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Application of Investment Theory on Individual Stocks

Background

Trading has been around since the dawn of man and creation of language, markets in which to trade followed closely after(Watson 2006). The first stock exchange dates back to 1602 when the Amsterdam Stock Exchange was established by the Dutch East India Company for dealings in stocks and bonds(Vega 1988). Over one hundred years later the New York Stock Exchange was founded in 1817 which has become the pinnacle of what Americans think of when they hear the words stocks or trading. Back then stocks, trading, investing was a very conservative boring way of living, stock brokers were paid far less, and financial instruments were less complex. That has changed significantly today as trillions of dollars move through exchanges every day. The life of someone who trades, invests, or is involved in financial markets is thought of as very lavish. Too lavish for many since the 2008 Financial Crisis which helped expose some of the fraud involved in financial markets and exposed some of the “fat cats” on Wall Street. The fact that more than most countries gross domestic product passes through different stock exchanges everyday is the root of the power financial markets have on us. We as an individual or as a country can be involved in financial markets or suffer the opportunity cost that comes with not being involved.

Individual stock returns are random, assets are priced efficiently, all available information is known by all investors, you can’t beat the market(Holden 2015). How is an investor today supposed to make a profit? When the greatest investors around the world are making near twenty percent returns how are individual or non-institutional investors supposed to make a return. Individual part time investors are doomed from the start and even more so doomed if you are a trader. The idea that a single person can outperform an entire investment firm or even a single person that does this practice for a living is crazy. It’s like me putting my life savings on a one versus one match against Lebron James it’s just not possible for me to come out on top, in many cases it’d be more realistic for me to say the entire Cavs team. Why would I even want to be an individual investor, there is no reason to put my own money at risk. Investing has been around forever, but has become a life commitment today when you look at how different and diverse investments can get.

Important Definitions, Formulas, and Resources

Investing: spend money with the expectation to make a profit (Bodie 2017)
Finance: management of money (Bodie 2017)
Binary Event: financial betting which displays the price of a bet as an odds index (Shkreli 2015)
market capitalization = shares outstanding * share price (Bodie 2017)
enterprise value = market capitalization – cash + debt (Bodie 2017)
net present value = (cash flow / (1 + discount rate) ^ 1 + (cash flow / (1 + discount rate) ^ 2 +…. (cash flow / (1 + discount rate) ^ t (Bodie 2017)
Investopedia

Martin Shkreli’s Approach

This paper will look to bring focus to practical ways to analyze individual stocks and start to make a portfolio. To understand my thought process and methods from which I analyze stocks in this you have to understand Martin Shkreli’s approach which I have adopted much of it. First you have to start with his logical road map, you have to be realistic(Shkreli 2015). As I mentioned above it is unlikely a poor college student will be able to outperform the likes of Warren Buffet, Carl Icahn, and George Soros. In fact Shkreli emphasizes not even getting involved in the stock market usually. Most of your money throughout your lifetime will be made on some sort of fee basis. Hence you are better off advising people with money how to invest it than put your own money at risk. This advice must be worthwhile and have some type of meaning behind it(Shkreli 2015). Shkreli for example has a complex understanding of the pharmaceutical industry having started his own pharmaceutical company and owning two different ones in his career, Shkreli understands the industry in a way that few people do. Specialization in a field is necessary then to make this advice worthwhile and Shkreli has done just that.

Shkreli’s investment process and analysis involves analyzing the three “holy trinity” of financial statements. These statements include the income statement, balance sheet, and statement of cash flows. He values companies in the same way a financial manager would in that the value of a company is worth the sum of all discounted cash flows from operations until eternity using net present value(Ross 2017). Shkreli uses a fundamental approach to investing, part of which he adopted from Phillip Fischer in his book Common Stocks and Uncommon Profits. In doing so he believes a proper investment decision comes after spending near one thousand hours understanding a company. Some approaches Shkreli uses aren’t exactly widely adopted. For example Shkreli believes that stocks do not go up in the long run when you adjust for inflation and taxes(Shkreli 2015).

