Wednesday, August 3, 2011

Insmed: The Definition of Risk

The mainstream finance profession will have you believe that risk is akin to price volatility. Unless you are a short-term trader, this is wrong; a change in a business' price rarely affects its operations. Real investment risk has to do with the business risks faced by each of the companies in a portfolio. Yesterday's 50%+ drop in the share price of Insmed (INSM) demonstrates this disparity of definition very clearly.

Prior to the steep drop in Insmed's price yesterday, the company had a beta of -0.15. This suggests that the company's price volatility was rather low relative to the market. To mainstream finance enthusiasts, this would suggest that the stock was not risky as part of a diversified portfolio. In reality, however, this company's risks were (and still are, despite the 50% price drop) extraordinary.

First of all, the company is losing money. Unlike other companies that are losing money, Insmed cannot just cut costs and shrink down to its most profitable niches/segments/locations. This is because Insmed has no profitable segments!

The company is betting heavily on the market's acceptance of a new drug (currently undergoing FDA clinical trials) that it has developed for the treatment of lung diseases and infections. If it works out, shareholders will of course do very well. But investors should not be focused on the "if all goes well, I'll do very well" scenario. Instead, investors should analyze risk by focusing on the "if things go wrong, what will happen?" scenario.

In many cases, things won't go wrong, and so even the investor who pays no attention to risk will do well. But to avoid losing principal, prudent investors seek to invest in companies where the likelihood of things going wrong is low and where the damage won't be large even if things do.

Insmed fails on at least one of these counts, and shareholders paid the price yesterday, as the company is now worth half of what it was the day before. The news came out that the FDA has placed a hold on Insmed's Phase III trials of the aforementioned drug after reviewing the data from a previous trial.

It is, of course, entirely possible that the trial will resume and that the company's product will go on to have a successful future. Unfortunately, there's little to no fallback for this company if things don't work out. As such, investors who buy into this company while it trades for more than its cash balance are risking significant portions of their principal.

Disclosure: No position

5 comments:

Anonymous said...

Saj,

I would like to respectfully disagree with your point of view on this post. This is one of my favorite blogs - so don't take this criticism the wrong way - but I don't think your investment advice is good in this case. Here's why.

You wrote,
"But investors should not be focused on the 'if all goes well, I'll do very well' scenario. Instead, investors should analyze risk by focusing on the 'if things go wrong, what will happen? scenario.'
... prudent investors seek to invest in companies where the likelihood of things going wrong is low and where the damage won't be large even if things do.
... Unfortunately, there's little to no fallback for this company if things don't work out. As such, investors who buy into this company while it trades for more than its cash balance are risking significant portions of their principal."

Now I'll start off by saying I know nothing about Insmed or its prospects. But in general, I disagree with the idea that an investment that has a non-trivial probability of a large loss is necessarily a bad one. I would claim that the key metric is the investment's Expected Value (EV). That is, a probability-weighted average of all possible future outcomes. If the EV is very high, then even a moderate probability of total loss should not discourage an investor from placing this bet into a *diversified basket* of such bets.
I agree that it's a mistake to have a *concentrated* position (e.g., 10% of the portfolio) in a stock like this one, but if the EV is high, then having a basket of, say, 1% positions like this may make a lot of sense.

-aagold

Saj Karsan said...

Hi aagold,

I understand what you're saying, and it does make sense, but I disagree. My answer would be long enough to fill a post, so I'll write a post on this topic early next week in response.

Mityo said...

This is good, but isn't a one-day 50% drop rather an example of volatility than anything else. If the company recovers, a possibility you concede to, it might not be a definition of risk but just a display of market mood.
This is not an argument in defense of INSM, which is most probably a very weak company, but rather against making a conclusion based on a single-day price move.
If it were a different company, the value investing framework would advise hanging on through this "rough patch."

Saj Karsan said...

Hi Mityo,

I see what you're saying, but I think the price drop is reflective of the fact that the company is so reliant on this one product. Even after this drop, you can't say downside risk is protected because there is no protection all the way down to the company's cash balance. That does make it different from other value plays where you would want to buy more or hang in there.

Saj Karsan said...

For those interested, I responded to aagold's comment in this post.

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