The Orexigen Reverse Split - A Value Investing Lesson

| About: Orexigen Therapeutics, (OREX)

Summary

From a fundamental point of view, the upcoming reverse split is a non-event.

A recent Seeking Alpha article agrees with me on this point - yet unintentionally highlights an all-too frequent value investing mistake.

In addition, the negative expectation bias further blurred the author's view and led to some totally irrational arguments.

On Sunday, fellow Seeking Alpha contributor Spencer Osborne published an article on Orexigen's (NASDAQ:OREX) upcoming reverse split. I actually happen to agree with the starting point of this article: The reverse split is a non-event from a fundamental point of view. The company remains the same, risks and opportunities have not changed. I don't agree with the final point of the article, though: "Now, more than ever, it is time to assess."

Confusion Click to enlargeWhy do I disagree and what is the problem with that statement? I believe the article highlights in an exemplary way one of the mistakes investors make too often. The short characterization would be: They start as fundamentally oriented value investors and end up as traders.

Obviously, on paper we are all value investors. We are all looking for a bargain. Yet our methods differ, our time frames differ and both matter.

Many years ago I used to invest in mutual funds. Some of them issued monthly, some even weekly updates on their transactions. So, in week one you could see that the fund had just bought a position in IBM (NYSE:IBM) because of its exposure to international revenues and the belief that the US$ would come down over time. In week two you could read that the position was sold. - Why? Because "fundamentals had changed": Seven days later, the fund manager considered a rise of the dollar to be more likely. That fund manager described himself as a value investor focused exclusively on fundamentals. Yet he was effectively a trader and a speculator.

Something similar happened in the article mentioned above. First, the author cautions investors that there is no reason to change their opinion on Orexigen just because 10 shares will become a single one next week and the price per share will rise tenfold, satisfying the Nasdaq listing criteria of a share price above $1. But then he says that

"investors should be prepared to see this equity go from an opening price of $4.45 or $4.50 on Monday to a closing price that see's(sic) at least 4% or 5% of the value evaporate by the end of the week."

This doesn't make sense to me. First, this stock has gone up and down like crazy every day. 5% intraday price increases or decreases are no exception, but the rule with this stock. Second, because it contradicts the initial focus on fundamentals. In fact, if fundamentals don't change, neither a rise nor a fall is warranted. Period. So why talk about "evaporating" value?

Yet it seems that the author's negative bias carries him a little too far - which leads him to an only apparently rational argument:

"What we have is a company that has gone from a float of 145 million shares to a company with just 14.5 million shares. This low share count can bring extra volatility that is likely good for active traders, but very frustrating for longer term shareholders. Transactions involving just 1.4 million shares are actually seeing 10% ownership in the company change hands. Investors need to grasp that the volatility in this equity may become dramatic in the weeks ahead."

First of all, especially for long-term shareholders, volatility should not be frustrating at all. Why should I care about the stock price today - when my focus is on the company's value several years from now? I can tell you, I rarely look at where Orexigen is trading. It's meaningless. What I care about is where the company is going. Which steps it takes. Whether it improves its prospects.

In addition, the volatility argument based on the effects of higher trading volume relative to market cap is totally irrational as well. Nobody buys, independently of their price, 10,000 shares. People I know invest x bucks, independently of how many shares are needed to invest those bucks. This means that next week investors will simply buy (or short) less shares to invest the same amount of money they would have allocated to OREX anyway.

Finally, nobody can sell more shares than they have, i.e. if I own 100,000 shares today, after the reverse split I will own only 10,000, but worth 10 times as much each - and those are the only ones I can sell.

So where should this huge volume spike come from? As an effect of the reverse split, trading volume, expressed in shares, will simply shrink by a factor of 10. Expressed in dollar value, it will roughly stay the same. If there really was that huge volume spike foreseen by Spencer Osborne, the stock would go through the roof. In fact, as shorting is unlikely to increase tenfold, the only noteworthy trading volume increases could come from buyers! All potential sellers, i.e. those that already have the stock, will own just 10% of the shares they had in their portfolios until yesterday. So how could they possibly sell ten times as many? They can't.

That said, I agree that Mr. Market is not rational, especially in the short term. While the split is a non-event from a fundamental point of view, it might still cause some volatility - but only because of irrational reactions like the ones intentionally and un-intentionally highlighted by the mentioned article.

From a fundamental point of view, there is no reason to agree with that final sentence: "Now, more than ever, it is time to assess." - It is always time to assess, not more and not less than yesterday.

I concede it is tough to stay rational, but if you succeed, as Charlie Munger says, "the stupidity of the world helps you."

Disclosure: I am/we are long OREX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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