo shows the potential to generate eventual earnings in the hundreds of millions.
- Scenario #5: Organovo has a value of more than $5 billion (five year target share price more than $110). 3D printing of human tissues is an accepted therapeutic methodology and there are effectively no competitive alternatives. Organovo has the potential to generate tens of billions in revenues and billions or more in earnings.
Don't Panic! Stay Calm. Ommmm…
So, Grasshopper, do you know that it's not the fluttering of the stock price that concerns us, it's the journey's end. If you agree with the assumptions I've described, we can assign probabilities to each, estimate what Organovo's value might be if each scenario occurred, and then calculate an expected value. (If you don't agree with the assumptions I've described, it's a simple exercise to create your own). Look at this table I've drawn here in the sand:
Expected Organovo Share Value
In Scenario #2, for example, Organovo shares would have an estimated value of $2.00 in five years. Discounting this by 10% per year, we calculate a Net Present Value of $1.24. We assume this scenario has a 20% chance of occurring, so the expected value of Scenario #2 is $0.24. By adding the expected value of all the outcomes we identified, we arrive at a share value today that reflects our expected returns: $20.12.
Meditate on this, Grasshopper, for this guides us to know where our "buy", "sell" and "hold" prices lie. If the price tomorrow hits $20.12, we should sell. We might even sell for a little bit less than this in order to grab a sure thing. But we aren't going to sell for, say, $12.00 what we think is worth $20.12.
To find our "buy" and "hold" points, we must reflect deeply on what our table of probabilities is telling us. One thing it tells us that there's a 60% chance that Organovo isn't worth more than $6.21 today. The only reason we're not selling at $6.21 is because we're hoping that Scenario #4 or #5 will occur and Organovo is a "home run" stock. Yet our assumptions say that, much as we might hope this will happen, the odds less than 50%.
So, Grasshopper, I would certainly not "buy" Organovo at more than $6.21. In fact, being somewhat cautious, I would likely split the difference between the $6.21 and the $1.24 and use the resulting $3.72 as the most I would pay. My rationale is that $3.72 is the point where I have a 50% chance of getting at least a 10% return on my investment over the next five years. (Note, however, that if I get less than a 10% return, it will probably only be a little less; on the other hand, if I get more than a 10% return, I might get much, much more).
I believe, Grasshopper, that LTBH investors should have a small place for volatile small-cap stocks in their portfolios. Not just one, but several because the chances of any one being a home run is small, but the return from a home run will offset losses from the others which don't develop.
As we hold these stocks, we need to realize that there are others who trade using different philosophies. There will be great volatility in many small stocks. Don't let the fluttering of the butterfly become a fluttering in your stomach. Keep your eye on the prize, Grasshopper. We LTBH investors are not looking to sell at $4 or $6 or $10; while we continue to believe this stock can be a home run, we're holding. I find that doing this sometimes requires the patience of a Zen master.