Biotech trees and investment forests

FezHenry has a very interesting comment about my last post (valuing biotechs). I like (and agree with) several of his points - I have taken the liberty of copying the majority of it below, as I want to highlight the parts I agree with, and show why I think differently on others.

>>Thank you for taking the time to post such an in-depth response. The reason why I asked initially is because all of those biotech stocks you've mentioned have had zero positive free cash flow over the past ten years. This rate of cash burn has always been a reason why I have never personally invested in bio-tech's, because in my opinion, the majority of them just end up as giant cash-sucking research machines in the long run.

Yes, that giant sucking sound was not just jobs moving to Mexico - it is also biotechs (and nearly all early corporations) siphoning cash out of investors and giving them back lottery tickets. And you know what typically happens with lotteries...

I like how you've analyzed these stocks in such great detail, and you've obviously done some interesting modeling as well, but I'm somewhat concerned that you may be missing the investment forest for the bio-tech tree. For a company to be a proper investment, it needs to be able to generate more than just positive earnings...it has to be able to generate free cash flow.

Free cash flow (FCF) - or ANY kind of cash flow - is an attribute of a good company. And I agree FCF is something a typical investor will be looking for. Let's explore WHY that is.
Once a company is making more than it spends, on a real earnings basis, there are typically four things they can do with it. They can (i) pay a dividend (ii) retain earnings and reinvest in the company (usually better equipment to manufacture more quickly or more cheaply), (iii) reinvest in R&D for new or better products) or (iv) acquire other companies, with which they hope to make more or better products than it costs to acquire them.

But please note something about these choices:
Option i is perhaps the best from the investor's point of view (I can certainly spend extra money better than my favorite company can!) but note that the company then does not grow.
Option ii is wonderful up to a point, but you can make only so many widgets at a lesser price that people are willing to buy at any price.
Options iii and iv act just like what the company did when they themselves were the ones raising capital, through issuing more shares or debt. The difference of course is that they can pay for it as a going concern, but a couple products that don't make it from the lab to the shelf, or bad acquisitions, and that money is still sucked away.
My point is NOT to slam products, or making money via them. It is that companies making these profits will eventually have to revisit risk and invention. They have a far firmer foothold than pre-earnings corporations, but still have to allocate their capital in an intelligent way.

I think you may need to pay more heed towards how these companies are financing their revenues, and the impact on their profitability in the long term, otherwise you are just gambling that one of them will discover the next big thing.

Ah, but here's the thing. Even the next big thing is not a guarantee of a great company that is a good investment.
As example #1, I will pick on Tivo. I had a roommate who literally was probably one of the first 100 people to buy one. And the next day, he went and bought another (the larger storage one) for a second room. He LOVED A-V equipment and was a technophile. And he was right - everyone loved it. The problem is that the company made some poor choices with marketing and has been a dog for several years. Someone who waited for the sales to begin, measured them for a few quarters, projected them into the future, and was finally confident enough to buy, was the person who finally capitulated several years later for a loss.
Example #2 will be your choice of the financials over 2006 and 2007. Maybe Bear Stearns? Profitability up the yin-yang, darling of Wall Street, sweet credit ratings, and at the height amazing earnings that were projected to increase at astronomical multiples. Even though they did not make widgets, making deals can be just as profitable. But we all know how that ended up.
I am NOT dissing a company making actual profits. Many companies make great marketing decisions, and do not go charging into bubbles, as these two examples show. But simply having real FCF is not the only answer either.

I hope you don't think that I'm trying to rain on your parade, so to speak. I know that you have superior analytical skills from working with you @ CNB all of those years, but I just think you need to maybe take more of a fundamental view on some of these companies so you can properly estimate your risk. From a fundamental perspective, I personally wouldn't invest in any of these companies until they can at the very least, generate positive free cash flow and be able to stand on their own without financing their operations via shareholder dilution, or excessive leveraging...

Pre-earnings biotechs, as a category, are far riskier, as FezHenry notes, because to raise the funds necessary to maintain operation, they have to leverage debt, or sell more shares.
Note that I do not worry too much about the dilutative nature of issuing more shares (to a point!) - I may own 1.05 millionth of a company instead of 1 millionth but those existing shares then have $0.00001 more cash per share. And if I trust management enough to use that cash, I do not care if they raised it in a secondary or by achieving FCF.

Now here is the real difference, I believe, in the investing styles. I view fundamentals as more than just the metrics of cash per share, earnings per share, current ratios, and debt/equity. To me the fundamentals are "is what the company is doing, advancing its potential?" and "do I trust the management?"

... but I follow Warren Buffett's first two rules of investing:
1. Never lose money.
2. Never forget rule #1.

I think FezHenry and I are actually closer to each other than apart. I am a huge Buffett fan (I just finished Alice Schroeder's Snowball: Warren Buffett and the Business of Life and it is a fantastic telling of Buffett's life) but what you actually get out of it is that Buffett the investor is inhuman. I do not have the investing resources nor the time horizon of Buffett the investor. He can buy entire companies which gives him pricing power. He can sit on Coca Cola for 30 years. I freely admit I cannot.
But - there are a couple things I like to emulate him on. You do your research (due diligence), you talk to people, you fanatically find out every scrap of information you can, and when you get your fat pitch, you buy. Buffet talks of a punch card where you only make 20 investing decisions over your whole life. If you use 1/20 of your lifetime buys on Sangamo, you will want to make sure it is a great opportunity.
The other quality I have learned from Buffett, through Ben Graham, is that Mr. Market truly is insane. You can buy the same company for $20 a share one day and for $19 a share the next day. It is NOT 95% as good a company the second day, it is simply a function of fear, greed, reaction, hope, and maybe a little bit of the weather in New York. So if after my research I am in a company and I am convinced it is overvalued for the moment, I can sell some of my position without freaking out that I am breaking "Buffett's rules". The key for me from this second point is that you enter a position into a company you like with a core position, and can also trade around that position.

Please check out this post for an idea of what I am speaking of: http://www.fwallstreet.com/blog/31.htm

Done! And a good example of what you are leery of. However, I will point out that as a company, it may not be making money, but some investors had an amazing ride. Investing is a zero sum game - every share that gets bought means someone else has sold. The company really isn't more or less valuable - it is simply the relative pressure of the fear versus the greed.

I hope I haven't gone down too many rabbit holes and you are still with me. To close, my argument really boils down to my biotechs simply haven't started selling products yet. Once they do, the metrics you want to use (fundamentals) will either bear out the story, or they won't. You have different information available to you with the Buffetesque companies you choose to follow - actual sales information. I have to model out the potential sales before they happen with the companies I choose to follow. I do have to make the leap of faith that I have the next best thing, but you are making the implicit leap of faith that your competitors won't come out with the next, next, best thing.

As always, thanks for the thought provoking comments.

Regards,
Trond