Part III: Dissecting and Analyzing the Special Situation in Paratek Pharmaceuticals, Inc. (NASDAQ:PRTK)
To review, in our introduction to this series, we presented an argument for special situation investing in pursuit of absolute portfolio returns by taking a value-investing approach as articulated by some of the foremost value investors. We then briefly introduced the Reader to Paratek Pharmaceuticals for consideration of a special situation investment, and we ran some probability-weighted, risk-adjusted calculations to arrive at expected annualized returns on investment in order to determine the approximate yield from a special situation investment in this Company; identifying the conclusion of the Phase 3 trials as catalysts (i.e. corporate events) to unlock significant value.
In this installment, we will continue our case study by further dissecting the special situation investment thesis for Paratek Pharmaceuticals, and expand our analysis using time-tested, value-investing principles.
Only Slightly Less Brief Summary Investment Thesis
Please feel free to skip over this section if you diligently read the referenced articles in the first part of our case study, but for those who have not yet done so, and at the risk of only slightly less drastically over-simplifying the investment thesis, we provide it in what we believe are clear bullet points below.
· PRTK is in late stage (i.e. Phase 3) development of two drugs: Sarecycline and Omadacycline. Please refer to Slide #3 of the Paratek Corporate Presentation 1-9-17, available here.
o Sarecycline is a modestly valuable acne drug, the development of which involves collaboration with Allergan PLC (NYSE:AGN), which is currently in Phase 3 trials. We will largely ignore Sarecycline except as it relates to evaluating the risk of loss inherent in a special situation investment in Paratek, as well as opportunities to monetize the asset for future capital needs.
§ Please refer to Slide #s 35-37 of the Paratek Corporate Presentation 1-9-17, for more information.
o Omadacycline is the potential blockbuster drug, to which Paratek retains global rights, and is the primary non-cash asset held by Paratek.
§ Please refer to Slide #s 6-7 of the Paratek Corporate Presentation 1-9-17, for more information. There are several promising indications for Omadacycline. The largest markets, and most advanced indications for the drug, are:
· Community Acquired Bacterial Pneumonia (CABP)
· Acute Bacterial Skin, and Skin-Structure Infection (ABSSSI), also known as "skin indications"
· Urinary Tract Infections (UTI)
· PRTK has cash balances (approximately $100M net cash) that are believed to be sufficient to cover development costs required to successfully complete the Phase 3 studies for the CABP indication and Oral-Only ABSSSI indication of Omadacycline, which will further complement the already successfully completed Phase 3 trial for IV-to-Oral ABSSSI indication.
o We trust Management's guidance that further capital raises, and hence shareholder dilution, are unnecessary at current share price levels pending the read outs of the Phase 3 trials, and we believe that by the time incremental cash needs arise, strategic opportunities (and more compelling asset valuations) will be available at far more beneficial terms than the recent $13/share raise in mid-2016. [Incidentally, the cash raise provided us with a very compelling entry point, so we are not complaining, and we acknowledge the modest dilution to prior shareholders.]
· PRTK can submit a new drug application (NDA) to the Food & Drug Administration (FDA) with two successful Phase 3 trials for two separate indications. As noted above, the Company already has one (successful Phase 3 trial), and expects two more in mid-2017, and anticipates filing the NDA with the FDA in the first half of 2018.
· A promising ABSSSI indication (IV-to-Oral and Oral-Only) obtained from two successful Phase 3 trials would suggest a value in the $30/share range, or up to $700M market capitalization, depending on available cash balances and other factors. That is roughly a double from current levels, and we put the probability of successful top line results at 90%. [Of course, we aren't saying the share price will necessarily immediately reflect the underlying value of the business, but we believe the catalyst may trigger the Market's recognition of said value, and opportunities for monetization are likely to arise soon thereafter.]
· A promising CABP indication obtained in successful Phase 3 clinical trials, in conjunction with one or more ABSSSI indications, suggests a value of $45-$60 per share (or more), or from $1.1B to $1.4B market capitalization. We believe these valuations to be conservative based on past M&A activity; however, we acknowledge that valuations fluctuate widely (and quickly) in this area. That is roughly a triple or quadruple from current share price levels, and we put the probability of successful top-line results at 70%+. [Again, we aren't saying the share price will necessarily immediately reflect the underlying value of the business, but we believe the catalyst may trigger the Market's recognition of said value, and opportunities for monetization are likely to arise soon thereafter.]
o Provided the trial is not unsuccessful due to a materially adverse safety result, and any inferiority stems from efficacy or tolerability, we are not overly concerned with that 30% "unsuccessful" result, as although it would likely impact the share price, PRTK isn't a crowded, speculative stock, and intrinsic value of the remaining indications, and even the long-term CABP indication, shouldn't be unduly, permanently impaired. In other words, we believe the skin indication should still be worth as much as $30 per share.
