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.


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