Wednesday, February 15, 2012


"It is expensive to sit on cash."

"I gave you my money to invest in the markets, not to sit on it and do nothing with it."

Yes, investors dish out plenty of advice to 'professional' money managers. If the 'professional' does not oblige, the investor takes her money back and gives it to a 'professional' who will oblige and invest every last cent in stocks right away. If this is the case, we would advise the investor to keep her money and just buy an index fund, saving herself the fees and expenses associated with 'active' and 'professional' money management. This is because being fully invested makes sense only when Mr. Market is throwing fat pitches at us - we define a fat pitch as a company which is trading at a significant discount to its intrinsic value. This is when you want to go all out and swing confidently. Otherwise, you need to keep cash on hand to take advantage of the fat pitches when they are thrown sometime in the future. If you were planning to buy and own a private business, would you buy it when sellers are demanding a premium for their businesses or would you wait until you find a distressed seller who must sell his business at a price you perceive to be attractive?

If an investor trusts her risk capital to an asset manager, then presumably she has assessed the opportunity cost of parting with this capital for a reasonable period of time. There is no sense in coercing the manager into taking undue risk because you don't want the manager to 'just sit on cash'. The manager's task is to provide the investor with reasonable absolute returns over an entire business cycle. If the investor does not have the patience for this and has better uses for her cash, then by all means she should have never parted with it to begin with.

In the end, the asset manager's job is to own high quality businesses which will prosper over time, resulting in higher stock prices which will therefore increase the purchasing power of our hypothetical investor. The magic is to buy these businesses at attractive valuations and with plenty of margin of safety. This is possible only if the manager has had the foresight to hold onto cash, waiting for opportunities when volatile markets cause the valuation of securities to decline below their long-term intrinsic value. No cash, no possibility of taking advantage of Mr. Market's gyrations.

We recently watched an interview with Matthew McLennan, the portfolio manager of First Eagle Funds (of Jean-Marie Eveillard fame), who eloquently articulated the need to maintain cash on hand when constructing a portfolio of stocks. Mr. McLennan notes that markets are like stormy waters and investing is analogous to sailing a ship through the choppy waters without getting thrown overboard. It is the cash on hand which provides the ballast the ship needs to avoid disaster as Mr. Market's mood fluctuates from giddy to fearful. Without that ballast, the investor would never have the chance to take advantage of the fat pitches.

Do not be afraid to hold onto cash in your portfolio. But also do not be afraid to be greedy when others are fearful. These days investing in the bluest of blue chip global companies will enrich you with highly attractive dividend yields (much better than locking your capital in 10 Yr Treasuries for a meager 2%) while providing you with the opportunity to participate in the future growth of these wonderful enterprises. Intel (NASDAQ: INTC), General Electric (NYSE: GE) and Coca Cola (NYSE: KO) are a few names that come to mind. Happy sailing.


Thursday, January 19, 2012

Nucs Proliferate

Gilead's acquisition of Pharmasset (NASDAQ: VRUS) has been completed and PSI-7977 is now safely tucked into Gilead's pipeline drawer. As we discussed earlier this year, this was a relatively attractive merger arbitrage opportunity if you could stomach some downside risk.

Sure enough, the love affair with pre-approved HCV products and the companies developing them continues to proliferate. On January 8th, Bristol-Myers (NYSE: BMY) announced it will acquire Inhibitex (NASDAQ: INHX) for $26 or $2.5B. Inhibitex shares were trading at around $10 before the announcement. Inhibitex's crown jewel is INX-189, a nucleotide polymerase inhibitor or "Nuke" for short. For obvious reasons I prefer the acronym "Nuc". If you want to know what a Nuc looks like, here is a nice picture:

Inhibitex shares are trading at $24.61 today. By buying the shares and waiting for the acquisition to be completed, the return on investment would be 5.65%. The acquisition is expected to be closed by February 10th and would result in a spectacular annualized return.

It is important to note that this investment opportunity is somewhat riskier than the Gilead/Pharmasset merger arbitrage trade. INX-189 has not cleared the all important 12 week hurdle in its Phase II trials and therefore it is possible that an adverse event such as liver toxicity signals in patients enrolled in the trials will occur prior to close, scuttling the acquisition.

The bidding for Inhibitex was a competitive process as Bristol-Myers had to raise its offer several times to fend off other companies which rumors suggest included Johnson & Johnson and Merck. I highly recommend that you read the Tender Offer filing by Bristol-Myers, which lays out the bidding process in detail, prior to making an investment in Inhibitex shares. You will note that Bristol-Myers was able to review non-public material information prior to making its bid. Somewhat comforting.


Thursday, January 05, 2012


It has been a while since I made any changes to the Model Portfolio. That may be an understatement since the last trade in the portfolio was completed in October of 2009. Cadbury Schweppes did get gobbled up by Kraft (NYSE: KFT) which itself is spinning in to two companies. Two companies we have discussed in the past and held for some time in the portfolio.

I have decided to stop maintaining this portfolio going forward as I simply do not have the time to manage it. Having said that, I will continue to track the performance of the portfolio as is (including the cash position). It will be an interesting 'buy-and-hold' experiment to look back on years from now.