· Assuming a successful Phase 3 trial for an Oral-only ABSSSI indication and/or a successful Phase 3 trial for a CABP indication, the NDA is anticipated to be submitted in the first half 2018, with approval anticipated six-to-eight months thereafter under the FDA's fast track status. The probabilities for this milestone may be derived partially from the above.
· Paratek Management has verifiable industry and antibiotic-specific expertise, and has been consistently under-promising and over-delivering, which is one of our favorite qualities in management teams. We further verified, with the benefit of hindsight, their recent estimates surrounding cash usage, cash needs, and projections surrounding the time for completion for clinical trials, and they have demonstrated a pattern of consistent reliability, careful risk management, and keeping shareholders up to date in a prompt and transparent manner.
o We wish to take this opportunity to applaud Management for its prior transparency, as it is an attribute, which provides shareholder confidence, appreciation, respect, and (we believe), great value.
· If both Phase 3 trials currently under way produce inferior results, the impact to the share price in the next 6-12 months can easily be a drop to $4-$10 per share, or even less. [We believe that this range represents the immediately expected share activity upon such an event, not necessarily the intrinsic value of the Company or its assets. Markets can behave irrationally in the short-term.] We calculate this risk to be remote (less than a 10% chance, conservatively, that both Phase 3 trials read out negatively, as we have both a 90% probability event coupled with a 70%+ probability event), but the risk exists.
· If a materially adverse result is obtained from one or more of the Phase 3 trials, as it relates to safety, the impact to the share price (indefinitely) can be a drop to $4 per share (or existing cash per share at such time)[i]. We calculate this risk to be remote (estimated at a 5%-10% chance), but it does exist.
· If the FDA rejects Paratek's NDA for one or more indications of Omadacycline, or requires restrictive labeling requirements, the impact to the share price in the next 18-24 months may result in a similarly catastrophic drop, though it is premature to pretend to understand what the balance sheet will look like by that time, as any number of strategic events and partnerships to raise capital are likely to have already occurred. We calculate this risk to be unlikely, and even remote, but it does exist.
· To summarize, we believe PRTK represents a potential two-to-five-bagger in the next 6-24 months on the upside, and a potential permanent loss of capital of up to 80% (from current levels) in the same time frame, within the probabilities noted above.
Dissecting the Special Situation
Does Paratek Pharmaceuticals meet our criteria as a special situation for potential investment? Let's review the following Characteristics of a narrowly-defined, special situation?
A. Does the investment thesis have a discrete and identifiable time table? Yes. In fact, there are three catalysts that are presently playing out.[ii]
a. Six (6) months for CABP and Phase 3 Oral-only ABSSSI top-line results.
i. We believe it likely that the shares may gap up towards the value implied by a successful CABP indication as the top line results for the pending Phase 3 trial for CABP approaches. In other words, prior to, or immediately after the announcement of the Phase 3 CABP results, we believe the shares could approach $45.
ii. We believe it likely that the shares will further increase to the value implied by a second successful skin indication as the top line results for the pending Phase 3 trial for Oral-only approaches. In other words, prior to, or immediately after the announcement of the Phase 3 Oral-Only ABSSSI results, we believe the shares could approach $30 (taken in a vacuum and absent news on the CABP, which results should read out prior to Oral-only).
b. Twelve to eighteen (18-24) months for the submission and subsequent FDA approval of an NDA.
c. In addition, various asset monetization and acquisitions events are likely to arise, but we are not assigning probabilities or potential returns to these scenarios in this article.
