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Thomas Macpherson
Thomas Macpherson
Articles (170)  | Author's Website |

When Being Certain Isn't Enough

At Nintai, it's simply not possible to reduce risk enough where you are totally comfortable with your investment. Here's a case to show you why.

August 30, 2019 | About:

All men make mistakes, but a good man yields when he knows his course is wrong, and repairs the evil. The only sin is pride.” - Sophocles

It is the highest form of self-respect to admit our errors and mistakes and make amends for them. To make a mistake is only an error in judgment, but to adhere to it when it is discovered shows infirmity of character.” - Dale Turner

Over the course of my investing career, I’ve made some terrible investments. I’ve written about them before. In one, I talked about the general concept of looking like an idiot (“The Fine Art of Looking Stupid”). In another, I talked about education through ignorance (“Learning from My Mistakes”), and I’ve even discussed a specific case of ineptitude (“Anatomy of a Failed Investment”). Today, I thought I’d address an investment failure (so far) from the perspective that several readers have asked about – when do you know enough to stop being uncertain? Or put in a different way - how do you know you’ve reduced risk to a reasonable level?

Biosyent: An investment gone awry

In October 2017, Nintai purchased shares of Biosyent Inc. (BIOYF) (TSXV:RX), a specialty pharmaceutical company based in Mississauga, Canada. The company, through its subsidiaries, sources, acquires or in-licenses pharmaceutical products and markets them. In May 2018, I compared the company’s business model against that of Valeant (now Bausch Health Companies (NYSE:BHC)) in an article entitled “Opposites Don’t Attract.” In the article I pointed out that Biosyent’s model was the opposite of Valeant’s – the company had no debt, it generated high return on equity, assets and capital and high free cash flow margins. Most importantly, while it in-licenses new products (similar to Valeant), its business model did not require increasing prices by 6,000% to survive. My overall thesis was Biosyent could take a great deal of pressure in a business downturn and still work out as an investment, whereas Valeant had little margin of error.

With all that research and industry expertise, you might ask how the companies have done over the past year. Well, talk about being hoisted on your own petard! Biosyent is down 38% versus Bausch Health’s -10% return. Biosyent’s free cash flow is down 31% versus Bausch’s drop of 1.5%. Biosyent’s revenue is down 15.8% versus Bausch’s increase of 3.1%. Not a pretty picture. In just about every measure, Bausch has outperformed Biosyent.

So what happened? How did I get my investment thesis so wrong? Before I get into that, let me quickly review how Nintai generally deals with such a debacle. First – and before anything else - I will generally pick out some classical music, pour a glass of whisky and roll up my sleeves at my desk. This is no time for hasty action. I will pull out my previous investment case and valuation spread sheet and begin to pull it apart piece by piece and assumption by assumption. I will also review everything we had broken out as both a risk and an uncertainty. What I’m most interested in is whether there was a risk (where we could ascertain a percent chance of happening) we either overlooked or underestimated, or was it an uncertainty (an event we could not apply a reasonable percent chance of happening) that did my estimates in. One thing I find most helpful is writing to our investment partners about the investment and giving an overview of the investment and what’s happened since our initial investment. This process is very helpful in removing the emotions from the investment. The following is a letter that was sent to all our investment partners late last week discussing our investment in Biosyent.

"To Our Investment Partners:

Biosyent (BIOYF) released its Q2 and H1 2019 results today and they were as ugly as we expected. Q2 2019 net revenues were $5,156,476 which is 13% decrease versus Q2 2018. H1 2019 net revenues of $9,635,290 which is 7% decrease versus H1 2018. Q2 2019 Canadian pharmaceutical net revenues of $4,844,090 decreased by 4% versus Q2 2018. H1 2019 Canadian pharmaceutical net revenues of $9,114,230 increased by 4% versus H1 2018. This was a pleasant surprise. However, the international numbers simply couldn’t be worse. Q2 2019 International pharmaceutical net revenues were $0 (yes, that’s nil) as compared to $511,483 for Q2 2018. H1 2019 International pharmaceutical net revenues were $0 as compared to $1,077,324 for H1 2018. Ongoing import restrictions on FeraMAX® meant that no international shipments were made at all in H1 2019. Finally, it appears the decision to cancel regulatory submissions to Health Canada for two new cardiovascular products is final. The company took a one-time impairment loss on intangible assets of $424,941 with this decision.

