In today's column, I'd like to answer an email that was sent to me by Alan, a reader of one of my recent columns with whom I have now traded several emails and a phone call in the last couple of days. This was his first email to me:
I just saw your article on penny stocks. I am heavily invested in one penny stock that is about to bust out big time. The company is Peregrine Pharmaceuticals (Nasdaq: PPHM), a cancer biotech. I've probably violated all of the "rules" with this stock as I have over 95% of my investment in this company. The thing is, the more I research the company, the more I believe it would be foolish for me to do anything else. In fact, I nearly moved my last bit of investment out of Disney and into Peregrine, making it 100% of my investment. My projections are that this company can be as big or bigger than Genentech is today in 4-7 years. That's when I get to retire.
Of course Alan is right -- he is breaking all the rules of investing -- and not in a good way. Putting 100% of your portfolio into one stock, any stock, is very, very risky, and I don't think anybody who knows anything about investing would tell you different. But to ride ALL of your money on a development stage biotech company is the ultimate gamble. This isn't Berkshire Hathaway (NYSE: BRK.A) or General Electric (NYSE: GE) we're talking about here -- this is a company that is two years away from even having a product on the market.
Speaking of Berkshire Hathaway, I often hear people make arguments in favor of running super-concentrated portfolios. This is based upon Buffett's oft-quoted principle that in investing, you want to wait for your perfect pitch, and to make a big bet when you do swing. It's the Barry Bonds school of investing -- wait for the perfect pitch, then hit it out of the park. Of course, Buffett's idea of a perfect pitch is to buy a company with a tremendous moat around its business that generates great returns on capital at a bargain price. I don't think that a development stage biotech company fits the bill, because if you strike out, you don't get another chance to bat. In investing, it's critical to keep yourself in the game.
But lest you think that Alan is a backwoods yahoo, let me tell you that after reading his mails and talking to him on the phone, I am convinced that he is smart as a tack and that he has done some serious research as well. He's just really convinced that Peregrine is a perfect pitch.
This leads to a very interesting question. What do you do when you are convinced you have the investment of a lifetime? Obviously, you want to put as much into it as you think prudent -- if it's a 50-bagger, you may be set for life. But what if something goes wrong?
The Kodak Moment
When something does go wrong, it can be a devastating picture. I don't know if you saw the Senate committee hearing about Enron's blowup on C-Span the other day (by the way, if you didn't, you should read expert witness and Fool colleague Bill Mann's brilliant testimony). There were several good folks who had virtually all of their wealth invested in Enron, which made them all very wealthy right up until things went bad. One older guy had over $1.3 million in his retirement account, and now it's gone. Nada, nothing, zippo. (Well, I think he had about $20,000 left, which sounds very similar to "zippo" when you used to have $1.3 million.)
That's the "after" picture. Want to know what the "before" picture looks like. It probably looks a lot like Alan if he isn't careful (and by the way, Alan is in his late 30s, married, and has a small army of children, so this will be a family photo.) But how does Alan satisfy his conviction about this stock without risking a total blowup?
Making the argument
Here are my thoughts on the subject. First, for most people, I think that the absolute upper limit for any single position in a portfolio should be somewhere around 25%. And that's if you are very risk tolerant. This limit probably should drop as your age increases -- if you are under 30, then a 25% stake is probably fine. If you are in your thirties and forties, you would probably want to limit your exposure to any one stock to no more than 20%. And if you are older than 60 (especially if you are retired), you probably want to limit your risk by limiting any one holding to about 10% of your portfolio. This is just my opinion, of course, and the "focus investing" style, as practiced by Buffett (and explored by Robert Hagstrom in his book, The Warren Buffett Portfolio) has many fans. Remember, I'm talking about "most people," and Warren Buffett is anything but.
As far as Alan and Peregrine are concerned, I can not recommend to Alan putting more than 10% of his portfolio in the stock. My rationale is that there are two ways to play the small-cap biotech investing game. The first way is to play it the way Alan is playing it -- just to let it all ride on your favorite horse. If you win, you win big. If you lose, you lose big. The odds favor the latter, and while nobody can give you precise odds, I'd guess that it's not even close to 50/50. Maybe it's one in ten. The biotech sector is littered with companies that were once shiny and full of promise, only to take it on the chin when the expected FDA approval did not materialize. Take a gander at a two-year chart of Praecis Pharmaceuticals (Nasdaq: PRCS) or Cell Pathways (Nasdaq: CPTH) for examples. I'm still rooting for both of these companies by the way, though I've never owned the stocks.
The other way is to play the biotech game by the probabilities. Build a basket of three or more small-cap biotech stocks that you believe have a high probability of payoff, and try to purchase them at reasonable prices. Chances are, you'll get satisfactory overall results, and you still have an outside chance of a big winner (or two!). This is much more like being the casino rather than the gambler -- the longer you play the game, the better you get at it, the more the cumulative odds work in your favor, and the higher the probability that you win in the end.
I'll be back next week to look at Peregrine Pharmaceuticals, and we'll see if Alan's comparisons to Genentech have any merit. For those of you interested in the biotech sector, my favorite small-cap biotech stocks, as well as stock ideas from 15 other industries, are included in our special year-end investing product, Industry Focus 2002.
I'd like to thank Alan for his correspondence, and I wish a Merry Christmas and Happy New Year to you!
Zeke Ashton does not own shares in Peregrine Pharmaceuticals or any of the biotech stocks mentioned in this article. Zeke does own Berkshire Hathaway stock. The Motley Fool is investors writing for investors.