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IFB130: A Biotech Value Trap?

Announcer:                        00:00                     You’re tuned in to the Investing for Beginners podcast. Finally, step by step premium investment guidance for beginners led by Andrew Sather and Dave Ahern. To decode industry jargon, silence crippling confusion, and help you overcome emotions by looking at the number, your path to financial freedom starts now.

Dave:                                    00:36                     All right folks, we’ll welcome to Investing for Beginners podcast episode 130 tonight. Andrew and I are going to try a little experiment. Well, Andrew is going to test some stuff out on me so he had a great idea for the show and I don’t know exactly what we’re going to do. I do, but what’s going to happen is that Andrew is going to read some information from a tank K and some footnotes, and we’re going to talk about a possible value trap. And so I’m going to be a little bit of his Guinea pig tonight, so it is like if you, and he and I were talking to you guys as listeners, I’m going to be kind of the listener tonight, so this should be kind of fun. So without any further ado, I’m going to turn it over to Andrew and he’s going to do some pocket.

Andrew:                              01:18                     Yeah, let’s do it. I wanted to give like kind of a fresh perspective where you’re somebody who has no idea what’s going on, kind of a thing, and you can interject on when you have ideas or thoughts and see where the conversation goes from there.

Andrew:                              01:35                     Basically, what I’m going to do in today’s episode is I’m going to do like, like let’s sit down as if we were going to try to find a stock today. So we’re going to use a screener, we’re going to use some, some financial metrics. So for you to understand where this conversation is going, you’re going to want to know the basics of that. So like I say, over and over and over again, if you haven’t already, you can go back to the archives. We have lots of intro stuff. And so get that foundation first and then maybe come back and listen to this one. But you know, we’re going to, we’re going to do that now. And so it’s like, let’s take stock or a group of stocks today, run a through a screener. I tried to find good stock.

Andrew:                              02:22                     I’m going to show you one that looks like a great stock, has all the right metrics but is a value trap. And that I will show you why and we’ll see what that discussion kind of, if it takes off or if it’s just completely boring, you’re just going to have to listen anyway. But, you know, if you’ve been following the market at all. Recently, I’m recording this on December 20, 19, so many different stories. A sort of big one and one that I see just kind of over and over and over again is surprisingly, or maybe not surprisingly, biotech is still really huge right now. So there’s a lot of huge jumps in stocks. Like we’re talking about these biotech stocks that will jump 15% in a matter of minutes or drop 10% in a matter of minutes. And this is all kind of par for the course.

Andrew:                              03:19                     People aren’t blinking an eye. Biotech’s always been super volatile. But what I’ve seen a lot lately is a lot of stocks that are dropping on this piece of news or that piece of news. So one big idea, one big example of that that has been going on recently is a lot of these biotech stocks have been doing public offerings. And so it’s basically where, you know, kind of like an IPO, but then they’re doing it again. And so we’ve talked previously about how Tesla is funded a lot of their losses by issuing shares and diluting the shares and all of that fresh cash can, to Christian those losses. Well, a lot of these biotech companies are having, they’re doing these secondary offerings, and so they’re issuing stock, they’re diluting their stock and getting a bunch of cash for it.

value trap

Andrew:                              04:19                     And you know, the market, we like to say the market’s emotional, and we say that a lot and it’s, it’s very, very emotional and it overreacts probably a lot more than it doesn’t. But at the same time, while it’s emotional, it’s also not stupid. So when it sees something like this where basically, you know, the company is saying, Hey, we’re out of cash. We need more cash, let’s do something and try to get more cash. So the market tends to respond to that negatively. And you’ll see a lot of biotech stocks at least in the past couple of weeks who have dropped five, 10, 15% as soon as they’ve announced a public offering. And on the flip side, there’s been stocks that just on any the news, and it’s not like really small news. These are, these are big breakthroughs. So a lot of times, again, talking about biotech, there’s all this science stuff behind all this R and, D they could have like an FDA approval on a drug and that would lead to a drug that couldn’t turn a biotech stock that’s not profitable into one that is now churning and cashflow.