With today’s losses our position currently stands at a roughly 31% loss on our initial investment. Over the coming week, we will be revisiting our investment case. We intend to speak with corporate management, strategic partners, customers, Health Canada officials, and industry thought leaders. On the positive side (if one can be found here), Biosyent has no short or long-term debt, still generates free cash flow, and is ready to launch a new product next year. We believe the value of our investment methodology is being proven in this case. A rock solid balance sheet, high returns on capital, and generous free cash flow as a percent of revenue gives us a significant leeway in terms of damage the company can withstand. It also dramatically reduces the chances of a permanent impairment of our invested capital.

That said, it’s not the drop in Biosyent’s price (in fact we like to see that in most cases) but the drop in our estimated intrinsic value that bothers us. A drop of 50% in our estimated value means we missed something significant in our due diligence. As Count Ciano said, “Success has many parents but failure is an orphan". At Nintai, failure is openly acknowledged and discussed. There will be no investing Ospedale della Pietàins in our shop. We intend to go back and find out what went wrong and what we can learn from this. We will update you over the next 30 days and discuss these findings."

These types of letters aren’t the easiest to write. Opening up your mind and revealing a flawed process is difficult on the investor’s ego. But over time, writing this type of update can get your mind thinking more clearly and helps you become a better investment manager.

Mistakes and changing perspectives

Quite a few readers have written asking about how we deal with risk and uncertainty when it comes to making an investment. At Nintai, we try to apply different mental models in decision-making. This allows us to tease out different approaches when it comes to making a final choice. We recognize we will never be able to reduce risk to a perfect 0% level. Nor will we be able to reduce uncertainty to a “perfectly acceptable” level. For instance, when it comes to uncertainty in making a final choice, we found we share a similar dilemma to musicians. At what point during a studio recording do musicians say, “That’s it. That’s the final take.” What is it about that take which causes the musician to feel they can’t improve the song any more? Why not two takes before? Or three takes into the future? I find that many readers are asking a similar type of question in their emails – at what point can Nintai say, “That’s it. I don’t need any more research or run any more numbers. I’m ready to put in the purchase order.” I thought it might be interesting to try to answer that question using Biosyent as a case study. After taking a shot at answering it, I thought I would then use the case to see if there isn’t a way to improve the process.

Looking back to October 2017, I felt confident I had the right amount of data and research to say, “I don’t need any additional work here. I’m ready to invest in Biosyent.” In light of a roughly 30% loss to date, however, something clearly wasn’t right. But the question is whether this was a problem in not understanding the risk or was it simply a case of not taking into account the uncertainty of investing in biopharma.

Read more here:

Nintai’s hierarchy of risks

Whenever we think of investing, Nintai has a general hierarchy of risks (our apologies to Maslow), ranking from the very worst to those we place as least important. I’ve pointed out in previous articles how we see the difference between risk and uncertainty. For the sake of brevity, I will simply re-quote Nate Silver’s great description in his classic “The Signal and the Noise.”

"Risk, as first articulated by the economist Frank H. Knight in 1921, is something that you can put a price on. Say that you’ll win a poker hand unless your opponent draws to an inside straight: the chances of that happening are exactly 1 chance in 11. This is risk. It is not pleasant when you take a 'bad beat' in poker, but at least you know the odds of it and can account for it ahead of time. In the long run, you’ll make a profit from your opponents making desperate draws with insufficient odds. Uncertainty, on the other hand, is risk that is hard to measure. You might have some vague awareness of the demons lurking out there. You might even be acutely concerned about them. But you have no real idea how many of them there are or when they might strike. Your back-of-the-envelope estimate might be off by a factor of 100 or by a factor of 1,000; there is no good way to know. This is uncertainty. Risk greases the wheels of a free-market economy; uncertainty grinds them to a halt.”

As we look to think about risk, there several macro-risks that are essential to take into account as an investment manager with fiduciary responsibility to our investment partners. They are listed in rank of significance.

