While this blog has been focused on biotechnology as of late, I do have interests in a few other sectors. Inspired by Bershire Hathaway and the mini-Berkshires, I have compiled a few resources on insurance company investing. 

Have something to add to this list? Put in the comments below:

1. David Merkel's Aleph Blog has a seven part series "On Insurance Investing", and "A Summary of my Writings on Analyzing Insurance Stocks".  Here is more from Merkel as a guest blogger on Barry Ritholtz's Big Picture Blog.
2. David Schiff published Schiff's Insurance Observer from 1989 until 2007.  He has been kind enough to make it all free on the web. Schiff's Insurance Observer isn't necessarily about investing, it's more of an industry focused publication. Serious investor know that these types of publications, written for industry insiders, provide insight that few research analysts can match.
3. Rob Bobman's Capital Returns Management is an insurance company focused hedge fund. Skybridge backed him in 2008, and he's been known to shake things up on earnings calls (first question in the Q&A session).  Regular readers know I am a fan of analyzing the 13f filings of excellent investors. The Capital Returns 13f is worth following. A backtest of Bobman's top ten positions, equally weighted, returned +86% since filing began. This handily trounced the SPDR S&P Insurance ETF (KIE) return of +72% and the S&P 500 total return of +68% over the same time frame. See a chart of the Capital Returns Management back test below.

Have a recommendation? Put it in the comments section or contact me. I am particularly interested in a book recommendation.

EDIT 2/27/15:  I should have included Shreyas Patel's Insurance Investor blog. This value oriented blog, which appears to have been unfortunately short-lived, has a several great posts:

• Buffett’s Buyback Math – why 120% of book value is the magic number for Berkshire

• Insurance float and intrinsic valuation

Occasionally people ask me for book recommendations regarding biotechnology investing. I always recommend the following two books:

The first book I always recommend is the The Biotech Traders Handbook. I used to give this book to interns on their first day. It has two parts, the first is a concise and non-technical introduction to the space. My interns could typically read that in an hour or two. The second part is an introduction to option trading in biotechs, and is appropriate for those who want to step their trading up beyond straight equity.

The second book is Biotechnology Valuation: An Introductory Guide. Have you ever been invested in a biotech company and seen it go down after it's drug was approved by the FDA? If you go to Yahoo message boards afterword, you will see investors saying "I just don't get it" and blaming short sellers. In reality, unsophisticated investors don't get valuation. Most likely, the stock was overvalued going into the FDA approval, and now its getting back to reality. This book with teach you rNPV modeling of pipelines, so you are not surprised again.

Full disclosure: I recently became a contributor at Chimera Research Group. The author of Biotech Traders Handbook, Tony Pelz, is a founder of Chimera. However, I have been recommending the book for years.

One my favorite things in the market is finding obscure situations that elude conventional analysis. My latest interest is the pricing of Priority Review Vouchers.

A little background:  The 2007 Food and Drug Administration Amendments Act (FDAAA) created Priority Review Vouchers (PRV). The purpose of the vouchers are to incentivize drug development for neglected tropical diseases which can represent a limited commercial opportunity. 

These vouchers reduce the FDA review time for drug approvals from 10 months to 6 months, and are awarded by the FDA to a company that obtains approval for a treatment for a neglected tropical disease.

Things got interesting in November when Gilead Sciences (GILD) paid $125,000,000 to purchase one of these vouchers from Knight Therapeutics (GUD/CN).

How many of these vouchers exist? According to Evaluate Pharma, only four have been issued, with three being of the Neglected Tropical Disease type, and one being for Rare Pediatric Disease. The two programs currently have some important differences, so for the purposes of this article we are focusing on  Neglected Tropical Diseases. Below are the status of all four: 

Things got even more interesting when the Senate voted for the Adding Ebola to the FDA Priority Review Voucher Program Act, which would change three elements of the  Neglected Tropical Disease Priority Review Voucher program:

1. Add Filovirus, which includes  Ebola,  Marburg, and Lloviu to the program.
2. Shorten the notice period to use the vouchers from 365 days to just 90 days. 
3. Allow the re-sale of the vouchers an unlimited number of times. The current limit is once.

The bill has broad bipartisan support, and is expected to be passed by the House and  signed into law by President Obama. While the headline is about Ebola, we are interested in points two and three, which would bring the neglected tropical disease program more in line with the rare pediatric disease program.