Andrew:                              05:32                     And so when these big drugs go through the different stages, and they perform well from like the science standpoint, then wall street recognizes that, Hey, now this stock has a lot more potential. And they’ve been it up higher, and a lot of that momentum tends to perpetuate on itself. And so you’ll see these huge gains. So with that, you as a value investor, it’s, it’s tough if not impossible to find biotech stocks that you would consider a value stock. Many of these will be unprofitable. Like I mentioned, many of them will be trading at astronomical valuations, ten times book, ten times sales you know, PE of a hundred plus. But you know, every once in awhile, you get one of these biotechs that shows good metrics. And so I wanted to highlight one of those and, and take you through your, so let’s say if you’re able to follow along on the computer probably most of you aren’t.

Andrew:                              06:42                     But let’s say you were, you would go on finviz and on finviz, which is a stock screener that lets you input certain metrics and they will sort through the universal stocks. Fin. This has 78, 45, 7,000, 845 stocks in their database right now. And those are all like traded on the NYC or the NASDAQ. So if you to go on there and let’s say what’s cool is you can sort by industry. So let’s say, you know, all this biotech news made you excited about biotech stocks, and you want to see if there were any that would fit your metrics. So that’s exactly what we’re going to do. You go on [inaudible] dot com in the industry tab; you hit biotechnology, and let’s say in the PE tab you hit profitably. So that’s going to eliminate all those non-profitable biotechs. And it just took a list of 568 stocks.

Andrew:                              07:39                     So there are 568 biotech stocks. And then I hit the profitable tab, and only 47 came up. So I’m a really small percentage of these. You are profitable. And so let’s say we want that, let’s say we want debt to equity low. So I’m just going to say under, I’m going to cheat because I knew what stocks were going to come out. So I’m going to say under 0.1, which is the lowest you can go. So that would be basically like, or we want to stock with no debt, one that is debt-free, and then we’re going to get rid of some of this outlandish price to sales and price to book stocks. I see here’s one that’s a price of sales of 47 price to book of six. So good luck to you if anybody’s trying to do that. So I just hit price to sales under two and price to book under two, just as an example.

Andrew:                              08:32                     And magically, one stock came up. The ticker is JNCE. And so when I click on it, they are a biotechnology stock. They have a market cap of 225 million, and they don’t pay a dividend. So just kind of right off the bat, this wouldn’t be for multiple reasons. It wouldn’t be a stock would score well on the BTI. However it has some great looking other metrics on here. And so I can see certainly why somebody would be intrigued by this and could you know, make a wrong choice and maybe think that just because these numbers are good, it’s going to be a good investment. I’ll show you why that’s, that’s kind of not the case. So for J and C E their company name is jounce therapeutics; I probably mispronounced that they have a price to earnings of 3.38 according to it is a price to sales of 1.34 price to book 1.32 and the price to cash of 1.28.

Andrew:                              09:39                     So basically what that’s telling you is the stock is trading that three a little over three times earnings. So for every $3 you’re paying in the stock, you’re getting $1 of earnings. That’s pretty incredible — a price to sales and price to book just over one. So same, same kind of logic, but with the sales and the book value and then price to cash of one point 28. So you’re getting, let’s say you pay $128 a hundred dollars of that is cash. So you’re only paying like 28 cents. Right? So that sounds like a crazy good deal. And it’s like how is nobody jumping on this? Right? And not to say nobody’s jumped on it since October, the stock has grown from $3 to $7 and 61 cents. So there is interest in it, there is positive momentum, there’s been a lot of volumes lately.