Waste Management (WM)

Waste Management is one of the largest waste and environmental service companies in the U.S. headquartered in Houston, Texas. In the northeast almost, all large waste containers and dump trucks have the Waste Management logo. Clearly they have a huge presence and without any understanding of their company let alone stocks in general you would expect the company to be worth a lot. With a price of $80.92 as of 11/21/17 and 442 million shares outstanding of common stock it has a market capitalization $35.837 billion(Waste Management 2017), so yes Waste Management is worth a significant amount when you look at their market capitalization. When you subtract cash and add back debt you get the enterprise value of $44.849 billion. I will be using enterprise value in my calculations versus market capitalization. Why? When you buy stock in a company you are actually buying part of that company and the rights to their assets and net incomes that come from operations(Bodie 2017). Market capitalization is a poor measure of value when compared to enterprise value as it does not consider debt and cash.

MC + Debt – Cash = EV

For example if I was looking to buy a company with a market cap of $100, debt of $5, and cash of $75 my enterprise value would be

100 + 5 – 75 = 30

Even if I pay the full market cap price of $100 for this company it’s really like I am paying $30 because they have little debt $5, and a lot of cash on hand $75. If I flip this around though the opposite happens

100 + 75 – 5 = 170

In this situation when the debt is equal to $75 and cash equal to $5 the enterprise value becomes $170. If I were to pay the full market cap price of $100 I would not be happy. ¾ of this company is debt I would want to be compensated for the risk associated with that. I would not want to buy this company unless at a far discounted price from their market price.

Once I have my enterprise value in my model I begin entering the numbers from the income statement in. Generally I want to have every quarterly and annual financials in my model but in this case I opted to 3 years of quarterly statements and 14 years of annual statements. When reviewing WM income statement some of the first things you might notice is that they make large amounts of revenue at well over $3 billion the past 12 quarterly statements and that they have done this the past 14 years as they’ve been making close to $13 billion on average over the past 14 years. When you look at their net income though you can see they are only making $0.10 on every $1 they make in revenue. So clearly this is a very capital-intensive industry and a high cost industry. Industries like this make way for monopolies and oligopolies to be possible. There are extremely high barriers for other firms to enter this market due to the high costs, in this situation we expect WM to have a large market share in the waste industry, which they do at almost 30% of all waste collection, 47% of all landfills, 63% of all transfer stations giving them a total share of around 37%(Waste Management 2017).

Waste Management Analysis and Conclusion

            When you look at WM this is the type of company that one would consider an economic moat as Warren Buffet would put it(Skkreli 2015). There are low barriers to entry for other firms, protecting it’s profits and it’s unlikely a company like this could just disappear, hence the low discount rate in my model. The most important thing for me about WM is how they can innovate. They have been buying competitors and currently don’t have much cash on hand to keep doing that. Some people frown on this business model while others encourage it. I was not impressed with their purchases and gave them a return on invested capital of -1%. Most of the value form WM comes from their dividend. For them to be even worth holding one would have to hold them for an extended period of time and that’s with the assumption their dividend keeps growing. In my opinion there are far better investments out there than WM unless some type of huge change is made. I found this video interesting, at some point the oceans will have to be cleaned, and that debris in the ocean has recycled value. Maybe one day WM can invest in something like this to make them a more interesting or maybe even more profitable company.

Axovant Sciences Write Up

Axovant Sciences is a clinical stage bio pharmaceutical company that commercializes therapeutics for neurodegenerative diseases. Axovant was founded in 2014 as a subsidiary of Roivant Sciences, they have offices in Bermuda, Switzerland, and London(Axovant Sciences 2017). Axovant has two products as possible treatments for lewy body dementia, Intepirdine and nelotanserin. Intepirdine has just recently failed a pivotal phase III clinical trial showing no efficacy. Intepirdine is Axovant’s number one drug candidate for the treatment of lewy body dementia. Intepirdine was acquired from Glaxo Smith Kline in 2014 for $315 million. Idalopirdine is a class similar drug to Intepirdine that failed all three of its clinical trials and did not have positive efficacy. Glaxo Smith Kline also sold Axovant this drug candidate after it had failed their own clinical trials(Axovant Sciences 2017).