B. Are we able to predict, within reasonable error limits the results (in other words, when we will get how much)? Yes, as it pertains to the two ongoing Phase 3 trials which are expected to read out in mid-2017; the submission of the NDA, and obtaining FDA approval for Omadacycline.[iii]
a. The timelines are given in the analysis of Characteristic A.
b. The probabilities of obtaining favorable Phase 3 top-line results for the Oral-only, ABSSSI indication, within our timeframe, are believed to be 90%+.
c. The probabilities of obtaining favorable Phase 3 top-line results for the CABP indication, within our timeframe, are believed to be at least 70%+.
d. The probabilities of successful submission and subsequent FDA approval, for one or more indications, within 24 months are believed to be at least 80%[iv] (assuming one or more successful Phase 3 read-outs, so the probability of successful FDA approval is the product of the relevant probabilities).
e. The probabilities that FDA approval is provided for a relatively "clean" label are believed to be relatively high, but are as yet, unknown pending completion of the Phase 3 trials.
C. What might upset the applecart? The critical risks for our designed special situation include:[v]
a. The risk that the Phase 3 Oral-only Trial for the ABSSSI indication does not demonstrate non-inferiority in either efficacy or safety or tolerability.
i. Risk estimated at 10%. Remote.
b. The risk that the Phase 3 Trial for the CABP indication does not demonstrate non-inferiority in either efficacy or safety or tolerability.
i. Risk estimated at 30% or less. Remote-ish, but just barely.
c. The risk that, assuming one or more of the above Phase 3 Trials is successful, that the FDA rejects the NDA for whatever reason.
i. Estimated risk multiplied by the risk of unsuccessful Phase 3 Trials for the ABSSSI Oral-only and CABP indications.
1. Note we have an extremely painful recent example in Cempra (NASDAQ:CEMP) of what such an eventuality can do to the share price, although the story is on-going.
d. The risk that the drug, if/when approved, must include restrictions on its label and/or is only an alternative drug to be prescribed only after trying alternatives.
e. The risk that Management (and we believe these specific risks to be highly unlikely)
i. has either not disclosed material concerns relative to the drug's efficacy or safety, or
ii. is not conducting the Phase 3 trials in a manner that will be acceptable to the FDA reviewers, or
iii. has not disclosed or ascertained problems with the third-party manufacturers of Omadacycline.
f. Various political and reputational risks surrounding drug pricing policies may dampen Big Pharma's appetite for any M&A or other monetization activities, or may lead to changes in FDA established endpoints or drug approval processes.
g. M&A trends in the broader Pharmaceutical industry may slow substantially from what we have seen in recent years. The relatively short duration of our special situation investment (6-12 months for several catalysts) reduces this risk somewhat, but the trends have been largely positive in the recent-to-mid-recent past.
D. Will an investment in PRTK yield a return, largely irrespective of the course of the Market as a whole? Based on our initial analysis to this date, we believe the answer is squarely in the affirmative. It is business factors, and not market forces, which should ultimately determine the value of Paratek's assets; although in the short term, there is always some degree of correlation between the Market's acknowledgement of the intrinsic value of the business underlying the publicly-traded shares.
Measuring an Investment in Paratek against our (Pirated) Investment Criteria
Okay, so we think PRTK meets our criteria for a special situation investment. It does not, however, necessarily follow that we should initiate a position in the shares. In order to determine this, we must first run through our four investment selection criteria derived from Buffett and Munger, which we will repeat here for ease of reference.
We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price.[vi]
Is the Paratek Business Understandable?
It is what we don't know that we don't know that keeps us up at night. Admittedly, this situation has taken us some time, given the previously part-time attention and focus we invested in the endeavor over the past six months, and it requires some work, and we are taking this opportunity to dip our toe (back in) in the pharmaceutical drug development pool, rather than choosing to dive in head first. The concentration of the Paratek business in only two drugs has made this task simpler than say, analyzing the businesses of Allergan, or Merck (NYSE:MRK); though we visited their SEC filings to confirm the Trius and Durata take-outs, and to see how they were accounted for and valued by their (ultimate) acquirers.
Does Paratek have a Durable Competitive Advantage?
Paratek, via its developmental drug Omadacycline, pending favorable Phase 3 studies and a successful NDA, will have a durable competitive advantage in the form of patent rights through 2028. As it is not central to our investment thesis, we have not fully analyzed the commercialization capabilities of Paratek to adequately bring Omadacycline to market in a way that maximizes its market-share and value.
However, we believe there are various avenues and opportunities to partner with various members of Big Pharma (particularly for non-U.S. rights to Omadacycline), and we have confidence in Management's experience and strategic vision, which makes this not an immediate concern.
