Biotechnology's Moat

On a recent excursion, I got a new "wise one" on the differences between the biotechnology industry and traditional pharmaceutical companies. The primary difference is that biotechnology companies focus on "large molecules" and pharmaceutical companies focus on "small molecules." I understood that prior to my recent discussions. But, I did not understand the deeper difference in their competition with generics.

In the 2006 annual report of Amgen, CEO Kevin Sharer writes, "Biosimilars, or follow-on biologics as they are called in the U.S., are not in any way comparable to generic pharmaceutical products. Protein-based medicines cannot be copied in the way that small molecules can be. Their production is complex, and their safety must be ensured through rigorous processes and tests." Without my new insights, I could not have deciphered this statement.

Essentially, both small and large molecules must be patented as a "utility patent." Their patents is published. Small molecules are not only easily understood, but more importantly, easily produced. Large molecules, even when perfectly understood, are affected by their "complex" method of production. The method of production is not disclosed as part of the patent, but only to the FDA as part of the "rigorous processes and tests." Because of the complexity of production, generic copycats cannot generate an easily approvable without replicating these "rigorous...tests." These tests raise the cost of production significantly. That moat is significant.

Tim McElvaine

Readers of my blog know that I have a list of cachamim or "wise ones." My goal is to "get dirty from the dust of their feet" - so close would I like to study their wisdom. Tim McElvaine is on the list. He is a Canadian investor. Recently, I came across a brilliant statment he made: "buy on the assets and sell on the earnings." This insight is profound and rewards reflection.

Is Big Pharma Inefficient?

A NYT article (2/11/2007) titled "It's Alive! Meet One of Biotech's Zombies" describes insight into the biotechnology industry. At first glance, it appears that biotech companies bring nimble, entrepreneurial qualities to the pharmaceutical industry which are lacking within Big Pharma (large traditional pharmaceutical companies). The article shows that's not true.

The article quotes Arthur D. Levinson, chief executive of Genentech, as saying "biotechnology has been one of the biggest money-losing industries in the history of mankind.” He estimated that the biotech industry as a whole has lost nearly $100 billion since Genentech opened its doors in 1976. Only 54 of 342 publicly traded American biotech companies were profitable in 2006, according to Ernst & Young.

The article also offers insights from an industry observer. Gary P. Pisano, a Harvard Business School professor has put forth a new book, “Science Business: The Promise, the Reality and the Future of Biotech,” in which he argues that the biotechnology industry is inefficient — or at least no more efficient at drug development than Big Pharma.

If the biotech industry is no more efficient than Big Pharma, then their presence is merely a version of the "lottery principle" articulated by Alan Greenspan during the roaring 90s and not a superior way to invest in the health care industry.

Leading Grocer: SYY

Sysco Corporation (SYY) is the leading grocer to restaurants. "Eating out" (foodservice) and "eating in" (retail) now make up roughly equal shares of the total U.S. food dollar with each grossing (a word derived from grosse, meaning twelve dozen, that also led to the word grocery) about $500 billion.

Eating out is a broad category, including schools, hospitals and supermarket services. For years foodservice was gaining share from retail, but has levelled out since 1998. Excluding supermarket and fast food categories, SYY has roughly 15% market share of selling groceries to foodservice, a $200 billion category.

SYY gets slightly over 50% of its revenues and most of its profits from "street customers," a term it uses to describe independent restaurants. The independent restauranteur is declining in the take out category, but is thriving in the full-service arena. SYY is a valuable ally to these customers, equipping them with the benefits of technology that would normally be available only to large scale buyers such as McDonalds.

Viewed in these terms, SYY is similar to Wal-Mart (WMT), another "leading grocer" with over 24% market share. Just as SYY expands the purchasing power of these "street customers" with scale and technology, so does WMT expand the purchasing power of its customers with scale and technology. However, SYY's customers use the expanded power for competitive purposes in business, while WMT's customers use that power to enjoy a wider range of products and services.

Based on this comparison, I tried to compare the long term stock price performance of the two companies. This graph shows the result:

Through 2003, these two stocks had similar performance, but have diverged since then. Looking at their financials, I saw they had similar results. However, the market gives SYY a P/E of 24 that is significantly higher than WMT's P/E of 18. In fact, past divergences in price are also mostly caused by P/E (market value) differences, not operating ones. (Here it appears that WMT has compelling value versus SYY.)

Interesting to me, SYY has almost 9,000 trucks while WMT has about 7,000 trucks, even though the gross revenues of WMT (in the U.S.) are almost eight times greater. This difference indicates that SYY could have some real improvements in the distribution area with its much anticipated redistribution centers (RDC). Look at the following graph the company has supplied:

If trucking times improve as indicated, either less trucks will be required or a greater volume will be moved with the same number of trucks. In either case, SYY will have moved another step towards helping its customers compete.

Hedge Hog?

As I wrote in an earlier blog, I continually look for cochamim, "wise ones" to learn from. One good way is to look for the footprints in the sand and James H. Simons is making big footprints. In fact, his footprints are so large that I'm leery about their accuracy.

James H. Simons is an accomplished mathematician turned hedge fund manager. For 2005, he was the top money-maker with his reported take-home pay to be $1.5 billion. The math for his compensation does not require a Ph.D; he earns a 5% fee plus 44% of outperforming his benchmark. (And to think that I was squeamish about 2% plus 20% of outperformance!) As if that compensation number is not mind-boggling enough, his investing techniques are even more alien.

He is a "high frequency" hedge fund manager. This new breed uses advanced mathematical and scientific processes to detect the "visible hand" in the tick by tick trades in the stock market. This relatively unknown trader's firm is reputed to make over 10% of the daily trades on the NASDAQ.

His returns are extraordinary. Apparently he has exceeded 35% per year for over 20 years. But these returns are not verified nor are his processes public. For years, the claim has been made that his firm, Renaissance Technologies, would not market, nor even need to market. Despite those claims, Renaissance cranked up the marketing and moved from $5 billion to $16 billion in assets under management (AUM) by the end of the year 2006.

Was $1.5 billion in compensation not enough?

Battered Stocks?

Recently, someone referred to "battered stocks." There hasn't been much battering lately, but it is where the big gains can often be found.

GEICO is one of Buffett's largest and longest-held stock positions. GEICO has done so well for so long that it is difficult to imagine its "battered" origins. In 1975, GEICO reported a loss of $7.13 per share, dropping its equity value from $8.13 to $2.08. This loss of about 75% of the net worth of an insurance company in 12 months is horrendous. During the following year, while GEICO was reporting another $1.51 per share in loss, Mr.Buffett began purchasing the stock at $3.18 per share. This price paid seems high (greater than book value) for a company teetering on bankruptcy.

The results were spectacular. During the following 20 years, Mr.Buffett's return on GEICO stock was 27.2% per year. He profited two-fold: the inherent high quality growth of the GEICO business and the deep discount he paid rose to its inherent worth.

Effects of WWII?

Keeping with the title of my blog - "random bits," I have included something for a future sociology paper. The "replacement ratio" for keeping a steady population is 2.1. The lowest replacement ratios of all developed countries are these three which are, coincidentally or not, the three major Axis powers of WWII. I guess if the quest for "lebensraum" was not going to be met with more territory, then perhaps a low birthrate could have the same effect.