Axovant currently doesn’t have much of a position in the treatment of neurodegenerative diseases. They number one drug candidate Intepirdine has no efficacy and Nelotanserin is still only in phase II clinical trials. Axovant acquired all the rights to Nelotanserin from Arena Pharmaceuticals last year. If Nelotanserin proves to have efficacy and gets FDA approved, it will be one of the first treatments used for lewy body dementia (alzheimer’s disease) with donepezil a current FDA approved treatment for lewy body dementia. Some competitors and peers in the industry of neurodegenerative treatments include Amgen, Nova Nordisk, Gilead, Celgene, Biogen, Shire, Vertex, and Incyte(Yahoo Finance 2017). All of which are far less speculative and more diverse than Axovant.

In the neurodegenerative therapeutic industry, the current FDA approved drugs include Donepezil, Galantamine, and Rivastigmine, all of which are acetylcholinesterase inhibitors. Intepirdine is a 5-HT6 receptor antagonist, as I mentioned above Idalopirdine is a 5-HT6 inhibitor failed all three of its clinical trials(Wilkinson 2014). Currently Axovants entire company is relying on the approval of their 5-HT2A receptor drug Nelotanserin’s approval, even though they have already spent much of the cash from their IPO on getting Intepirdine approved. It seems unlikely Axovant will have much success now or in the future. The current best-case scenario is for Axovant to continue the clinical trials for Nelotanserin and hope it shows efficacy. Though it seems unlikely they will be able to continue spending money on the production and approval of Nelotanserin. It seems more than likely that if Nelotanserin ever makes it into the neurodegenerative therapeutic market that it will be through another company if it is acquired.

The current CEO David Hung who has had previous success building the drug company Medivation which was later sold to Pfizer for $15 billon says he has no interest in being acquired, stating he is focused on true innovation not creating new versions of drugs that have already been made(Axovant Sciences 2017). One of his main focus being his employees who he seems to have the utmost confidence they are competent to get the job done. If Hung truly does believe Nelotanserin will be successful than it seems likely he will be able to find investors to put money into it. Axovant’s stock price dropped significantly after the phase III results of Intepirdine from the mid $20s to almost $5. It has since continued to drop falling below $5.

Axovant Sciences (AXON) Ratio Analysis Comparison to Gilead Sciences (GILD)

