The Fine Art of Selling
Selling equities is difficult for me. I become attached them, having rooted for their success, and, whether selling at a loss or at a gain, it is hard to part with that which has consumed so much time and thought. Today, I did just that, and there may be some merit in describing the decisions that led to them.
The first was Biovail (BVF), which I profiled some time back. The company was a producer of generics and, also, a creator of novel therapeutics — bought at the same time as purchases of Forest Labs (FRX), Barr (BRL), and Teva (TEVA). The thesis of purchase, beyond it being undervalued, was that healthcare inflation would continue the institutional payors’ preference for generics. The company, however, has suffered more than its share of difficulties, including law suits and a proxy battle with the founder, which, due to a court ruling this week, will continue for at least another round. During this time, current management made the decision to devote most of the firm’s R&D efforts to researching novel therapeutics (a flipping of strategic focus). While the company may succeed in the long run, and I certainly hope it does, it strikes me as a wandering and dysfunctional enterprise, and, with regret, I sold today at a significant loss (around 30 percent).
A 30 percent loss, by the way, does not bother me, but I must be sold on the company, the quality of management, and the story behind the stock and its future. In fact, Barr lost 30 percent during my ownership of the shares, and, convinced of the company and its prospects, I bought on the way down — prompting my wife to question my sanity. Today, rumors of a purchase of Barr by Teva for the equivalent of $70+ dollars per share gave the stock a one-day boost of more than 20 percent (to $57.17). Concerned about the prospects for Biovail, I elected against buying during the painful decline. The paper gain on BRL easily exceeds the realized loss on BVF by a factor of 3. The truth of the matter, however, is that I should have sold BVF as soon as management outlined the change in strategic focus, and, more importantly, this is a lesson I should not need to learn today — I teach it to my management students.
[BVF Note: I should mention that my initial profile preceded the change in strategic focus by management. This prompted me to pull the profile and to republish it with a description of the change. I have held the stock the entire time.]
Next, is National Oilwell Varco (NOV). I inherited the shares when NOV purchased Grant Prideco, in a stock and cash transaction. Grant Prideco was an excellent company, with sound fundamentals and a cheap stock price. I purchased Grant at a 10 percent discount to its price on the day of the announcement, and NOV paid a further 15 percent premium. I held on to the Grant stock until completion of the merger because I did not like the pre-take-over discount (compared to the time remaining — in what became an arbitrage decision). NOV, however, was overvalued and not as well managed as Grant, but, due to the virtues of size and relative profitability, NOV was the acquiring firm. I would have sold NOV after the merger settled, but NOV’s stock was climbing with the oil boom, and I chose to let it run. The price grew by around 15 percent over a couple months and declined in the last several days, before I sold for a 10 percent grain (more than 20 percent on an annualized basis).
With BVF, I had a hard time because it was the ugly puppy that need someone to love it. With NOV, it was the product of a shot-gun wedding, and the divorce was easy. The third of today’s sells fell between the two.
Gardner Denver, which produces supplies for the oil and natural gas industry screamed “Buy Me” on December 3rd of last year. It was wildly undervalued at $33 (by something on the order of 80 percent by my DCF model). This was before the pundits began raving about oil. So, I bought OXY, OSG, and GDI at around the same time and for the same reasons (i.e., valuation). I have since sold OXY for a nice profit (could not tolerate the CEO’s salary), and OSG is has meandered to an 11 percent gain (and is still a holding in my portfolio). GDI, on the other hand, climbed to a gain of 60+ percent, before dropping marginally in advance of today’s sell.
I did not sell in order to take profits, however. I did so because the company is investing in growth. Now, this may seem nothing less than stupid, but Weighted Average Cost of Capital (12.32 percent) exceeds Cash Return on Invested Capital (8.4 percent), CROIC is just 7.2 percent (weak if the economy is suspect), and Replication Value has exceed Earnings Power Value every year for the past decade. Is all that money spent on growth benefiting the stockholders by increasing the company’s value? If it were, the numbers should be different.
I realize that this week’s posting is shorter than most, and there are not any graphics to display. There is a reason for this, and, blessedly, it has nothing to do with computer problems. I am preparing to speak at a conference in Charleston, SC next week (meeting with senior leaders with the Veterans Administration and the Centers for Medicare and Medicaid services). This blog will, therefore, be up but minus a posting from me until the weekend after next. I do want to cover two items related to investing before closing, however.
First, in a recent posting, I mentioned a phone conversation with a Wall Street equities analyst. At the time, he indicated concern over the market’s health, and this prompted me shift half my holdings into cash. Actually, it was not just his comments that prompted that decision, but, rather, my own concerns on this front, largely drawn from an assortment of recent articles coming out of Europe. All of this was before the testimony before congress this week by Treasury Secretary Paulson and Federal Reserve Chairman Bernanke. Last night, I spoke with my friend again, and he remains persuaded that, despite the government’s intervention with Freddie and Fanny, IndyMac, and the SEC going after naked short sellers, the problems that plagued the markets last week are worse than reported and that we are not yet half way through the problems related to sub-prime, the liquidity crisis, etc. This prompted me to review all of my stock holdings today, and it led to the three selling decisions just described. Those sells were prompted by company fundamentals, however, not rumors or market gyrations. For example, the commodities have taken a hit over other last several days, but I am still holding on to FCX and PCU. The market can go away for the next decade, and I would be happy to own both — even though FCX’s management needs to grow up and stop playing Napoleon.