Permanent impairment of capital

First, from the highest level of assessment, Nintai’s primary risk is the permanent impairment of our investors’ capital. We believe this mostly falls under risk, but there is certainly some uncertainty that comes into play. To make such an event possible, we have to assume the possibility of several catastrophic events. One could be a massive and widespread case of accounting fraud. With a long history of audited financials that meet both Financial Accounting Standards Board and Canadian regulatory requirements, we believe this is a very low risk.

Second is the complete shutdown of operations due to severe regulatory violations and non-compliance. Again, the company has a long history of meeting Food and Drug Administration, Canadian Food Inspection Agency and Health Canada inspections and we see this type of risk as minimal at best.

Last, the company is unable to identify, locate or purchase new in-license candidates and revenue collapses. While we’ve seen a few instances of product approval failures (such as the two recent cardiovascular products), this in no way has led to a collapse in revenue. Decreases yes. Collapses no. We believe this event would be a blend of risk (e.g., warnings such as audits with material weaknesses) and uncertainties (insider activities hidden by accounting fraud). We still rank this extremely low as a possible risk.

Significant reduction in estimated intrinsic value

As an investment manager, there is only thing worse than having to slash your intrinsic value (see previous). It happens more often than I like, but it’s bound to happen when you invest in companies that are sometimes going through difficulties. In Biosyent’s case, we didn’t think this was the case at all, and, boy, did we get that one. If you take a look at the previous five-year annual growth rates versus the trailing 12 months, it’s not a pretty picture.

Five years versus trailing 12 months:

  • Revenue growth: 21.2% versus -2.4%.
  • Operating income growth: 20.8% versus -9.2%.
  • Earnings per share growth: 22.5% versus -15.8%.
  • Free cash growth: 24.1% versus -31.0%.

Any time you invest in biopharma, you run the risk of not getting product approvals from the appropriate regulatory body. In Biosyent’s case, Nintai obviously did a poor job in breaking out the pipeline and assigning risk to each product. An obvious lesson is to build out a far more robust evaluation process for an investment’s pipeline and model that against the investment’s valuation.

Risk-driven investment paralysis

One the dangers of building out an outstanding risk-based assessment tool is creating a process that leads to investment paralysis. We know of one case where a firm had built out such an impressive risk assessment process that it became nearly impossible to put the company’s capital in play. In the time that it took Nintai to build out a 20-company portfolio, the firm had not chosen a single holding. It is critical to remember that any system that incorporates risk and uncertainty must – by its very nature – be part art and part science. There will always be a human component to value investing. Whether it be that panicky feeling when the markets drop 5% in one day, or the feeling of greed when a portfolio holding jumps 18%, human emotion will always be something to master and take advantage of in investing.


In March 2015, I wrote about the four interwoven factors that are essential to master if you look to be a successful value investor (“The Four Horsemen: Risk, Uncertainty, Price and Value”). Every time an investor makes a decision to buy, sell or hold, they are creating an interplay between these four factors. What they tell the investor is partially driven by the inputs the investor uses, the questions the investor asks and the value that is given to each individually. One thing is certain – working with them individually or together is as much art as it is science. As the reader can see, Nintai’s decision to invest in Biosyent - at the price we thought was a significant discount to fair value - was flawed at best. What we thought were clearly defined risks actually had underlying uncertainties. We have been saved from the worst possible consequences (so far) by building in a margin of safety that structurally makes it difficult to permanently impair value. Any process that can produce such results is worth revisiting on a regular basis.

As always, I look forward to your thoughts and comments.

Disclosure: Nintai is long Biosyent.

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About the author:

Thomas Macpherson
Thomas Macpherson is Managing Director and Chief Investment Officer at Nintai Investments LLC. He is also Chairman of the Board at the Hayashi Foundation, a Japanese-based charity serving special needs children and service pets. The views expressed in his articles are his own and not necessarily those of the firm. He is the author of “Seeking Wisdom: Thoughts on Value Investing.”