AXON gives a very bad outlook for future performance when compared to GILD which is probably an unfair comparison for AXON, currently as AXON is a small speculative company that has yet to get a product on the market, while GILD is a well-developed bio-pharma giant. Regardless GILD was not long ago a small company trying to get it’s first drug approved. To begin AXON’s profit margin is non-existent since they have yet to get a product approved(Axovant Sciences 2017). They have been burring through cash attempting to get their first product Intepirdine approved which has just recently failed a phase III clinical trial. GILD on the other hand has a very high profit margin of around 86% which is very favorable(Gilead Sciences 2017). Both return on assets and return on equity are negative for AXON as well. Which is unfortunate for shareholders who are earning negative amounts when it comes to profit per dollar of assets (ROA) and negative amounts of profit per dollar of equity (ROE). GILD on the other hand has some favorable numbers for their ROA at 24% and ROE at 71%. The fact that GILD’s ROE is much higher than their ROA suggests they are using financial leverage. Being a new player in the bio-pharma market AXON has a very high quick and current ratio, at 17.9 for both, AXON can cover all their current liabilities 17.9 times over. AXON could easily be liquidated very quickly which is common for new bio-pharma companies that are still trying to start earning revenue. This can be looked at positively or negatively, the fact that both ratios are above 1 is positive, but that fact that it Is 17.9 times could be looked at negatively. GILD has healthy quick and current ratios at 2.05 and 2.22 meaning they have their liabilities covered 2 times over even when you minus off their inventory. AXON’s debt-equity ratio is currently 0.41 as they have just started taking on long term debt this past year. Some might view this as positive which in some ways it is, because every healthy company usually has some level of debt. However, AXON currently has no revenues so the fact that they have a debt-equity ratio of 0.41 with no FDA approved product is not very good. For a company trying to get their first product FDA approved it is important they have a lot of cash on hand, so they can pay for clinical trials and other costs that come with the process. Once they have a product FDA approved we should expect them to get some level of debt or royalty payments by setting up manufacturing and distribution deals, or starting their own manufacturing and distribution. Inventory, asset, and receivable turnover ratios are all 0 for AXON because AXON currently has no sales or cogs. GILD on the other hand has an inventory turnover of 2.66, receivable turnover of 6.73, and asset turnover of 0.53. Having a high inventory and receivable turnover ratios is desirable(Ross 2017). GILD has just that, the high inventory turnover rate meaning inventory is not sitting around, and high receivable turnover rate meaning they are able to get their receivables payed back quite fast. Which can be a hard thing to do in the third-party payer system we use to pay for most of these products. The asset turnover ratio for a company like GILD is healthy, for every dollar in assets GILD generated 0.53 cents in sales. Bio-pharma is a capital-intensive industry, but not as capital intensive as say an Eversource energy which would have much more money in assets and a higher asset turnover ratio than GILD. AXON has a negative earnings per share ratio, again because they currently have no sales and are spending cash on operating expenses. A lower PE ratio suggests a firm could be undervalued, though a higher PE ratio might suggest investors believe there is growth to come in the company. GILD for example has a PE ratio of 7.23 which is not very high for a company that is pulling in billions of dollars in revenue with a low profit margin and gross margin. Many investors may be skeptical of GILD’s diminishing Hepatitis C revenues and whether they can bounce back from losing a large source of revenue. AXON has a price to book ratio of 4.40 which is a desirable ratio to have, GILD also has a desirable price to book ratio at 5.04. A price to book ratio less than one suggests a company has not been successful at creating overall value for its shareholders(Ross 2017). Which is surprising because AXON in many ways has done just that with a negative PE and the recent phase III failure. GILD on the other hand has maximized shareholder profits over the years. One might think about investing in GILD instead of AXON because of this which would probably be smart.

Axovant Sciences Conclusion

Again I would suggest against investing in AXON, had intepirdine gotten positive efficacy in their phase III trial and FDA approved this past month it would have been a different story. However their 5-HT6 inhibitor failed to do so, much like previous 5-HT6’s have in the past(Wilkinson 2014). AXON could run out of money before 2020 if they continue to spend at their current pace, though they only have one more drug to currently spend money on, which is in a phase II trial. However phase III trials are the most expensive trials and AXON will need cash on hand to pay for it(Stevens 2014). The best case scenario for AXON is that they get bought by a larger competitor that sees potential in their only other drug Nelotanserin. All of the ratios AXON has to provide suggest in many ways it is not smart to invest in the company and that one would be better off investing in a competitor such as GILD.

