FREE KIC - NO. 29 FEB 08
EXPERIMENTING
WITH DRUGS
I have written on a number of occasions
about my admiration for Warren Buffett. When faced with a new investment idea I
will often end up asking myself “What would Warren do in this situation”. Sometimes I
have come to the conclusion that he would answer by saying that he would
dismiss the idea. One particular example of this has been in relation to my
investments in technology companies. Warren
regularly says that he never invests in technology because he doesn’t
understand it.
When I thought about investing in ASM
Pacific and Linear Technology I had to recognise that I did not fully understand
the underlying technology. I have written about these two companies in other
opinion pieces (No 15 and 16) and I go into a lot of detail as to why I have
been prepared to break one of Warrens main rules.
Maybe the magnificent returns on ASM
Pacific have been down to good luck because at the end of the day I do not know
whether they will continue to dominate the wire bonder market. Maybe Linear
Technology will never generate the type of returns I need to justify the risk
but at the end of the day I have tried to develop my own way to invest and
given my time as a technology specialist there are one or two companies where I
have placed my trust in the management of the company.
ASM
Pacific has just reported their 2007 results and I am happy to read about their
record sales and profits. In 1996 I put my trust in Patrick Lam and he did not
let me down. I hope his successor will continue that success.
In 2006 I put my trust in Paul Coughlan of
Linear Technology. I believe that he will not let me down. In other words I may
not understand technology but I hope there are certain people that are
trustworthy. If you read about Warren Buffett you will see how much emphasis he
puts on the people who run a business.
When I started out on my own in 2005 I
decided to look closely at the drug sector because it has some of the industry characteristics
I think are important:
§
Patent protection creates barriers to entry (Warren calls it a moat!)
§
Aging populations mean demand should increase
§
Wealthy populations will pay anything for innovative drugs
§
Margins tend to be good
§
Free cash flow can be strong
Given the above characteristics of drug companies I was always inclined
to think that drug companies had a significant role to play in any portfolio
once they could be bought at a reasonable price.
What
generally prevented me from getting too excited about drug companies was:
§
Lack of new blockbuster
drugs
§
Generic threats
§
Valuations were never particularly
cheap
§
Governments were always interfering
in pricing
In 2005 I spent a good bit of time
listening to JP Garnier the CEO of Glaxo and reading about their existing drugs
and pipeline of new drugs. I knew that a number of their drugs were due to come
off patent in the coming years but I also knew that they had one of the best
pipelines of new drugs in the industry. In particular their cervical cancer
vaccine, Cervarix, sounded like a potential blockbuster.
On a valuation of about 14x 2006 earnings
and with a dividend yield of over 3% I felt that the downside should be
relatively limited. I felt that there was a certain degree of confidence in the
way JP Garnier spoke about the future.
Before I bought any shares I asked my usual
question, would Warren
buy it? Even though he owned shares in Johnson and Johnson, a company that had
a major drug unit, he did not own any companies where the majority of their
revenues came from drugs. As far as I can remember I think he is on the record
as saying that he did not understand drug companies well enough to invest in
them.
Once again I went against what I felt Warren might do. I put my
faith in JP Garnier. (This was a change for me as I had not met JP Garnier in
person whereas I had met Patrick Lam and Paul Coughlan)
I bought some shares for myself in 2005 and
more in 2006. As you can see from the chart below it has not yet been a
successful investment.
In 2006 I felt reasonably confident that it
was only a matter of time before Glaxo broke out on the upside.
I was surprised to see that Warren had bought some
Sanofi Aventis, the French drug company. This confused me because I have never
heard him explain what had happened to change his mind. The very fact that he then
owned a drug company gave me some comfort.
Moving forward into 2007 a couple of events
made me think that maybe Warren
was right in the first place, maybe we should not buy drug companies. I began
to wonder if Warren
would have to add drugs to airlines as a sector he invested in but got wrong. (Warren is the first
person to admit that he has made mistakes).
The first event that concerned me happened
last May. There was academic analysis of clinical trials (known as meta
analysis) that suggested Glaxo’s second biggest drug, Avandia for diabetes, increased
the risk of heart attack. Sales of Avandia fell rapidly.
The second event has been the delay to the
launch of Cervarix in the United
States. Analysts seem to be unsure as to the
reason for the delay.
I am obviously not the only investor that
was beginning to despair. How else would you end up with Glaxo now being on a
valuation of 11x 2007 earnings with a dividend yield of 5.5%? Expectations and
confidence had fallen away, Glaxo was (and still is) unloved.
In January it was announced that Warren had just bought
some Glaxo shares. My initial reaction was one of surprise but then it dawned
on me that Warren
loves when something has become really unloved because then the price tends to
be cheap. The only thing I remain confused about is why he now feels he
understands the industry when in the past he said he didn’t. I was hoping that
he would talk about it in his annual newsletter that was published on February
29th but there was no mention of it so I remain in the dark. All I
know is that we are now in it together. Both of us are now experimenting with
drugs..................
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