The market is hungry for well-tolerated, efficacious and safe, broad-spectrum, once-daily, oral-only, bacterial resistant antibiotics. And although competition exists, the antibiotics currently on the market, and in development, are arguably insufficient in number and effectiveness to meet the market's existing and future needs. Drug development costs and patent protections being what they are, we believe Paratek will have a durable (meaning 10-year) competitive advantage in Omadacycline.
[Please refer to Slide #s22-31, 34, and 42-48 of the Paratek Corporate Presentation 1-9-17, for more information.]
A few notes from Jim Roumell's interview with Evan Loh:[vii] In Biopharmaceuticals, if the product is good, a company can attract top-level management, and can raise money and have a durable success story. Omadacycline is a tetracycline derivative. Tetracycline is a drug that came on the market in 1945 and has been on the market for about 70 years. The safety profiles of Omadacycline very closely mirror the safety profiles of tetracycline.
Omadacycline has demonstrated a mild imbalance in liver tests, mild imbalance in creatine phosphokinase or CPK (which is an enzyme coming out of the muscle), a little imbalance in BUN (blood urea nitrogen), and a very interesting heart rate response. The safety data is tracking that of tetracycline closely. The Company has 90-day toxicology results in two species, which is something of overkill for a 14-day antibiotic product, and the availability of 90-day toxicology data minimizes the likelihood of encountering a rare, adverse event.
[Note, a competitor's antibiotic recently tried to convince the FDA they would limit its drug's use to 5-7 days due to safety concerns, but the FDA still issued a CRL saying the drug's safety profile was not adequately characterized.] PRTK Management is deliberately trying to create transparency with shareholders to minimize surprises for investors. For instance, Management has submitted their bio equivalency data for IV-to-oral and oral-only.
Same mic 90 curves (MIC 90 is the minimum concentration of the drug required to inhibit 90% of the growth of the target organism in question). Well tolerated (i.e. little to no vomiting). This is one reason we can be highly confident about the current skin indication (ABSSSI, oral-only, Phase 3 trial). With their modeling, with respect to Omadacycline's effectiveness, the Company knows with their skin trial they are five times higher than they have to be, and in their pneumonia trials they are ten times where they need to be. Safety is the most key.
[Please refer to Slides #11-12 of the Paratek Corporate Presentation 1-9-17, for more information.]
Does Paratek have Honest, Experienced, and Capable Management?
As referenced throughout this article, we rarely come across companies possessing Management as seemingly capable and transparent as what appears to exist at Paratek. The Company has a blue-chip, Big Pharma (BP) experienced development and commercialization team, primarily with experience at Wyeth and Pfizer. The Company's Chief Medical Officer developed an antibiotic by the name of Tygacil, a drug for which Pfizer booked peak revenues of $358M in 2013.[viii]
[Note we are not certain what worldwide revenues are for this drug, just the revenue recognized by Pfizer.] We understand that Paratek's head of Commercialization, Adam Woodrow, has brought six previous antibiotics to market. An interesting article[ix] about the critical need for antibiotics and the evolutional bacterial resistance in which Mr. Loh and Mr. Woodrow are quoted is available here.[x]
[Please refer to Slide #4 of the Paratek Corporate Presentation 1-9-17, for more information.]
An example on competence is warranted. The FDA/AdCom recently raised concerns relative to a competitor's antibiotic involving that particular company's manufacturer. Paratek's Management, on the other hand, has previously committed to have their quality audits in place, and has committed to audit all their manufacturers in order to avoid either commercialization delays, or FDA approval surprises associated with manufacturing problems.
Furthermore, Paratek communicates its approach to chemical manufacturing and controls (CMC) for its molecule, in order not to focus so myopically on the R&D that years of net present value (NPV) end up being forfeited due to the inability to commercialize the drug immediately upon FDA approval. As part of FDA approval process, Paratek is making commercial batches of Omadacycline to have on hand.
By making and storing these commercial batches now, the Company will be able to demonstrate the necessary shelf-life stability upon FDA approval (and likely beforehand). Given the drug's unique past, we believe the Company already has several years of shelf-life, stability data on hand.
[Please refer to Slide #33 of the Paratek Corporate Presentation 1-9-17 for more information.]
Is Paratek Available at a Reasonable Price?