Since inception on September 1, 2006 the Model Portfolio's NAV increased by 16% versus the S&P 500's total return of 8.09% through the end of 2011. This does not include any dividends received since September 2010. Below is a snapshot of the portfolio as at the end of December 2011.

Monday, January 02, 2012

Start 2012 with a VRUS

It's been over year since I last posted on Margin of Safety. Let's just say life has been super busy. But for 2012 the plan is to post once a month at a minimum. Let's see how that resolution plays out.

A lot has happened since my post on October 2010 and I won't rehash the events of 2011 here in too much detail. Needless to say it was one of the most volatile years for the markets in recent memory. Retail investors abandoned equities in droves and prominent hedge fund managers were clobbered as high correlations apparently offset their superior stock picking skills. Meanwhile in Europe the situation went from bad to worse as leaders struggled to come up with a solution to appease the bond vigilantes. And then there is our favorite Mr. Buffett who was going about his business as usual and was putting his cash to work even as investors were fearing a total world collapse instigated by the affairs in Europe. In 2011 Mr. Buffett became a 5.5% shareholder of IBM (NYSE: IBM) at an average price of $170. IBM ended the year at $183.88. Yup, it seems stock picking does work after all and Mr. Buffett doesn't charge 2/20 to do the picking for you.

So here we are the day before the markets re-open for 2012 and many of the overhangs present in 2011 remain. Certainly the situation in Europe will continue to be on everyone's radar as will the U.S. Presidential race and D.C. politics in general. There are also worries about a Chinese hard landing and a double-dip recession in the U.S. 'Macro' will be the topic of discussion yet again. Investors remain cautious and are sitting on a substantial amount of cash - or they are taking their money out of equities and piling into fixed income securities and specifically U.S. Treasuries. Nevermind that some of the largest blue chip companies in the world will pay you a higher dividend yield than the U.S. 10 Yr. Intel (NASDAQ: INTC), Johnson & Johnson (NYSE: JNJ) and Coca-Cola (NYSE: KO) come to mind.

But there are plenty of other opportunities to take advanatge of which will somewhat insulate your portfolio from Mr. Market's volatility. The key is to focus on investments which are uncorrelated to the markets. Consider a risk arbitrage investment opportunity in shares of Pharmasset (NASDAQ: VRUS) which I profiled on Canada's Business New Network (BNN) on December 19th.

Pharmasset is being acquired by Gilead (NASDAQ: GILD) for $11B or $137 per share. When the announcement was made in late November, Pharmasset shares soared from around $72 to $134. Then the shares began to drift lower and traded as low as $123 before rebounding last Friday to close at $128.20. The deadline to tender shares is midnight January 12, 2012 with the acquisition expected to close shortly after.

The potential reasons for the decline are numerous. What is apparently spooking merger arbitrageurs is the potentially large downside (see below) and the fact that the purchase and sale agreement provides Gilead with a broad Material Adverse Clause (MAC) provision allowing the company to walk away from the deal if there is a Material Adverse Event associated with Pharmasset's Hepatitis C Virus (HCV) drug under development. There are also other conditions which could trigger the MAC but this is the main one. The drug under development is a paradigm changing oral product for treatment of HCV code-named PSI-7977. This is what Gilead is after.

By investing in Pharmasset shares at $128.20 you woud lock in a 6.86% return on your investment. Assuming he deal closes by the end of Q1 (I think it will close in January), the anualized return (a metric used by merger arbitrageurs) would be about 27.44% which is incredibly high. If you really want to juice up your returns, you can also consider selling one January 21, 2012 $125 put option for about $7 for each 100 shares of Pharmasset you purchase. This of course doubles your exposure and magnifies your losses if Gilead walks away from the transaction. But if the transaction goes through, your return on investment including the option premium you collect would be 12.32%.

Of course no investment is without risk hence the term 'risk arbitrage'. Usually such situations offer a lower upside as the target stock trades closer to the acquisition price. At the same time the downside is usually on the order of 20%-30% if the deal is scrapped. This is what merger arbitrageurs are used to. In Pharmasset's case, if something does happen to PSI-7977 between now and closing of the deal, the stock would be decimated by 50%-80%. So you get more juice on the upside but you also have to stomach a potentially very large downside.

In my opinion what the folks in the merger arbitrage camp are missing is that Gilead is an expert in the anti-viral therapeutic space and they would not be putting $11B on the line for a product which is not yet approved by the FDA. The acquisition will almost certainly close before any additional clinical trial results will be announced and most certainly before PSI-7977 is approved. The key is that PSI-7977 has passed some key hurdles which almost guarantee its success including 12 weeks of treatment without any adverse liver signals being detected. By contrast, on December 16th, Pharmasset announced the discontinuation of another pipeline drug PSI-938 due to abnormalities detected in liver function during a Phase IIb trial. This news by the way further spooked the markets and was the reason for the decline in the shares to the $123 level. Nevermind that this news had no bearing on Gilead's offer to acquire Pharmasset. We have talked about Efficient Market Theory before, right?!

Before you invest in Pharmasset I highly urge you to do your own research as well as read the SC-14D9 filing by Pharmasset on for details of the transaction and the negotiations between Gilead and Pharmasset. It's a good read.

All the best for 2012.