FOOL ON THE HILL
My Worst Investment in 2002

As undesirable as it is to make investment mistakes, they can lead to valuable lessons. In the case of Elan Pharmaceuticals, which fell from $45 to $3 over the course of 2002, the key portfolio management lessons were: 1) Don't pour good money after bad; and, 2) Don't let your losers run.

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By Matt Richey (TMF Matt)
December 30, 2002

With the year winding to a close, I'm in reflection mode as I look back on my investment performance in 2002. Given the tough market, I'm thankful I managed a positive overall return. But my portfolio wasn't without its share of mistakes, and this is where most of my thoughts are revolving right now.

Why? Not because I'm beating myself up over what I woulda-coulda-shoulda done. But rather, I'm looking at my investment mistakes because, hard as it is, therein lies the secret to improving my future returns. In this, investing is no different from any other pursuit in life: Improvement begins with a teachable spirit. And being teachable starts with a willingness to look at one's mistakes. So here I go...

For me in 2002, the mistakes that most stand out fall under the umbrella of sub-par portfolio management. For example, I made mistakes overweighting some stocks while underweighting others. As a result, my losses were sometimes made more severe and my gains less substantial than they should have been.

This is nowhere more evident than in my very best and worst stock picks of the year, where, sadly, I lost more money and made less money, respectively, than I should have. Today, I'll tell the tale of my biggest loser, and I'll be back tomorrow with the story of my biggest winner. In each case, I've learned a couple of major port management lessons.

First up, my big, fat, Irish loser: Dublin-based Elan Pharmaceuticals (NYSE: ELN). This has been a dog's dog of a stock. A year ago, Elan traded above $45; today, the share price is below $3. Even though I didn't jump into the fray with my first buy until $12.95, I still managed to lose a cumulative 81% of my investment. And because this was a big dog in my portfolio, its bite chomped a hole out of my full-year return measuring 11.3% in diameter. Ouch!

Prelude to a falling knife
Let's dial back the clock one year and take a look at what happened. Elan entered 2002 with all the signs of a healthy, even thriving pharmaceutical company. Products included seven marketed drugs with growing sales, plus a full pipeline of new drug candidates. Having averaged sales growth of 47% annually since 1997, the company was due for a breather in 2002, with 10% sales growth anticipated. Profits were expected to be strong, though. Analysts were calling for 2002 earnings per share (EPS) of $2.35. So at the Jan. 2 closing price of $44.35, the stock was selling for what appeared to be a reasonable 19 times forward earnings.

But the stock trickled downward throughout January, until the first bombshell hit on Jan. 30. Overnight, The Wall Street Journal Europe ran a story questioning Elan's research and development joint ventures (R&D JVs). These entities pushed the accounting envelope and were rightly criticized as being a source of aggressive revenue recognition. That day, the stock plummeted, falling from a previous close of $35.20 to as low as $22.40 before finally closing at $29.25.

From my perspective, Elan's R&D JVs were an illegitimate source of revenue, but not an illegitimate means of drug development. These JVs were, after all, being used to create real drugs, as could be seen by the successful partnerships with Ligand Pharmaceuticals (Nasdaq: LGND) and Isis Pharmaceuticals (Nasdaq: ISIS). The only problem was that revenue shouldn't have been recognized upon JV's creation. As such, I compensated for the questionable revenue by reducing management's EPS guidance by $0.50 (my own estimate). At that reduced estimate of $1.85, the stock (at $29.25) was trading for a forward P/E of about 16. It appeared to be getting cheap, but I was still in wait-and-watch mode.

And it's a good thing, too, because on Feb. 4, Elan's management sent shock waves through the financial markets when it warned of a massive shortfall in its 2002 earnings, which it blamed on product-launch delays and higher costs. The new earnings guidance called for EPS of $1.55 to $1.65. After deducting $0.50 for the questionable R&D JV-based revenue, I saw "real" 2002 EPS as being $1.05 to $1.15. With the stock now down to $14.85, the forward P/E appeared to be only about 13.5. This for a company with $700 million in net cash on the balance sheet. I was beginning to get interested.

