Monday, August 24, 2009

Illogical OrthoLogic

The number one rule of value investing (as coined by Warren Buffett) is: Don't lose money. Hence the appeal of net-nets (stocks trading below their net current asset values), since they offer a dollar of tangible, liquid assets at a discount. But that number one rule is at a high risk of being violated if the net-net under consideration does not even have an established or proven business model.

Consider OrthoLogic (CAPS), a biotechnology company. It trades for $28 million despite having minimal liabilities and a cash balance above $40 million. The company has been around for a number of years, but investors must be careful to note a significant change in its business lines. In 2003, the company sold its revenue generating segment and decided to focus on developing therapeutic peptides. As a result, the company has had no revenue for the last several years. Furthermore, the company intends to keep investing in R&D to push one of its products to market.

In essence, an investment in CAPS represents purchasing a startup. Despite the fact that CAPS is a net-net, it is clearly not a value investment. Investors in startups tend to be venture capitalists with deep industry expertise who are willing to accept the risk of loss. Value investors, on the other hand, make money by making it a priority not to lose money.

While investors are offered the opportunity to buy a company that has done extensive research for only a fraction of what that research originally cost, the future is still very much in doubt. Despite the fact that the possibility exists that the company will eventually be successful and see its profits soar, the possibility also exists that the company will continue to burn cash until there is none left. Value investors look for asymmetries between the downside risk and the upside reward; unfortunately, this stock could go either way.

Disclosure: None

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