Visit Thomas Macpherson's Website

Rating: 5.0/5 (5 votes)



Stephenbaker - 1 month ago    Report SPAM

Tom, I find your articles most thought provoking on a number of different levels. Did you reduce your estimate of IV strictly because of the last 12 months' performance? How do you know the pipeline is not as robust as you first believed? Personally, I don't invest in drug or biotech companies because I have no ability to evaluate the efficacy of chemical compounds for medical use, nor any kind of scientific background that could evaluate possible competition or superior products in some stage of development at other companies. I assume you, or people on your staff possess that ability, otherwise these types of investment seem much more like gambling than investing. 12 months of declining revenues does not necessarily destroy a longer term thesis, all else being equal. If your thesis on the pipeline was well founded and still in tact, 12 months is but a blip. If your thesis was wrong, I go back to the notion that drug and biotech development has to be one of the most difficult areas to evaluate - even if you have knowledgeable experts to rely on. When there are so many factors outside of your (and even company management's) control, when does a company or industry simply fall in the "too hard" pile? In my elementary way of thinking, there is no need to invest in every industry (or even any industry, for that matter). When you limit your investments to areas you know and whose products and/or services have a comparatively clearer future than drugs, you eliminate certain risks. Said another way, if you are going to assume risk, assume known risks rather than unknown (or unknowable) risks. Best wishes.

Thomas Macpherson
Thomas Macpherson premium member - 1 month ago

Hi Stephen. Thank your for your thoughtful comment. I'm glad you find some value in my ramblings. Up front I want to say that the Biosyent's investment case is broken only - and I can't stress this enough - for now. I stress the "for now". Another Nintai holding - Manhattan Associates (MANH) - went through a similar 30% drop after purchasing it but is now a quite profitable position. I also should stress that I think (and certainly don't guarantee) Biosyent will end up being a similar case. But make now doubt the failure to obtain regulatory approval for their two cardiovascular products put a good dent in our estimated intrinsic value. Having been in healthcare consulting for 25 years, I felt comfortable (and have a team that makes me much more comfortable) that we understood Biosyent's business model, operations, and market. I put our failure not seeing the regulatory failure as roughly 70% uncertainty and 30% risk. This leads me to think we put too much value on our knowledge and not enough on the vagaries of regulatory officials (or the differene between gambling and investing as you say). My hope (and I think I'm backed up by quality research) is that we will remain investors in Biosyent and will likely add to our current position. But overall, I think it was a great chance to make the distinction of "how much we know" versus "how much we think we know". We certainly will be more cautious in our due diligence as well as in our rating methodology going forward. Thanks again for your great comment. Have a great holiday weekend.

Stephenbaker - 1 month ago    Report SPAM

Tom, I truly hope the Biosyent investment works out. Someone once asked me if I would invest in a company that had just found the first cure for all cancer. I thought about it for a while and replied that I would but only if there was no lockup period on my investment. A gamble on the initial public reaction probably makes sense, but after that who is to say that this company, in the environment in which we exist, would ever turn a wonderful finding into profitabilty?

Robert Abbott
Robert Abbott premium member - 1 month ago
Hi Tom - I think the most important part of this article comes in your comments, responding to Stephenbaker, where you take a longer-term perspective. Throughout the article I saw a real focus on quarterlies and the present, but very little about what might happen in five years or ten years. I'm not sure who said it (perhaps Charlie Munger (Trades, Portfolio)), but they made the important point that many troubles with stocks are eliminated just by being patient. You obviously have great analytical skills and instincts, your long-term track record beats almost all the gurus. Trust those skills/instincts, drink an extra glass of wine, and settle down with a good mystery novel.

Thomas Macpherson
Thomas Macpherson premium member - 1 month ago

Hi Bob. Thanks for your comment. It doesn't say much about the article when the best parts are in the comments section ;o) I struggled with this article to convey the short-term problems created by my poor prognostication with the long-term value of the company. I think your comment is spot on though. Re-reading it from your perspective, I really didn't address the long-term view very well (in the article). Given the chance, I'd probably rewrite it. Given my sloth and indolence, I likely won't. Thanks again. Best - Tom

Robert Abbott
Robert Abbott premium member - 1 month ago
Following up on my earlier comment, for those who are not familiar with Tom's performance record: Over the past 10 years, he has averaged an annual return of 18.47%. To put that into context, if he was included on the GuruFocus 10-year Scoreboard he would rank third, behind only David Tepper (Trades, Portfolio) and Frank Sands (Trades, Portfolio) (and ahead of almost every other famous guru you think of). In my opinion, Tom is an unrecognized investment genius!

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