Insmed, The Definition of Risk

Aug. 3.11 | About: Insmed, Inc. (INSM)

The mainstream finance profession will have you believe that risk is akin to price volatility. Unless you are a short-term trader, this is wrong; a change in a business's price rarely affects its operations. Real investment risk has to do with the business risks faced by each of the companies in a portfolio. Yesterday's 50%+ drop in the share price of Insmed (NASDAQ:INSM) demonstrates this disparity of definition very clearly.

Prior to the steep drop in Insmed's price yesterday, the company had a beta of -0.15. This suggests that the company's price volatility was rather low relative to the market. To mainstream finance enthusiasts, this would suggest that the stock was not risky as part of a diversified portfolio. In reality, however, this company's risks were (and still are, despite the 50% price drop) extraordinary.

First of all, the company is losing money. Unlike other companies that are losing money, Insmed cannot just cut costs and shrink down to its most profitable niches/segments/locations. This is because Insmed has no profitable segments!

The company is betting heavily on the market's acceptance of a new drug (currently undergoing FDA clinical trials) that it has developed for the treatment of lung diseases and infections. If it works out, shareholders will of course do very well. But investors should not be focused on the "if all goes well, I'll do very well" scenario. Instead, investors should analyze risk by focusing on the "if things go wrong, what will happen?" scenario.

In many cases, things won't go wrong, and so even the investor who pays no attention to risk will do well. But to avoid losing principal, prudent investors seek to invest in companies where the likelihood of things going wrong is low and where the damage won't be large even if things do.

Insmed fails on at least one of these counts, and shareholders paid the price yesterday, as the company is now worth half of what it was the day before. The news came out that the FDA has placed a hold on Insmed's Phase III trials of the aforementioned drug after reviewing the data from a previous trial.

It is, of course, entirely possible that the trial will resume and that the company's product will go on to have a successful future. Unfortunately, there's little to no fallback for this company if things don't work out. As such, investors who buy into this company while it trades for more than its cash balance are risking significant portions of their principal.

Disclosure: No position