Implicit in this question is having formed an opinion on approximate value. We believe the Paratek business to be worth approximately $30 per share, or more, currently. If Management chose to explore strategic alternatives prior to the pending Phase 3 trial readouts (something we do not expect, nor a strategy we believe is wise), we believe they could attract Big Pharma bids north of $30/share.
We initiated a small position under $13 per share, and have added to it since. While the shares currently trade around $15, we continue to believe the price to be attractive at these levels because the current market value assigns perhaps $4 to the cash on the balance sheet, $5 to Sarecycline; leaving just $6 assigned to Omadacycline, which strikes us as ridiculous. That isn't to say we expect the shares to trade significantly higher until the Phase 3 results become available, and the investment becomes even further de-risked, but the shares have recently been gapping up.
Whether on speculation or the recent blow to one of the Company's competitors with the accompanying antibiotic development spotlight shifting to Paratek, we are not certain. We obviously liked $10 even more than $15, and we continue to watch for attractive entry points. Indeed, we would hope that the shares trade around current levels while our investment thesis plays out, in order to allow us to potentially increase our position. We don't have high hopes this bargain will continue to exist at current levels.
Margin of Safety
The real question concerns the presence (or absence) of a significant Margin of Safety. Sometimes we address this concern under the Favorable Business Prospects / Durable Competitive Advantage section, as a competitive advantage can itself provide for an adequate margin of safety. Most times we address this topic under the Available at a Reasonable Price section, as a substantial discount to intrinsic value is most often itself a margin of safety.
In this case, we do not believe either the patent protection, or market opportunity for, Omadacycline provides sufficient margin of safety on their own, given the Phase 3 trials have not yet read out, and the drug hasn't yet received FDA approval; but we do believe that the price versus the intrinsic value yields an acceptable margin of safety. We list this consideration out separately in this article.
To illustrate, consider the recent comparables for similar antibiotic take-outs with a single skin (ABSSSI) indication. Do those comparables provide an acceptable margin of safety? Nothing is certain, but with all data currently available to us, we believe the value inherent in the business provides sufficient room for error, that if we are wrong on the minimum current valuation by one-half, we still shouldn't lose money on our investment. Add to that the significant catalysts for substantial upside potential, and the risk of permanent capital impairment (which we believe to be remote) is justified.
We further believe the probabilities of obtaining favorable top-line results for the Oral-only ABSSSI trial (which again, we believe to be highly probable) serve to further de-risk the investment; however, shares are likely to appreciate considerably by the time that information is definitively available, at which time, it may to be too late in terms of an attractive entry point.
Consider the existence of Paratek's already successful IV-to-Oral skin trial. There is an argument that the shares should already trade at $30 or above. The existence of the one favorable Phase 3 read-out, coupled with the heretofore absence (knock-on-wood) of any significant adverse safety concerns, further bolsters our estimate of intrinsic value. We believe this intrinsic value, when compared to available share prices, provides a sufficient margin of safety.
As we saw recently with Cempra, and earlier with Tetraphase, there are no guarantees, even after seemingly successful completion of Phase 3 trials; however, those subsequent market declines resulted from the emergence of safety concerns, manufacturing concerns, and the lack of published bio-equivalent efficacy. Thus far, Omadacycline's safety profile is strong, and its bio-equivalency (for oral-only vs. IV-to-oral) is more than sufficient and provides significant room for error.
Further consider the balance sheet. As we have noted, Paratek has no debt, and has sizeable cash balances. Admittedly, the cash provides only $3-$4 per share as a safety net, and as we see currently with Cempra and Tetraphase, shares can trade below even net cash levels, if catastrophic news comes about. Again, no such concerns have (yet) arisen from clinical/registration trials with respect to Omadacycline.
Conclusion - PRTK Case Study
In summary, we do believe our estimate of intrinsic value, relative to the currently available price of the Company's shares, provides for an acceptable margin of safety for a special situation investment in Paratek Pharmaceuticals, Inc. . We believe the probabilities are in our favor. We doubt we will run into Mr. Buffett and Mr. Munger in this special situation (after all, it is too small for Berkshire's capital base, among other reasons), but we do see Mr. Klarman and Mr. Roumell here.
