March 9, 2015
I appreciate the chance to contribute to Brian and Jolyon’s forum. I have long admired their bold decision to fill a vacuum in Canadian healthcare investment banking at a time when the economic sentiment was anything but optimistic. Of course the pessimism of 2008 has evolved into exuberance over the past couple of years.
How do we maintain our focus and discipline as market conditions change?
And how can our partners in management and banking help?
Of course we start with fundamentals. The biotechnology and life sciences industries are built on a foundation of rapid and dramatic innovation in the basic sciences, an environment that can lead to well intentioned investing with poor outcomes. Part of the challenge is that companies in the space have long incubation periods between inception and revenue generation, and lack the easy quarterly financial benchmarks that investors typically use to measure value creation. Instead of objective and certified statements of profit and loss, we use surrogate markers to evaluate these companies: clinical trial results, progress towards regulatory approval, outside validation through strategic partnerships and the gradual accumulation of an experienced team as the company progresses from one core competence to another.
In order for investors to confidently mark progress in these more difficult-to-value companies, it’s essential that companies communicate clearly, setting reasonable expectations for milestones and honestly handicapping outcomes. Management decisions can facilitate this process in two ways: by strong execution on the operational side of their business and by creating a capital structure that fosters transparency of ownership to prospective investors and avoids making common stock a derivative of other securities.
While we appreciate scientific and product development progress in a vacuum, we do want it to translate into higher valuations of our positions. Imprecise and shifting guidance or promotional rather than honest representation of a company’s assets are factors that repel stable investors, and those are crucial to biotechs because they will not only hold but add to their positions as the company executes.
Complex capital structures, layered with convertible debt or preferred equity, obscure just how much of a company a common stock investor is buying during a transaction. A share count grossly inflated with warrants or similar derivatives makes ownership in a company much less attractive by giving the warrant holders the opportunity for risk-free short trades that effectively cap the share price and make subsequent fund raising more difficult. Many companies failed to survive the toxic convertibles of a decade ago, but even today a poorly-conceived capital structure can make a company uninvestable.
By focusing on fundamentals, and supporting companies managed to build marketable value, we can confidently ignore what’s “hot” and instead focus on what’s valuable.
David Sable MD directs healthcare and life science investing for the Special Situations Funds and is portfolio manager of the Special Situations Life Sciences Fund.