Happy post-Labor Day! With school bells ringing again (and we think they're computer driven, not the old, rope-pull type), we turn to investing Sell School. Two flashing red signals to sell, taken from David and Tom Gardner's new book What To Do With Your Money Now, are: 1. The stock is overvalued, and 2. You've found a much more attractive place to invest your money.
Enjoy last week's column for a first look at sell criteria and the Rule Breaker Portfolio. It's not too late to share your opinion on whether we should sell our AOL Time Warner (NYSE: AOL) stake. Please, chime in.
Today, we examine whether any of our holdings are overvalued, and if there are better investments for this portfolio.
Overvalued, and not in a good way
When we invest in unprofitable, developing companies, we speculate on the glorious future of net cash-eaters. The Rule Breaker strategy first focuses on the business and management. Once a company passes that test, we evaluate its stock. We look at the stock's current valuation and extrapolate whether, if the business succeeds, our investment will return 10 times in five years. If we're going to take risks, we want the possible returns to be high.
A bleak five years for HGS
The potential we saw in the five years after we purchased shares of Human Genome Sciences (Nasdaq: HGSI) is all but gone. We bought it for several reason, most prominently its therapeutic protein-drug pipeline. But recent disappointments -- including one Phase 2 drug that unfortunately bit the dust one day after I wrote a glowing column on the company (doh!) -- mean it's nearly impossible for the company to have a drug approved in the next few years from which it earns anything more than royalties.
Human Genome Sciences (HGS) could be working on some magic partnering or purchasing deal. But CEO William Haseltine, a managerial whiz who assembled a terrific executive team, has been essentially dangling this possible deal in front of shareholders for years, while maintaining HGS is secure enough to determine its own destiny. All the while, revenues just trickle -- down.
Behind the Phase 2 drugs are many promising candidates, including HGS's albumin fusion technology and immune stimulator BLyS. Company execs say HGS's albumin fusion technology is the best. But at least one biotech insider, Ron Garren, M.D., editor of the biotechINSIGHT newsletter and consultant to New York's InvestBio, told me there's plenty of competing technology with prospects at least as good as HGS's. Garren is more excited about the explosive potential of BLyS (for which the company has received orphan drug designation), but any significant revenue is years away.
That's an opportunity cost. It's one thing to own eBay (Nasdaq: EBAY) or Starbucks (Nasdaq: SBUX) with a reasonable imagination about what those companies could look like in 10 years. You balance the potential with the fact that the downside isn't huge. From today's levels, HGS is likely to offer mediocre returns over the next five years.
Significantly overvalued, relative to your fair-value price
While it's difficult to, with a straight face, use traditional valuation metrics on a Rule Breaking company in the development stage with no profits, we can -- we must -- use them for profitable companies to gauge whether putting our money here offers more potential than there.
Using one of those measurements (enterprise value divided by trailing 12 months free cash flow), Starbucks, eBay, and Amgen are almost certainly overvalued today relative to their next few years' growth.
EV/ FCF Growth Ticker FCF(TTM) Rate (1)* (2) AMGN 42 14% -13% EBAY 71 -8% 331% SBUX 83 381% neg. to pos.
*Growth of most recent four quarters vs.
four to second-most recent
**Most recent two fiscal years
The catch is "next few years' growth." The longer you plan to hold a company from which you expect growth, the less overpaying today matters. You never want to overpay, but time can heal all wounds (or as in love, can wound all heels). Valuation always matters, but so does your willingness to hold.
There's too much potential for Starbucks' and eBay's vast growth to cut them loose on valuation grounds -- but if and when either company takes a breath from growth, the stock will be hit hard. And eBay merits a closer look in a future column, at least because it occupies 23% of the portfolio's value.
That leaves Amgen, which has been overvalued for at least five years and offers less potential. A year ago April, I first urged selling it. Then in December and February, I considered the Amgen-Immunex deal and beat the drum again. It's a free cash flow machine valued as if platinum-plated.
Is yours truly all hat and no cattle?
