Monday, November 23, 2009

Healthy Margins Of Safety Only

As value investors, we often foray into areas of investment that nobody else will. Current earnings may be poor, the outlook uncertain, and the returns not expected for several years. In return for these sacrifices, we require one attribute on which we are unwilling to compromise: a large margin of safety.

We are not interested in 10% off or even 20% off, because in the aggregate that does not give us adequate upside for our efforts. Our valuations could be off by such figures, or an adverse event affecting the company could reduce its value by the same.

With that in mind, consider Insmed (INSM), a pharmaceutical company that recently sold a significant portion of its assets to Merck for $130 million. As a result, while the company trades for $106 million, it now sits on $122 million of cash and only $3.5 million of total liabilities. Unfortunately, however, there are no other significant assets: the company continues to operate at a loss with its remaining product.

The company did state that it may distribute the funds to shareholders, but it may also continue to try to develop its IPLEX product. This is from the quarterly report from two weeks ago:

"...[W]e expect to incur significant additional losses for at least the next several years until such time as sufficient commercial revenues are generated to offset expenses."

Simply put, this cash does not represent enough of a margin of safety, because of the uncertain future. It's this same line of thinking, "large upside only", that has value investors like Seth Klarman more interested in fallen angels than in junk bonds, even if they were to trade with the same yield and risk characteristics: much higher upside exists for the fallen angels due to their large discounts from par. In other words, the reward makes it worth the risk. To ensure superior returns, value investors must demand strong margins of safety that not only reduce downside risk but also increase upside potential.

Disclosure: None


Anonymous said...

Hi Barel,

I read through your analysis and I have some few questions regarding your convictions.

I can see how expenses will degrade this cash they are sitting on thus reducing the margin of safety if they do nothing.

But, in my opinion I believe this company is far from being a lazy.
Under Nasdaq rules, this company must trade above 1 dollar or it will get delisted. They have until March 15th 2010 to raise their share value up or do a reverse stock split to maintain their listing privilege. They have gone through this before and has been proactive in keeping their listing status.
Also they have invested 95.1 million dollars in marketable securities which are to mature in less than a year. Although in my opinion not their area of expertise, they are proactive in maintaining some cash and whatever is left of their business.

If the company is doing nothing, then I do believe the cash does not represent MOS because the future is eaten away by the boards neglect, but these guys are fighting/doing something and that is enough for me to think this company has a vast potential upside.

I am still learning so any opinion from you will be greatly appreciated.



I am currently a shareholder of INSMED.

Saj Karsan said...


You are right that their cash position offers them some opportunities. The question is what will they do with it. Hard to say. As a result, the discount to their cash value is not as large as I would like to see, but it's just a personal opinion.