Andrew:                              10:38                     And despite all of the growth in the stock price, these evaluations still show up low. And then the last couple things here with a quick ratio and current ratio. I don’t want to get too in-depth into this, but it’s a balance sheet metric where you’re comparing the current assets with the current liabilities. So when we think of something that’s long term, you’re thinking of like, you know, like, like in personal finances, general debt is more longterm. Short term stuff would be stuff maybe that’s due this year versus stuff that’s due in five years. And so same thing with like their current assets. Those are things like cash accounts receivable stuff that’s like available in the very, very short term. I think the criteria is within the first year, but that’s just the general idea. So with a current ratio of 13, that’s extremely high.

Andrew:                              11:37                     Even if a stock has one of two, that’s pretty high. So you know, they don’t, in the, in the upcoming year, they don’t have anything from an expense standpoint that’s gonna make the business in trouble as far as the current ratio goes. And then the debt to equity is a 0.0. So, you know, again, on the surface, this sounds like the best kind of deal, the best kind of stock. Dave, any thoughts or feedback from what I’ve presented so far? No. Everything that you’ve read to me sounds like, you know, a, a dream. I mean, everything is just like ridiculously low. I mean, no debt. The price to cash or price to book is all fantastic. Appease, ridiculous. I mean, I was looking at the revenue growth was 189% for the year. You know everything looks fantastic. I mean just on the, you know, on the surface level of all this, it looks like where can I buy some and how quickly can I do it now.

Andrew:                              12:51                     So now let me just, now that I presented it and made it look all nice, let me just burst your bubble. So as you know, as you should and as we recommend when looking at stocks, you know, it always starts at the screener, but it should never end there. And so kind of like when we did the Starbucks balance sheet how we, we took a deeper dive, right? And we tried to figure out what’s going on with the business. You can do the same with this stock. So, in particular, I wanted to pull up the latest 10 Q. So there you have the 10 K and the 10 Q. The 10 Q is the quarterly report and wall street swears by it. But there are some downsides to using it. It’s not completely audited. And it’s just not as complete as a 10 K. But you know, it gives us some insight into how Finn is found this, these metrics because Finviz is working on the most recent data.

Andrew:                              13:58                     So you might see discrepancies when you’re looking at a stock versus what’s on a screener or a website like Finviz because when I look at stocks, I’m looking at the 10 K the annual report. And these sometimes are on more recent data, which isn’t always official, official. And the reason I bring that up is that in this company’s latest 10 K they had negative earnings, but in their latest 10 Q quarterly report, they had huge earnings, which is why the PE was so low. So when you look at the 10 Q, you can see the breakdown between here’s how the stock has done in the last three months, you know, the last quarter. Here’s how that’s compared to last year. And we see a huge jump. We see a situation in 2018 when, for the three months ending in September, they had a loss of 7.5 million, and now they have a gain of 98 million.

Andrew:                              15:08                     So you have to wonder how did they get such a huge jump? And like you said, Dave, with the revenue again, you compare this core there to the core and the year before you’re talking about a jump from 14 million to 119 million. So that’s pretty crazy, pretty significant. And you want to figure out what’s going on. I like to look at the cash flow statement, as well. I think that’s, that’s very helpful. Because that’s, that’s where you can see things like what were we, what we were talking about with if, if a company issues shares and they get a bunch of cash through there, then that’s where you can see where that played out. I, I like to look at a cash flow statement, but I realize that’s something because I’ve done this for a long time that I like to do it.

Andrew:                              16:04                     So let’s make it like stupid simple. What you can do when you look at, again, we’re taking this from the perspective of somebody who is looking for an opportunity. And so what you want to do is you want to understand the business model a little bit. We’ve talked about this over and over and over again. Similar to what buffet says about having a circle of competence, you want to know how is the business making money. And so if you go to the overview of this is their latest 10 Q, you go to the overview.

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Andrew:                              16:53                     So the 10 Q is a little bit different than the 10K, and it’ll probably be different depending on the business where they have the financial statements. So you can look in the table of contents, so that can give you some perspective. I’m going to click on item two, which is a little bit past the financial statements. And so they have like a, it’s called a management’s discussion of analysis and analysis of financial condition and results of operations. So results of operations. That’s kind of what I want to figure out. Right. Are there any nuts to why this stock just had a huge jump? And in their overview you can see within the first couple of sentences, first couple of paragraphs. And then here it says on July 22nd, 2019 we entered into a license agreement with Celgene. So basically they granted this company called Celgene an exclusive license to develop blah, blah, blah, blah, blah, blah.