Of course, as has often been noted by Warren Buffett "You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you…. You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct."[xi]
We like the Company, we like the space, we like management, we like the pending catalysts, and we really like the potential risk/reward profile within our stated time frame. If an off-target, adverse event were to occur in the Phase 3 trials currently underway, the magnitude of likely share price (and intrinsic value) decline makes us nervous (similar to a merger arbitrage special situation), but the probabilities for success based on all available information provide us comfort, and the magnitude of potential price appreciation far outstrips any merger arbitrage opportunities with which we are familiar. Lastly, we like the institutions in this stock as providing some cover to our minority, non-activist position.
If we were only allowed a single investment, we would likely buy shares in Berkshire Hathaway or continue to hold cash. But such is not the case. If we can invest in a basketful of Paratek-like opportunities, say 5-10 (with most of our capital being allocated to spinoff companies rather than late-stage, drug development, bio-pharmaceutical companies) to complement our long-term, value-based, equity portfolio.
We may be reasonably confident the odds will work out in our favor, in aggregate, leaving us with the foundations for an effective hedging strategy to help us weather market variations, and to provide us with ready investment capital if the broader markets were to decline during the timeframe inherent in our investment horizon.
Knowing when to Sell
Knowing when to sell a long-term holding is one of the most difficult aspects of portfolio management. We have found it easier to recognize undervalued securities to hold for the long term, and special situations with varying holding periods, than it is to recognize the most opportune time to exit. The temptation is generally to exit prematurely. One of the key lessons we have learned in our nearly 10-year experiment with special situation investing is this: It is a near certainty that if one sells a profitable investment after it doubles, or triples, one will never actually reap the benefits of investing in a 10-bagger.
For many investors and portfolio managers, this concept may appear obvious, but it took us a few years to learn. That said these are generally good problems to have. Fortunately, for many special situations, the holding period is a little more obvious, as catalysts generally have defined time frames.
Returning again to Mr. Klarman (after all, he literally wrote the book on margin of safety, pun intended):
"Investors should pay attention not only to whether but also to why current holdings are undervalued. It is critical to know why you have made an investment and to sell when the reason for owning it no longer applies. Look for investments with catalysts that may assist directly in the realization of underlying value. Give preference to companies having good managements with a personal financial stake in the business. Finally, diversify your holdings and hedge when it is financially attractive to do so."[xii]
The very best advice we have read or received on this subject comes from Mr. Greenblatt himself: "Trade the bad ones, invest in the good ones."[xiii]
Additional Ground Rules for Special Situation Investing
Before concluding with our topic of special situation investing in pursuit of absolute returns, we wish to reprint a few words of caution. Our foray into special situation investing is undertaken with the goal of achieving positive absolute returns while hedging and reducing risk, not in order to increase risk. We urge the Reader to study the following words carefully.
Immediately below we quote more of what Benjamin Graham said in the appendix to Security Analysis on the subject.
"The essence of a special situation is an expected corporate (not market) development, within a time period estimable in the light of past experience. Thus, here, as almost everywhere else in finance, wide experience is a major factor in lasting success; it must be supplemented by careful study of each situation and the possession of sound though somewhat specialized judgment."[xiv] (Emphasis added)
Upon embarking on our personal study and experimentation with special situation investing, nearly one decade ago, we followed almost every caution provided to us. In instances where we deviated from this counsel, we suffered unacceptable results. We confirmed that very significant rewards are possible within this particular area of investment, and that disciplined and vigilant adherence to the words of warning are of the utmost importance.
And to further quote Warren Buffett on "work-outs," we reproduce the below.
"We attempt to obtain all facts possible, continue to keep abreast of developments and evaluate all of this in terms of our experience. We certainly don't go into all the deals that come along - there is considerable variation in their attractiveness. When a workout falls through, the resulting market value shrink is substantial. Therefore, you cannot afford many errors, although we fully realize we are going to have them occasionally."[xv] (Emphasis added)
This particular comment was made specifically in the context of merger arbitrage, but it applies to various applications of special situation investing.
And some wise advice from Joel Greenblatt is copied below.
"So, am I that crazy cop, the one whose partner's always getting killed? You know, I keep making money investing in all of these special corporate situations while you end up in a fetal position wearing an old pair of feety pajamas? Well, the truth is, I could be that cop. Whether I am or not is largely up to you.