The reason we are interest in the time frame shift ( from 365 days to 90 days) is because it impact the value of the PRVs. Simply put, the sooner a firm can see revenue from a drug, the more its worth today. This is especially true if one were to factor in a the competitive landscape, where the first mover advantage can be critical. 

To estimate the impact of this shortened time frame I ran the back-of-the-envelope calculations below:

The take away here is once the Adding Ebola to the FDA Priority Review Voucher Program Act becomes law, the Neglected Tropical Disease PRVs will be come more valuable based on the reduced time frame alone. As for the discount rate, I came to 15% via a sophisticated method known as "from thin air". Yes, I can already hear you CFAs saying "you should use the WACC". To that I say drug development is a risky business and you should be more conservative in your modeling assumptions.

An additional factor that will drive up the value of PRVs is the lifted re-sale restrictions. Previously, if you bought the PRV you had to use it, as only one re-sale was allowed. However, with no re-sale restrictions, the pool of capital that could potentially purchase a voucher is much larger. One could see a healthcare firm with a large amount of capital scoop one of these up with the intent of selling it later. The liquidity premium is a real thing, and in this case I'm going to give it a conservative 2.5% liquidity premium, bringing the value to $142.3M. 

This brings the total gain from the legislation to +$17.3M per PVR. While this amount isn't going to move the needle for giants like J&J or Gilead, it certainly is material for a firm like Knight Therapeutics, which has a market cap of just $540M (Canadian). Ask them if they would like another $17 million for the PRV they sold to Gilead.

It is no surprise the Biotechnology Industry Organization (BIO) has come out in support of the bill.

Of course there are additional factors at play here, as I said this a back of the envelope exercise. For example, from a drug developers perspective, much of the value is derived from the drug and indication for which the priority review will be used. Furthermore, as the FDA issues more PRVs over time, the increased supply may drive down prices. One could also Again there are many factors that firms buying and selling will consider next time these trade hands, but I digress.

Those who want to learn more about Ebola can check out the classic The Hot Zone: The Terrifying True Story of the Origins of the Ebola Virus.

One last thing, once Filoviruses (Ebola et al) gets added to the list of indications PRVs can be used on, what does that list look like? See below:

My favorite way to generate investment ideas is reviewing Form 13F filings from great healthcare investors. I first read of this approach years ago in Mebane Faber's book. 

If searching for investment ideas is like looking for a needle in a haystack, then 13F filings are a stack of needles.

I later found out the great Mohnish Pabrai  also uses filings for idea generation. 

I've backtested the filings of 60+ healthcare focused investors, and I have ten that are worth following. These include the well known Perceptive Advisors, and Baker Bros Advisors, but also more under- the-radar firms such as Broadfin Capital. It is important that 13Fs are the beginning of an investment research process. Due diligence is still critical.

Some of my most successful biotechnology stock picks generated by 13Fs have been in the oncology space. An example would be when I bought Pharmacyclics (PCYC) at $19 in February 2012, and held it for a multibagger.

The most recent set of 13Fs were as of September 30, 2014. Here are the two most popular oncology stocks held by my group of hedge funds.  

Pharmacyclics (PCYC): A long time favorite of Baker Bros., also owned by Perceptive and BB Biotech, as of September 30, 2014. Ibruvica is currently approved for Mantle cell lymphoma (MCL)  and Chronic lymphocytic leukemia (CLL)  patients who have received at least one prior treatment. 

PCYC is in growth mode, after having Ibruvica approved, the company swung into profitability during the 3rd Quarter of 2014. Analysts expect 37% year over year revenue growth in 2015. 

At the upcoming ASH conference the company will be presenting data in the effort to get indication expansion into B-Cell Lymphoma. 

Investors are clearly very excited about the growth story here, as the stock currently trades at 11x next years estimated revenue. The bear case revolves around next generation competitors to Ibruvica.

The stock does appears to be near full value, as analyst average price target is $161, which is only 16% higher than current prices.




Celgene (CELG): Owned by RA Capital, Orbimed, BB Biotech, and Perceptive as of September 30,  2013. Celgene is a major player in the oncology space and has products approved for many indications. Revlimid represents 66% of Celgene's revenue. It is approved for  Multiple myeloma (MM), myelodysplastic syndromes (MDS), and Mantle cell lymphoma (MCL). Furthermore, there will be many presentations at ASH 2014.