Andrew:                              17:57                     And if you continue reading, you’ll see that that company, Celgene paid this company Jounce a one time upfront payment. And so they’re taking that whole payment upfront and putting it in the financial statement. And that’s why you see this huge jump. So you know, you have this, this upfront payment thing, you have all this cash that suddenly is coming into the company, but everything else around the business is still lost. It’s still like, a losing company. It’s still losing business. Yeah. So basically, you know, they have this onetime sale, and so basically the success of the business that we’ve seen so far in the financial statements is just based on a single transaction. You don’t know as an investor what’s going to happen from here. Nothing else within the core business has changed all that much. And so what you’re likely to see in a situation like this is a onetime bump to the financials and then it will go back to how it was before, once, once this upfront payment is reflected in the financials and then they go back to it.

Andrew:                              19:28                     So you know, if it was made up not as much, right? Like if, if it was a big payment but their revenue growth was still a lot higher than you would say, okay, maybe this was real business results, but everything’s pointing to just a one-time payment and nothing substantial over the longterm. And if you continue reading down you see, as they said, they had another agreement with Celgene back in July of 2016 where they also received a very large payment, cash payment, 225 million. So you know, the, your, that’s what, three years ago. So you have this huge kind of agreement that they’re coming to. But in the interim you have many periods of years where things aren’t that great. So those numbers and fenders aren’t reflective of what’s going on with the longterm health of the business because of what’s going on in these notes. Does that make sense?

Dave:                                    20:39                     Yeah. Because as you were, looking through all this and explaining all of it, I was of looking at The statements too. And just for an example, if you look at the revenue, if you look at the income statement for that’s in the 10 Q, when you look at the other line items that are listed below, just the license and collaboration revenue that, that the payment that they got from Celgene, if you look at everything else, it doesn’t change there, you know, their expenses are all the same. Their, their R and D no change, general administrative, their operating income loss is, you know, the year before for the same period was, you know, a loss. Whereas this year it’s, you know, a huge gain and it’s simple for that. And this, I think if I can interject it, it illustrates the strength of having to look at longer periods as opposed to just looking at the one shorter period because it’s misleading. It doesn’t appear that the company is making money at this point. It’s only been around since 2012 so it’s still a young company and it looks like that, you know, this is, like you said, a value trap. It’s just; it looks like you’d throw your money into it and then you realize the next year

Andrew:                              22:11                     What did I do? Yeah. And that, that was just kind of the whole point of trying to bring it up. I think the numbers are very helpful and, and when we start to learn them, that can open up the stock market and you can understand and I think it helps a lot to have a simplified kind of guide. That’s why I, I made one way back when. Right. And, and it’s intro on the show all the time and that’s where I teach things like the price, earnings, price to book, price to sales. And so there’s a lot of these simple ratios that are presented nicely in a lot of different stock market websites, but it pays to go deeper than that. Particularly the more you’re betting on these, on these different stocks and different businesses. So, you know, would it kill you to buy a stock like this?

Andrew:                              23:07                     If it’s just an average kind of 5% position size? Probably not. Would you regret it three months later? Once or let’s say a year later, once the numbers took a turn for the worst and that’s the reason why probably. Yeah. And so if we can avoid that as much as possible, then I think we can become better investors. I don’t think you have to catch all of it necessarily. Right. But I think taking that extra step can help your understanding and your comfort level and, and your knowledge and increase your chances of doing well in the stock market.