"While it's true that you can be a stock market genius, there's no guarantee that you will be. Like the acquisition of any new skill, becoming a good investor can take both time and practice. By leading you to new investment areas where the odds are stacked in your favor, I've tried to give you a big head start. But you still have to use good judgment. If you're not already an experienced stock-market investor, you might start off investing only a small portion of your assets in these special corporate situations. As your experience and knowledge expand, you may feel confident enough to commit a larger share of your resources."[xvi] (Emphasis added)
Note, we have been testing and experimenting with the special situations described in Joel Greenblatt's first book for the better part of a decade now, and we can attest to the validity of the opportunities, and the risks, described therein. We followed his directions, and on average, they worked out far better than we anticipated; though this may have been a function of when we began deploying them in mid-2008. In an effort to make a comprehensive study of this area, we intentionally (though foolishly) violated one or two of his warnings, and we validated the cautions, as well.
We conclude with the following quote from Seth A. Klarman, which accurately sums up our view of the market landscape in which we find ourselves today, as well as the relative prudence of a special situation investment such as we find in Paratek.
"At times when interest rates are unusually low, however, investors are likely to find very high multiples being applied to share prices. Investors who pay these high multiples are dependent on interest rates remaining low, but no one can be certain that they will. This means that when interest rates are unusually low, investors should be particularly reluctant to commit capital to long-term holdings unless outstanding opportunities become available, with a preference for either holding cash or investing in short-term holdings that quickly return cash for possible redeployment when available returns are more attractive." [xvii]
We believe the above quote accurately describes the broader market environment in which we find ourselves in 2017, and hence this argument for time-specific, special situation investing in pursuit of absolute returns, irrespective of the course of the broader market. As value investors, our opportunity to "make hay" generally occurs during and immediately following sharp market corrections and economic downturns. During the most exuberant phase of the market cycle, when compelling value investments are more infrequent, we exercise the patience and discipline to hold cash, and to invest in the odd special situation to complement a more sparse value portfolio.
[i] As of this writing, Tetraphase (NASDAQ:TTPH) is trading at roughly net cash, and Cempra is trading at less than net cash per share.
[ii] Note, is it possible that we hold longer than 6-18 months as a long-term investment, depending on how the identified special situation play out? Yes, it is possible we may maintain some position beyond this stage, either due to favorable commercial prospects, as a long-term commercial investment in which we have a low-cost basis, or possibly even in speculation of a take-out, but we would not hold it as a continuation of this particular special situation, and whatever we may choose to do will be based on the investment merits and available alternative investments at such a time.
[iii] Note, we cannot adequately predict within reasonable error limits the timeframe for any possible sale/acquisition/merger. Although this possibility exists, we are not incorporating that into our investment thesis.
[iv] See, for example http://www.fdareview.org/03_drug_development.php for average probabilities.
[v] The astute reader will note that we are not specifically identifying post-FDA approval marketing risks or execution risks. This apparent oversight is intentional. We are evaluating PRTK as a special situation investment, with emphasis on the Phase 3 trials and the submission and FDA acceptance of the NDA. This limits our time horizon, and to some extent, our limited time horizon limits the risks that are likely to occur within said time horizon. Thus, although there are real risks outside our investment horizon, we try to remain aware of them from a net present value perspective, but only insofar as we evaluate whether they are applicable, and to what degree.
[vi] Berkshire Hathaway Annual Letter 1977, 1978, etc.
[viii] Pfizer 2015 Form 10-K Financial Report, p. 24.
[x] Thanks to Jim Roumell for this link.
[xi] See for example the BPL 1961 Letter, p. 7.
[xii] Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor, Harper Business, Seth A. Klarman, p. 94.
[xiii] Greenblatt, You Can Be a Stock Market Genius, First Fireside Edition 1999, p 180.
[xiv] See specifically, Note 48 (p. 631 of the text), pp 734 in the classic 1951 edition, in which is included the reprint of SPECIAL SITUATIONS, an Article from the Analysts Journal, Fourth Quarter, 1946 (with Sequels Added).
[xv] Buffett Partnership, Ltd. 1963 Annual Letter, Appendix 3, at the end of a section describing a work-out in Texas National Petroleum (NYSE:TNP).
[xvi] Greenblatt, You Can Be a Stock Market Genius, First Fireside Edition 1999, p 239.
[xvii] Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor, Harper Business, Seth A. Klarman, p. 127.
Disclosure: I am/we are long PRTK.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.