It is worth noting this company has a less concentrated product portfolio than PCYC, with a single product on the market.

Analyst are expecting very strong growth from CELG specifically from their Revlimid, and  Abraxane franchises. Celgene's IR site tracks analyst estimates, and it states that EPS growth of 32% is expected in 2015.

CELG investors have been impressed with the growth story. The company trades as 9.7x forward sales estimates, and 25x forward EPS estimates. These valuations  could be justified if the firm can pull off its growth plans without any miss-steps. 

No value investor would call this either PCYC or CELG "cheap".

Most analyst would not call CELG cheap either. The current analyst price target is $116, which is about where the stock trades now. Investors would be wise to wait for a pull back, or wait for analyst upgrades.

Disclosure: I own none of the stocks mentioned in these articles and have no plans on buying them in the next 48 hour

Data: Ycharts.com/Morningstar and 4-Traders.com/Thompson Reuters.

Investors in Salix Pharmaceuticals were treated to some unpleasant news on November 6th. The company announced they had misrepresented key drug inventories, and the CFO resigned. SLXP traded down -34% the next day and -46% from its September highs.  I believe more accounting issues will be uncovered by the audit committee.

The company has all but admitted that it was channel stuffing, a practice used to inflate earnings, as discussed in my last post Was the Salix Blowup Predictable? This earnings inflating trick increased wholesaler inventories to levels way beyond their stated target, and much higher than industry norms.

Since the sell off, shares have rebounded. Investors are speculating either there is only one cockroach in Salix's kitchen, or it is still a takeover candidate despite the accounting issues. Indeed this company has a valuable GI drug franchise, and management with a credibility issue. 

The setup seems ripe for M&A activity. Further bolstering this line of thinking is Salix was previously a target of both Actavis (ACT) and Allergan (AGN), but talks fell apart during due diligence around inventories.  However, an audit committee composed of independent directors have been convened, and  I believe that the audit committee will uncover more accounting problems. For those who still wish to wager on a Salix acquisition, I have outlined a strategy at the end of this article.

One of the most useful tools for detecting earning manipulation is the Beneish M-Score. Developed by Dr. Messod  Beneish of the Kelly School of Business, and detailed in The Detection of Earnings Manipulation. The M-Score uses forensic accounting principles to produce a "Probability of Manipulation" or PMAN for any given company  by comparing two 12 month periods.

I was first introduced to the Beneish M-Score in Quantitative Value: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors. This book is excellent and I wholeheartedly recommend it.

In the book, the authors relate a story about an MBA team from Cornell which used the M-Score to give a "sell" recommend on Enron, a full year before it's collapse.

So what does the M-Score and its Probability of Manipulation say about Salix Pharmaceuticals? 

In Quantitative Value,  they noted the M-Score gave Enron a 30.5% PMAN.  For 1Q14 Salix has a 50.8% PMAN. That is what I call a red flag. Even it's 2Q14 score of 5.8% is high enough to be considered a weak signal.

Let's do some more digging; what is the M-Score recognizing in Salix to give it such a high PMAN?

The Beneish M-Score is a multifactor model with eight variables, each being a hot spot of earning manipulating activity. The eight variables are below:

1. DSRI - Days' sales in receivable index: Detect revenue inflation activity such a channel stuffing.
   
2. GMI - Gross margin index: Firms with declining margins may be more likely to manipulate earnings.
3. AQI - Asset quality index: Rising intangible assets may point to deferred costs, boosting  earnings.
4. SGI - Sales growth index: High growth firms have incentives to manipulate earnings when they fall short.
5. DEPI - Depreciation index: Slower deprecation can artificially boost earnings.
6. SGAI - Sales and general and administrative expenses index: Can point out overcompensated execs, who have been associated with earning manipulation.
   
7. LVGI - Leverage index: Firms with increasing leverage are incentivized to manipulate earnings when faced with a shortfall due to debt covenants.
   