So on Feb. 5, I took the plunge and bought shares at $12.95. It appeared that I'd been able to snag a profitable drug franchise at a conservatively estimated P/E of under 13. I felt pretty smart in my timing as, for a while, the stock actually rebounded to the mid-teens. But by April, I was underwater. And in May, the stock dropped below $10.

Feeling that my thesis was still intact, I doubled down on May 15 and May 16 at an average price of $9.68. But still the stock was headed lower. On June 4 and June 6, I tripled down at an average price of $8.33. The stock had taken a hit on June 6, when David Maris, an analyst for Credit Suisse First Boston, issued a research report questioning the company's earnings and cash situation.

Throughout June, Elan's stock drifted down slowly, almost imperceptibly from the high-single digits to a June 27 close of $6.60. I nervously clung to my shares, thinking that Elan's fundamentals were intact. But the fundamentals took a hit on June 28, when news hit that a competitor, Eon Labs (Nasdaq: ELAB), had produced a generic version of Zanaflex, Elan's largest marketed drug. This news came as a major blow because the market had not expected this approval to come nearly so soon. On June 28, Elan's stock opened at $5.90 and closed at $5.47. This was the beginning of the end.

Two business days later, on July 2, Merrill Lynch sent a stake through the heart of Elan's stock by downgrading it to "long-term neutral" from "strong buy," due to uncertainties raised in Elan's July 1 20-F filing. The stock crumbled on this news, closing at $1.65.

Soon thereafter, I threw in the towel -- mostly out of sheer disgust for how the situation had unraveled. I sold all of my shares on July 12 for $1.93. Again, that was an 81% cumulative loss that hit my portfolio to the tune of 11.3%.

As a postlude, Elan is now expected to post a loss of -$0.02 in 2002 and an even larger loss in 2003 (-$0.27). Clearly, my understanding of Elan's fundamentals was flawed from the get-go. On one hand, a lesson learned could be, "Know your thesis better." True, but I don't think I skimped on my research. Another lesson might be, "Beware when you see one cockroach -- there are bound to be more coming." Yes, but plenty of times, I've been rewarded for investing in stocks that have taken a hit for temporary bad news. That's why, in the final analysis, the lessons I most learned from Elan are in the area of portfolio management.

Lesson 1: Don't pour good money after bad
When you're a value investor, there's an incredible temptation to buy more of a stock as it becomes cheaper. But I've discovered it's critical to put no more money in a stock than you planned originally. If your standard position size is 5%, and you buy a 5% position to start off with, then you should refuse to make additional buys.

In the case of Elan, I intended to make it a 10% position, so the first and second buys were alright (they totaled about 10%), but the third buy (on June 4 and June 6) was out of line. My loss was already destined to be large, but I made the situation that much worse by pouring an unreasonable amount of capital into a single position.

Lesson 2: Don't let your losers run
This one is bound to be controversial, but I've come to the conclusion that if a stock falls 20% from my purchase price, then I need to sell and reconsider my thesis. Obviously, Mr. Market isn't always right, and a 20% move against me doesn't mean I'm wrong, but I see this automatic sell discipline as a way to protect myself against my own lack of objectivity.

The unavoidable reality is that when I own a stock, I'm biased to look at the facts in a light that's favorable to my position. By selling after a 20% fall from my purchase price, I can take a timeout to objectively reconsider my thesis. Then, if after careful evaluation, I decide the stock is a bargain, there's no harm in repurchasing.

In the case of Elan, had I utilized the 20% loss sell rule, I might've limited my losses substantially. Who knows whether I would've eventually repurchased shares and ultimately lost a ton of money, but at least I would've had a chance to reevaluate the facts and potentially take an objective look at Elan's shady management team.

Tomorrow, lessons from a winner
In the end, Elan was a horrible loser, but one from which I learned lessons that I believe will help me reap more gains in the years to come. Tomorrow, I'll be back to tell you a few more port management lessons I learned this year, but from the perspective of my biggest winner.

Matt Richey (MattR@fool.com) is a senior investment analyst for The Motley Fool. For Matt's best Foolish stock ideas and in-depth analysis that you won't find anywhere else each month, check out our newsletter, The Motley Fool Select. The Motley Fool is investors writing for investors.