We will repurchase about $25,000 of Human Genome Sciences (Nasdaq: HGSI) sometime in the next five business days. The money will come from the $12,800 in our portfolio currently, plus our quarterly $12,500 investment. We explained last month that we were selling it for tax purposes, and now, at least thirty-one days after our Sept. 20, 2001 sale, we are buying back shares.
Our ever-astute readers will note that we sold our stake at $31.76, but that shares were going for $38.32 a stub at Friday close. Are we happy that the price went up 21% after we sold, erasing the positive effect of the tax sale?
No way. We're bummed!
On the other hand, this is what happens in the market from day to day. People say, "Hey, David's Blue Genes (Ticker: ACGT) is down 10%. Anyone know why?" Or, "Tardior's Latin Book Store (Ticker: OLDE) has spiked skyward this morning. What's up with that?"
If that can happen in a day, imagine a month.
For the most part, these things are due to noise. Often, this takes the form of a press release. Regardless of the significance of news to a company's ability to produce free cash flow, a stock price may react -- in any direction. Somebody won a lawsuit, somebody lost one. Buy! Sell! This is about reaction, rather than reflection. Richard McCaffery offers sound counsel on this very issue:
"Paul Andreassen, a Harvard psychologist, demonstrated with two test groups that investors who paid close attention to daily news reports performed worse than those who ignored the constant flow of water over the news wheel. For more on this story, check out Gary Belsky and Thomas Gilovich's excellent book, Why Smart People Make Big Money Mistakes.
"Now, I think investors should be careful with this concept. We aren't advising ignorance. I like following news stories, since I want to learn as much as possible about my investments. But I don't reevaluate my investing decisions every time I read a story. If trading is in the back of your mind every time a news item crosses your desk, you probably shouldn't own stocks, or you should just own an index fund or low-cost mutual fund. After five years of reading and writing news stories, it's my opinion that 80% of what crosses the wires has no bearing on a company's long-term business prospects."
A recent example illustrates Richard's most excellent point: A bunch of companies gets hammered or pumped en masse due to some perceived benefit or detriment awarded by the news, regardless of whether a company's particular business could actually benefit or be hurt. It's the phenomenon of sector groupthink. As the anthrax news has accumulated, so have stocks having anything remotely to do with it.
For example, we might need testing. Cepheid (Nasdaq: CPHD) has an Anthrax test, right? Its stock price vaults from $2.79 on Oct. 1 to $8.19, drops, jumps, and slides again to $4.70 on Friday. Nanogen (Nasdaq: NGEN) is developing -- not marketing -- some pretty interesting technology for really small (hence, "nano") testing devices. Wow, it just received a $1.5 million three-year grant from the U.S. Army to continue development of its biological warfare detection systems. One-point-five million! Load up the truck! On Oct. 10, the day the company announced the measly grant, its stock climbed from $5.59 to $8.33 and up to $9.12 three trading days later. It closed Friday back down to $7.28.
Is Cepheid's test appropriate? Is it a consumer or hospital product? Who are its competitors? How strong are its business model, management, and finances? Is Nanogen anywhere near having a product it could sell for actual money?
There were other companies too -- companies lumped under the label "biotech" without regard to their individual businesses -- that were moved short term by bioterrorism noise. Perhaps HGS, perhaps not. This is news, not business, and watching the stock moves can drive you nuts. Some of us try to preserve our little remaining sanity by concentrating on the things that matter. Such as, why we're...
Happy to be back with HGS, the business
Our repurchase of HGS makes us happy, even if we're paying more than we sold it for. We now own what we consider two foot-stompin' Rule Breakers that aim to use a slew of newer biotechnologies and genomic information to become big drug makers ("big pharmas" in the parlance) -- HGS and Millennium Pharmaceuticals (Nasdaq: MLNM). In fact, a little over a year ago when we were sniffing around for a new purchase, the two companies made the choice very hard. Now we can love both our Foolish Rule Breaking children equally, risky as they are.
Near-term risk for HGS
At first glance, the biggest risk for investors is that HGS has no drugs in Phase III human testing. There are a number of biotech analysts who advise never buying a biotech drug maker unless it has a drug in Phase III trials. What does that mean?
Ambitious drugs candidates wend their way from lab to hospital and pharmacy through a process that includes three phases of human testing. Drug makers hope that those tests will provide enough data on safety and effectiveness to gain Food & Drug Administration (FDA) approval to market the drug. You can learn more about the drug development process through our InDepth: Biotechnology and Pharmaceuticals pages.
Bruce Goldman wrote in this month's Signals Magazine, "Studies indicate that 30 to 40 percent of compounds fail due to ADMETox (Absorption, Distribution, Metabolism, Excretion, and Toxicity) problems, with the steepest plunges coming during preclinical and Phase I trials." If that weren't enough, a drug industry rule of thumb is that after years of preclinical development, only 10% of the drugs that enter clinical (human) trials will be approved and marketed.
Sixty percent of those that make it past Phase I and Phase II and actually enter Phase III human trials will garner FDA approval and enter the market. Not even those approved are ensured success, because many fail in the marketplace to earn back their parents' research and development costs, let alone provide profits.
These are some pretty good reasons for not going within spitting distance of a newer drug maker that lacks a drug in Phase III trials. So it's no wonder that HGS, with no drugs in Phase III trials, earned this warning when we first bought it a year ago September:
"HGS is our most risky investment to date. It has virtually no revenue. The revenue it hopes to generate in the future depends on the approval of its drugs, the protection of its patents, the acceptance of its technology, and other uncertain factors. Even in the best-case scenario, HGS won't see revenue from its first drug for three to five years. It may make money from its data in the meantime, but that is not its business. Thus, significant revenue is years away, and actual profit some years beyond that, since HGS will spend heavily on research during that time."
Short term, if HGS' next drug in line in Phase II testing -- the potential blockbuster wound-healer repifermin -- doesn't make it into Phase III, the stock will take a hit. You can count on it -- likely 30% or more, such as that Vertex Pharmaceuticals (Nasdaq: VRTX) incurred recently when it pulled a drug after Phase II. We're not investing for that one drug, though. We're investing for the possibility that so many will pass through HGS' pipeline into the hospital and pharmacy in the coming five, ten, and twenty years that we will be rewarded many times over.
All investors in drug makers play the percentages. HGS is filling its pipeline faster and faster with more and more candidates (three to four each this year and next), whose profit rights it either owns completely or shares with partners who have ponied up much of their development costs. We know that there will be failures, but we don't know whether it will be this drug or that.
Sure, we could wait for a failure and buy then, but can anyone tell us when that will be? Doubt it, and we're not holding our breath for the likely next drug in line, repifermin, to fail, given GlaxoSmithKline's (NYSE: GSK) decision a year ago to share costs and benefits for Phase III trials and beyond. Failure might come tomorrow or it might not come for three drugs, in which case we would likely have missed substantial gain.
Bottom line? The company's lack of a Phase III drug is a near-term risk, and it's one we're more than willing to take. Welcome back to the portfolio, HGS.
P.S. That pesky short-term increase in HGS shares since we sold? Don't forget to balance it with the short-term gain on Millennium shares we bought at $16.06 -- shares we wouldn't have bought at the time without the corresponding HGS sale. Millennium closed Friday at $22.87, up 42% on paper.
Have a great week, and best Foolish wishes to y'all!
--Tom Jacobs (TMF Tom9 when strolling the discussion boards)
When faced with trouble, Tom Jacobs (TMF Tom9) sends in the clones. He owns shares of Millennium Pharmaceuticals and Vertex Pharmaceuticals. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.