8. TATA - Total accruals to total assets: Firms with higher accruals are likely to be earning manipulators.
   

Lets look at the table below to see how Salix scored on these variables compared to peers:

Based on the table above, and information the company has shared, I expect the following outcomes from the audit committee:

• Salix has been manipulating their expenses and will have to restate at least one quarters earnings. The method used is either intangibles to defer costs (AQI), or hiding something in accruals (TATA).
• The lower margins will be disclosed to be part of the channel stuffing (GMI), as will the higher accounts payable (DSRI), as discussed previously.
• Salix will not restate revenues, but may lower revenue guidance once the full impact of channel stuffing is known.

In short, I believe investors should be very cautious on owning Salix shares until the audit committee releases their findings.  An approach for those determined to make a bet on a Salix acquisition should consider a small starter position, with the intention to use the negative headlines from the audit committee as an opportunity to buy on weakness.

Disclosure:

I have no position in Salix Pharmaceutics as of this writing,  but may establish one in the future.

Geek Notes:

1. All my data is from Ycharts.com, as is the Beneish M-Score calculation.
2. Peer Group: US Listed Biotechnology, Pharmaceutical, and Generic/Specialty Drugs Companies with Enterprise Value greater than $3.0B, annual Revenues greater than $100M, and annual EBITDA greater than $0. After removing any companies with incomplete data, 38 remained.
   

Could the blowup at Salix Pharmaceuticals been seen in advance? This is a Monday morning quarterback look at the financials  in search for a tell.  

Investors in the pharma and biotech space are accustomed to certain risks; Clinical, regulatory, and commercialization risk are at the top of healthcare investors mind. 

Accounting shenanigans are not the sort of thing that keeps healthcare investors up at night. This is why the channel stuffing scandal at Salix Pharmaceutical has been so shocking, despite Bristol-Myers and Medicis having paid to settle channel stuffing allegations in the past. 

With Q3 2014 earnings, Salix Pharmaceuticals announced that key product inventory levels at distributors are elevated to nine months, well beyond the levels previously disclosed.  Adam C. Derbyshire, former Chief Financial Officer, has stepped down, and an independent audit committee has been convened to figure out what exactly went wrong.

The problem with channel stuffing (besides being misleading) is it steals sales from future periods. This approach could be used by management in a one-off scenario, with a low risk of being found out. However human nature leads them back to the same well until it is dry. 

There are legitimate reasons for distributors to allow inventories to build. For example, expected price increases, supply issues, and rising demand. While these all could play a part, management has all but admitted to channel stuffing. Below is a great graphic on the pharma supply chain from ContracIQ.

Why would distributors accept more inventory than needed? Because the company incentivizes them to stock up, so that the company may meet their sales targets. This is typically done through special financing arrangements. Extended payment terms, and product discounts are typical.  

A channel stuffing  company would show an unusual rises in accounts receivable due to the extended payment terms, and timing. These deals typically occur near the end of the quarter, when management knows it won't hit sales targets on their own. Also look for some impact on gross margins, due to discounts offered to incentivize distributors.

I recommend What's Behind the Numbers?: A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio. Authored by a short bias fund manager, it exposes many of the accounting tricks companies pull, such as channel stuffing.

When evaluating receivables, you have to look at it relative to revenues, as a quickly growing firm would naturally have rising receivables. Furthermore, you have to look at the trend in receivables. Quarterly Year over Year comparisons smooth out seasonality, and is the preferred metric.

There  few reasons AR can grow faster than sales:

• Processing problems in the AR department 
• Customers cannot or will not pay 
• Channel Stuffing
  

The huge spike in Q1 2014 is suspect. Salix closed the Santarus deal on January 2, 2014. Could it be related the the Santarus acquisition? 

Santarus had $43.5M in receivables in Q3 2013. Salix receivables rose from $146.9M in Q4 2013 to  whopping $438.5M one quarter later Q1 2014. So that doesn't explain it. If there is a smoking gun, I would say Quarter Y/Y receivables growth is it.

These types of issues apparently scared off Allergan.

 Furthermore, I haven't seen anything in the earnings calls or filings that explain the dramatic rise. Not that I would believe it now, coming from a disgraced CFO.

The overall level of receivables were also very high. Among a peer group of companies I created for this research, Days Sales Outstanding for Salix was the 3rd highest.

What about that other factor I mentioned,  gross margins?