Dave:                                    23:46                     I agree. And I think this is a great illustration of a lot of the things that Andrew and I talk about in regards to looking at longer periods and assessing a lot of the needs in and trying to, you know, think about this kind of like you’re sure I’ll call homes and you’re investigating and you’re trying to put together a puzzle and figure out what exactly is going on with the puzzle. And you may not necessarily know every single thing about the company, but you’re always looking for reasons not to buy it, I guess is the best way of putting it. And I like to think about what uncle Charlie says when he talks about inverting and trying to destroy good ideas. And when Andrew was first target stock talking about all this stuff going through all the preliminary numbers that he founded through the screener, that’s a perfect illustration of why you want to do additional research and not just buy based on just the screener itself, because it’s easy to fall in love with a company when you look at something like that.

Dave:                                    24:58                     But then when you start digging into the bigger numbers, and you find out, Ooh, this is, this could be dangerous. And like Andrew said, you know, yeah, you put 5% of your portfolio in this company, is it going to ruin you for life? No, but are you going to regret it? There’s a good chance you would. And that’s what we’re trying to help you avoid is falling in love with a company. Whether it’s something like biotech or it could be anything and trying to understand better what is going on. And I have another kind of a quicker illustration of a company that we’ve talked about in the past. Corning, they went through a somewhat similar situation a few years ago where they had sold a portion of their business to Dow and they received a large cash payment for that purchase. And they talked a lot about that in their 10 Ks, and their conference calls on their quarterly reviews and they told everybody what was going on, what was going to happen, what they’re going to do with the money, and they did all the things that they were going to do.

Dave:                                    26:09                     They said they were going to do; they used it to buy back shares, they used it to put back into the company to try to generate more income further down the road. And so they’re very upfront about everything that was going on. So you weren’t shocked by it. But if you look at a five to 10 year period of time and look at their revenue or their earnings and, and a lot of the things that Andrew and I talk about, you’ll see that there’s one per year or a year that it’s like, wow, that was awesome. But it’s, it’s, it was skewed because of that one huge benefit they got from selling a portion of their company. And those are things when we are investing that we need to investigate, no pun intended, to make sure that we are doing our due diligence because we work hard for our money and we don’t want just to throw it away just because we see something that’s shiny at first and we need to make sure that we’re as intelligent as we can when we’re deciding this.

Dave:                                    27:12                     Because it’s not, it’s not always easy, and it’s not always [inaudible] going to be simple and quick and easy to do this. But I go back to what uncles, Warren and Charlie talk about what they’re too hard pile. And if you come across a company that you don’t understand or there are parts of body that you’re just having a really hard time figuring out, move on, it’s just not worth the stress and aggravation to try to shoehorn a company into everything that you want it to be because there are so many different pitches that you could take a swing at that maybe this one would not be one you’d want to look at. But I think you know, Andrew illustration and his explanation of how he looked at everything is a great example of a way that you would want to investigate a company when you’re starting to try to put all the pieces together.

Andrew:                              28:07                     I love that you mentioned uncle Charlie and uncle Warren. I’m one of Warren Buffett’s best stock picks, Coca-Cola. One of the reasons why he liked it so much, she said they just year after year after year, you can see their earnings and their revenue and it grows a decent rate and it’s just dependable and, and been around for a long time. And so kind of to the point that you made at the beginning of the show, having that longterm look can help you avoid falling into a trap potential trap like this because you’re understanding, The bigger picture of what’s going on with the business. And I like that idea and I think it can help a lot with a stock like this or a stock like Corning and other stocks that will get into those types of situations.

Dave:                                    29:01                     Yeah, I agree. All right folks, we’ll, that is going to wrap up our discussion tonight. I hope you enjoyed our conversation about the company and the possible value trap, and I think Andrew did a fantastic job of laying that out, and that was fun. You put me on the spot and had me have to react to things. So it was interesting to learn how those things work and how they all interact, and doing your due diligence is gonna pay rewards in the long run for you. For sure. So without any further ado, I’m going to go ahead and sign this off. You guys go out there and have a great week. Invest with a margin of safety, emphasis on safety, and we’ll talk to y’all next week.

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