Inter/Multidisciplinary Approach to Investing 

By now with the commentary and models I have provided you should have some understanding of finance and financial statement analysis. Which involved the income statement analysis that Martin Shkreli influenced and the financial ratio analysis and comparison mostly coming from the text Essentials of Corporate Finance. All of which revolve around the disciplines of finance, economics, and some simple math. However when you view my analysis of WM you start to see some aspects of philosophy coming into play. WM is a well established firm with a large presence and could possibly innovate the future of waste if they put in the right spending into research and development. Will they invest in different ideas and continue to be the world leader in waste management? When you view my AXON analysis you start to see the importance of having an understanding of chemistry and pharmacology has when investing in bio pharmaceuticals. Someone with a very good understanding of these topics could’ve maybe predicted the recent failure of AXON’s intepirdine clinical trial. A person like Martin Shkreli for example who did just that here. Some of these topics are quite challenging and hard to put into context. Which is why often times individuals investing results in failure. There is a reason large investment firms hire thousands of people and invest in some of the most complex technology available today to help with their analysis. Which is why investing is entirely a multidisciplinary and often times interdisciplinary subject. Most firms have thousands of engineers, computer scientist, statisticians, accountants, doctors, and all sorts of other disciplines that have no idea how to do the work of one another.  The work they commit helps form the investment decision which will be given to someone with a more interdisciplinary background at a senior level to make a final decision. Given the information I gathered a few things seem apparent. WM’s stock price is currently fairly valued, they are however a world leader in waste and environment management. If they continue to adapt and invest maybe one day they could be worth something more. AXON could’ve been an extremely good short sale if you were able to predict the Intepirdine trial failure. AXON has two current scenarios either they are bought by another company at which point they will probably be worth more than the current stock price. Or they have another binary event that means life or death for the company. AXON could be a possible way to make money in the near future if more analysis of it is complete.

 

 

 

 

Citations

Wilkinson, David, et al. “Safety and efficacy of idalopirdine, a 5-HT 6 receptor antagonist, in patients with moderate Alzheimers disease (LADDER): a randomised, double-Blind, placebo-Controlled phase 2 trial.” The Lancet Neurology, vol. 13, no. 11, 2014, pp. 1092–1099., doi:10.1016/s1474-4422(14)70198-x.

Shkreli, Martin. “Investing Basics.” Https://Drive.google.com/Drive/u/0/Folders/0B7KHNVOBFX8qMEs1LWlKamZsRE0, Google Docs, 11 June 2015.

Waste Management. “Quarterly Financials Q1 2017.” Quarterly Financials http://Investors.wm.com/Phoenix.zhtml?c=119743&p=Irol-IRHome, 26 Apr. 2017, services.corporate-ir.net/SEC.Enhanced/SecCapsule.aspx?c=119743&fid=14967857.

Axovant Sciences. “Quarterly Financials Q2 2017.” Quarterly Financials , 2 Nov. 2017, investors.axovant.com/news-releases/news-release-details/axovant-announces-second-fiscal-quarter-financial-results-and.

Vega, Josef Penso de la, and Hermann Kellenbenz. Confusion de confusiones. Baker Library, Harvard Graduate School of Business Administration, 1988.

Watson, Peter. Ideas: a history of thought and invention, from fire to Freud. Harper Perennial, 2006.

Holden, Craig W. Excel modeling in investments. Pearson, 2015.

Bodie, Zvi, et al. Investments. McGraw-Hill Education, 2017.

Ross, Stephen A., et al. Essentials of corporate finance. McGraw-Hill Education Australia, 2017.

Axovant Sciences. (AXON).  Income statement, November 2, 2017. Yahoo! Finance. Retrieved
from http://finance.yahoo.com/q/is?s=AXON

Stevens, Erland. Medicinal Chemistry: the Modern Drug Discovery Process. Pearson, 2014.

Gilead Sciences. “Quarterly Financials 2017.” Quarterly Financials, 2017, www.sec.gov/Archives/edgar/data/882095/000088209517000027/q317form10-q.htm.

2 Comments

  • Robin DeRosa

    The work in your applied project was so technical, I really thought I was going to flounder when I got to this research article. But how refreshing to find that things were so clearly articulated and explained from the ground up. You put together a solid little portrait of how you can build brief but multifaceted pictures of companies and use those pictures to help you decide on whether or not the companies see like solid investments. I can see the beginnings of a possible future path for you here, as you work with regular people to help them use interdisciplinary knowledge and simple but well-informed strategies to make decisions about their own individual investments. As someone who is literally just a year into building my own financial plan and investment strategy, I’ve really appreciated this semester with you! Your work always reflects your passion, but it also reflects your willingness to spend time educating yourself– about math, computer science, specific companies (and all of their areas of knowledge– like neurodegerative therapy!!), theories and principles of finance, etc. A pleasure to learn from you, and to watch how you diligently integrate knowledge across these domains.

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