Margins have been impacted too. On this item, management had an explanation, however I would not be surprised if the audit committee ends up questioning this statement:

I find it particularly telling that in the Q1 2014 and Q2 2014 earnings call transcript, the word "discount" never appears. However, on the Q4 2014 call , the interim CFO had this to say:

Going forward, what should investors focus on? We have the pending audit committee review, and this statement:

This does not mean there will be no revisions to prior period financials, it does mean E&Y does not expect the revisions to be material in nature. While management has tried its best to assure there are no other issues, investors are applying the "one cockroach in the kitchen rule" and staying away. I missed the drop in Salix due to my focus on smaller firms. I currently have no position, but that may change, pending my research below.

In the next post, I will be exploring metrics that may be used to identify earnings manipulators, in the attempt to determine what other revelations Salix investors should expect from the audit committee, if any. 

After noting that the CEO at Arrowhead Research bought 16,000 shares yesterday on the open market, several people asked me on twitter if he had previously sold, as the stock is down 75% from its March 6th high of $27.63.

While the overall predictive power of insider's trades are mixed. I am of the opinion that insider's trades are worth a second look if they meet the following criteria:

• If the buyer/seller is clearly informed about future developments (C-level executives, not Jr. VP's)
• If the transaction happens on the open market, not part of a 10b5-1 plan.
• If the transaction is sufficiently large to be meaningful to the individual. For example if a CEO who makes $1M a year buys $10,000 worth stock, that is meaningless. 

With this criteria in mind, I dove into the insider transaction data, which I've show all the 2014 activity below.

It appears that Mr. Anzalone has not sold any shares in 2014, and I don't see any shares sold in years past. 

However, other insiders seemed to have actively sold shares, by converting their options and selling the proceeds. The best trader among them seem to be the CFO, having sold at $18.77 in February, and $14.02 in August.  His gross proceeds from these two sales are $861,150 or net $576,140 when you include the cost of exercising the options. 

It is also interesting to note that the CFO and a Director sold on the same day (August 15th) and the CFO got a better price. Perhaps he is a good trader.

Going back to our criteria outlined above:

• The CEO's purchase yesterday is an open market buy, 
• He is in the position to know about the companies future prospects, 
• Do the represent a meaningful amount to Dr. Anzalone? He earned $579,808 in cash, and $463,393 in option awards from Arrowhead in 2013.  Additionally, he owned 244,173 ARWR shares, plus 786,466 options, some of which are underwater.  

I would say that the purchase of $101,120 of ARWR stock, of which he already has a very large position, is a meaningful amount, but not tremendously meaningful. 

Keep in mind, I am not implying anything improper occurs when insiders sell, rather I believe some insiders are in the position to know the intrinsic value of the company better than other investors, and therefor in a position to buy an undervalued stock and sell an overvalued stock.


Geek note: I am using insider transaction data from OpenInsider.com.

Disclosure, I am long Arrowhead Research.

One of the most controversial names in biotech has been Arrowhead Research (ARWR).

The market was very disappointed with ARWR's late-breaking abstract for the American Association for the Study of Liver Disease (AASLD) meeting, part of the ongoing Phase 2a study of ARC-520 for hepatitis B. The abstract was released October 8th, 2014. The meeting is November 7-11, and is commonly referred to as The Liver Meeting.  

Investors were looking for a 1 log reduction in Hepatitis B virus from Arrowhead's ARC-520. However the company delivered a 0.3 log reduction in HBV, falling short of expectations.

The stock has declined more than 50% on the news. Management has tried to assuage investors with an open letter to shareholders.

For a good summary of the situation, I'll refer you to  Adam Feuerstein's article at TheStreet.com. For a more scientific take on the data, check out Dirk Haussecker's RNAi Therapeutics blog.

However, this hasn't stopped Daniel Gold's QVT Financial from increasing it's stake to 4,030,882  shares as of October 8, 2014. The stock closed at $7.03 that day after trading as low as $5.47, they now own 7.62% of the company . This position is up from 1,819,982 shares as of June 30, 2014. 

QVT Financial manages more than $8 billion, and has 27% of its 13F portfolio in healthcare.  QVT originated as a non-traditional proprietary trading group, lead by Deutsche Bank alumni Daniel Gold.