Second, Gerry recently posted a question following an earlier entry, indicating that he purchased UNH largely based on my defense of the company. While nearly all of my holdings have an 18-month to three-year holding target, UNH is, as indicated, a play on the tectonic shifts related to healthcare and US demographics. The boomers do not start retiring until 2010-2011, after all. UNH, however, is a value today, while it may not be in a year. Because it is so strongly related to healthcare and all the politics that surround it, the stock is likely to be volatile. Consequently, I view UNH as a long-term holding, with “long term” defined in the same way as swans view monogamy — they mate for life, you know. While I will sell if confronting evidence of infidelity, I have been renewing my vows as the market’s love for the stock abates.
In fact, it wasn’t long ago that JNJ was being trashed as a has-been — a sentiment that went away this week with their earnings report. Does this mean that the market gets things wrong? No. Today it is right. Last month it was merely mistaken. And their is no accounting for its ignorance during distant events — the dot.com euphoria, the S&L crisis, the Nifty Fifty, the run-up of the 1920s, or that inexplicable love of tulips we have heard so much about. But, “wrong” today? … never … until, of course, today becomes that distant memory, when others got caught up in the mania but we were conveniently off darning our socks or washing the car.
Robert,
I am trying to find information on Capital Surplus Ratios for non-profit managed care plans. Have you seen any info on this or know where I might be able to find it? Many of the for profit managed care plans are pointing to competition from non-profit health plans as a reason why their recent financial results are deteriorating. I am trying to see if there has been any correlation historically between the non-profit’s surplus capital levels relative to risk based capital requirements and the for profit managed care underwriting cycle. My thought is that even though the underlying cost trend may be increasing, it may be hard for the for profit companies to raise premiums above the cost trend if their competitors (in many cases they are non-profits) continue to price below the cost trend. Thus, it seems logical to me that if non-profit surplus levels relative to risk based capital levels were at peak levels, then it would be a reasonable assumption that these non-profit companies could price below the cost trend for a period of time. Therefore, for profit companies would continue to experience tough competition for an extended period of time. The other side of this is that if the Surplus/RBC ratios are low, then non-profit competition may abate sooner as these businesses would have to begin pricing premiums in-line with/above their costs to rebuild capital levels or maintain them above the required levels.
Thanks for any thoughts you might have.
Jay Douglass
August 13, 2008 at 3:34 am
Jay,
Interesting question. I’m afraid I do not have much to offer on the subject.
What you are describing is the equivalent of a price war, where non-profits have a competitive financial advantage due to the lower tax burden of non-profit status. Senator Charles Grassley (http://grassley.senate.gov/public/) has expressed concern that non-profit hospitals and hospital systems are openly and actively competing against for-profit hospital and hospital systems — making use of this competitive advantage, with the result being an undermining of the fiscal health of for-profits and their portion of the healthcare infrastructure (promoting upward pressure on healthcare inflation, with negative implications for CMS). The surplus scenario you describe would have much the same effect, since for-profit insurance would be compelled to make unsavory choices (from the perspective of CMS) to sustain RBC levels with Medicare Advantage billings.
In the past, CMS has monitored and enforced restrictions on hospital charges prohibiting price-war tactics (i.e., short-term reductions in price to CMS patients). The concern by CMS was that a price war designed to drive the competition from the market would subsequently provide the survivor with greater pricing flexibility and lead to higher costs.
The problem with answering your question more directly is twofold. First, the data and reporting typically falls under the purview of state insurance commissioners, whose principle purpose in collecting the data is to determine the health and solvency of individual insurance firms (for profit and not for profit, alike) — not to determine the likely winners and losers in a free market competitive environment. Second, to encourage accurate reporting, many (if not most or all) states do not require public reporting of this data. (See Section 5808 of Title 18 under Delaware’s Statute, at http://delcode.delaware.gov/title18/c058/index.shtml .) The Delaware statute is important in that many firms incorporate in Delaware due to that state’s more friendly tax policies. Corporate policy, thereafter, is more strongly governed by the laws for the state in which it is incorporated, even though the company is compelled to file and comply with the laws for each state in which it conducts business. I should note that I am not an attorney. Consequently, these comments represent nothing more valid than personal opinion.
My inclination is to believe that, if such a substantial competitive benefit is available and used by non-profits, the law would soon be altered to address the problem, given the implications for the states and federal government. This impact would extend beyond Medicare to include Medicaid, where the states have a stronger role as institutional payor (since Medicaid is a state / federal partnership). In recent years, federal contributions to Medicaid have been cut and, more recently, state tax receipts have been declining due to the economic slowdown.
From an equities investment perspective, it may be beneficial to view this as a contrarian play, if equities pricing of for-profit firms reduces them to value levels. I’ve written about my belief that government is all but compelled to sustain profitability for the major Medicare Advantage firms, so I won’t rehash the logic in support. Nevertheless, the same logic would suggest that government (state and / or federal) would be all but compelled to adjust the laws sufficient to sustain the solvency of for-profit health insurance providers or, alternatively, risk the consequences of the aftermath. In other words, government is in a stronger position if the insurance market is strongly competitive — keeping prices lower than if a price war reduced the number and health of competing firms.
Keep in mind that non-profit status accords a tax benefit designed to encourage coverage of lower income patients and those for whom coverage would not be available through for-profit firms. This includes state and federal government employees under Blue Cross Blue Shield. Government, therefore, has a more direct interest in this market and its stability than when providing oversight of less strongly linked economic sectors. The strategic investor will, consequently, consider the current environment and its trend PLUS the likely response, just as a chess grand master will think seven or eight moves out as the competitors thrust and parry their way toward checkmate or draw.
rcrawford
August 13, 2008 at 5:35 pm