So why didn't we sell? David Gardner asked me why I didn't press the Amgen case harder. Good question. I banged the drum for HGS in April, but fell back a little, too. Why? Do I lack the courage of my investing convictions? Am I a weak portfolio co-manager? Was my older brother right when he told me I could be replaced by an inoperative button?
No! The simple answer is I couldn't satisfy a major -- if not the major -- sell criterion. I had not found...
A more attractive place to invest the money.
You don't move money from one stock to another unless the new one offers a better return. Of course, if the current place is lousy, then a broad-market index fund or even a money market is better. That doesn't take much cogitation. But other stocks?
We don't sell lightly, because we want to deploy the cash in better investments. We'd have a lot of green stuff, too, if we added our current stakes in Standard and Poor's Depository Receipts (AMEX: SPY) (SPDRs) and HGS to the proceeds from covering our Sirius short while it's still profitable:
Shares Ticker Price Total 290 SPY $91.78 $26,616.20 590 HGSI $15.06 8,885.40 2500 SIRI ($6.90)* 13,475.00 Deployable Bucks $48,976.60 *Shorted at $6.90, Friday close $1.51.
And if we tried my suggestion from last week, selling half of AOL and keeping the other half, that adds another $25,426.50, to equal $74,403.10. That's before taking one thin dime, one measly Fool Buck, out of Amgen!
So at the very least, we have $26,616.20 in SPDRs to think about, and potentially as much as 25% of the portfolio. No wonder we didn't have to add quarterly cash in July.
There's a place for us
What's out there? Jeff Fischer (TMF Jeff) and I both see great opportunity for antisense technology leader ISIS Pharmaceuticals (Nasdaq: ISIS). Eli Lilly (Nasdaq: LLY) gave the company a life-preserving deal last August and partnered for ISIS's non-small cell lung cancer candidate, Affinitac, which sports fast-track review status from the Food & Drug Administration.
What about environmental DNA and gene-shuffler Diversa (Nasdaq: DVSA)? Profitable and growing semiconductor intellectual-property company ARM Holdings (Nasdaq: ARMHY), which some call a Microsoft in the making? Or Level 3 Communications (Nasdaq: LVLT), which may be the last one standing in fiber-optic networks and owner of the game when -- and if -- telecom recovers?
Is JetBlue Airways (Nasdaq: JBLU) a Rule Breaker, or just another airline benefiting from lower barriers to entry when labor costs and debt bring down the majors (who remembers People's Express)? What about NVIDIA (Nasdaq: NVDA), the kingpin of new-era graphics chips? Or my perennial favorite, networked device company Echelon (Nasdaq: ELON)?
Stop me before I type another question. You know the Rule Breaker strategy (and if you don't, review quickly). Which investments offer better opportunity than what we own? Please make your case on the Rule Breaker -- Companies discussion board.
Have a most Foolish week! Updated portfolio returns below.
Tom Jacobs (TMF Tom9) still can't believe he dulled the head on a masonry bit drilling into brick this weekend. Luckily, it was the last hole. At press time, he owned shares of ISIS Pharmaceuticals, Echelon, ARM Holdings, Diversa, and Millennium Pharmaceuticals. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.
Rule Breaker Portfolio Returns as of 8/30/02 Market Close:
RB S&P S&P 500 Port 500 DA* Nasdaq Week -3.45%** -3.36% -- -5.57% Month +2.15%** +0.49% -- -1.06% Year -27.33%** -20.21% -- -32.62% CAGR*** since 8/4/94 +20.81% +8.95% +10.83% +7.73%
*Dividends added. Or, danger ahead. Whatever.
**Please keep in mind that these figures will be distorted for the RB Port for the short period around which we add any cash (see next note!). Since July 2001, we consider depositing $12,500 in new cash each quarter unless we have enough available for new investments without it.
***Compound Annual Growth Rate using Internal Rate of Return. This performance measure is more meaningful than total return because we began adding cash occasionally in July 2001. In a total return calculation, or ((Current Value - All Cash Deposited)/All Cash Deposited), cash added would show up as returns. And that wouldn't be cricket!