The bull case for Arrowhead Research centers around the signs of efficacy we have seen thus far, and ARC-520 clean safety profile. Bulls think the viral knockdown to be demonstrated in higher/multiple doses (3-4mg/kg) will be sufficient for a high level of HBV knockdown. 

Geek note: Viral knockdown can be measured in log or percent change. Here is a link to a table that converts between the two. H/T to V. S. Schulz.

We've all heard of doubling down on an investment. How about doubling down 11-fold? This is exactly what RA Capital Management did, raising their holdings of ACHN from 2m shares to 23m as the stock moved against them from 2012 to 2014. Their conviction paid off when shares rallied from as low as $2.52 to over $13 in the summer of 2014.

RA Capital is a a Boston-based healthcare crossover fund, and according to this study (original here), a great stock picking firm.

I have been following RA for a few years now, and had the pleasure of seeing this trade play out in real time. I also had the good fortune of following them through this trade for myself and client accounts.

RA Capital first disclosed their position in Achillion in the summer of 2012. You can see the shares held (green and orange) on the right side of the chart above, with the stock price as the blue line. Over the next year, biotech industry observers pontificated that Gilead would dominate the space HCV space with sovaldi. 

However, things were just beginning to get interesting. The FDA put a clinical hold on Achillion's lead drug sovaprevir on July 1, 2013 due to toxicity concerns. On July 22, 2013  Peter Kolchinsky, Managing Partner of RA Capital Management, wrote a piece for xconomy, defending Achillion, and refuting the idea of Gilead capturing the entire market,  stating that Achillion would compete on price, carving out its own niche in the HCV space. By this time, RA had increase their holding from 2m shares to 7.4m.  For those interested, Kolchinsky's book The Entrepreneurs Guide to a Biotech Startup is a great read and can be found here.

When the FDA declined to lift the hold in September 2013, the stock took a beating from the $7's to the high $2's. However, RA Capital stepped up their buying in the rest of 2013, eventually owning 23m shares and over 20% of the company. 

During this time, bulls argued that the liver toxicities only occurred in a small subset of HIV patients, and therefor could be overcome. Bears saw a drug with toxicity issues that was late to market (if at all), and a pipeline that was not mature enough to get excited over.The shares traded as low as 2x cash on the balance sheet. However, those paying attention to RA Capital noticed the buying, and had ample opportunity to buy during the nine months the stock was down, which I did.

In June of 2014, two events occurred that boosted Achillion price. HCV rival Idenix was acquired, and the next day, the clinical hold was lifted. RA Capital's stake rocketed from $65m to $217m in about two months.

Since then, RA Capital has began to unwind its very large position, selling it down, presumably for risk management purposes, and to book some monster gains. The willingness to go against the grain, the deep level of conviction, and the huge win makes this one of my favorite biotech trades of all time.

Notes for the data geeks:

• ACHN price data from Yahoo Finance
• RA Capital holdings from Whale Wisdom, data sources are the following SEC filings3G, 3, and 4.
• Price and Cash & STI chart from YCharts
• This data is for common equity only. RA Capital disclosed option positions (bull call spreads) in the various forms. I have chosen not to include these in this graphic, so their actual economic exposure could be materially different.
• Between the forms 13F/D/G and the in Insider Forms 3/4, there are reporting differences of how many shares are held. I believe this relates to what accounts/funds get reported. To address this I cleaned up the data to best tell the story. 

Today Broadfin Capital, a healthcare specialist investment firm, disclosed a 1,301,622 share position in Anthera Pharmaceuticals ($ANTH), this represents 5.7% stake in the company as of September 25, 2014.  

This is an 70% increased from their June 30, 2014 disclosure of 766,329 shares. 

The timing is interesting because of  the near term of interim data from phase III CHABLIS-SC1 for Systemic lupus erythematosus in Q3'14 for and phase II/III BRIGHT-SC for rare disease IgA nephropathy in  H2’14.

On the valuation side of things, the company has $20m in cash, and a $40m market cap (round figures), if one believes they will see positive read outs, this could prove to be an attractive valuation. The average analyst price target is $3.33, for which represents an 85% upside from current levels.

Anthera has an impressive institutional shareholder list which includes a  13D from  Orbimed on August 1, 2014. Filing 13Fs as of June 30, 2014 from Great Point Partners, BVF, Perceptive, Sabby, and Abingworth.

I own no shares at this time.