Tuesday, June 25, 2013

The Pain of Selling


Well, I think the secret is if you have a lot of stocks, some will do mediocre, some will do okay, and if one of two of 'em go up big time, you produce a fabulous result. And I think that's the promise to some people. 
Investment legend Benjamin Graham taught his students at Columbia (which included a fellow named Warren Buffett) that a the proper way to judge the worth of security analysis is not whether subsequent market movements confirmed your work, but whether you got the facts right.  The market,  Graham felt, was simply too fickle.

I was reminded of Graham's words yesterday, when one of the stocks I own in many client portfolios cratered over the past couple of days.

I have long been a fan of Allergan.  The company is best known for its signature drug Botox, but it also sells a wide variety of specialty pharmaceuticals and medical devices.

I have seen management on a couple of occasions, and have listened to a number of well-respected analysts give their thoughts on the company's prospects.

Over the years that I have owned the stock, while I have at times been concerned about the increasing valuation that the market had been assigning to Allergan, I remained confident about both the company's prospects as well as its management to regard the position as one of my less-risky holdings.

That is, until it dropped -15% over the past couple of trading days.

Here's what top analyst (and occasional Random Glenings reader) Kelley Roche wrote about the company in an internal memo:

Allergan (AGN) is off almost 15% since Friday following the FDA's release of draft bioequivalence guidance for generics of Restasis (AGN’s market leading drug for dry eye). The potential for generic competition to Restasis has been a risk for AGN given the size of the drug (~14% of AGN’s revenue, 20-30% of AGN’s profit) and the May 2014 patent expiration, but the company and analysts thought a large, lengthy and challenging clinical study would likely be required to support a generic – and thus push out the life of Restasis. However….the draft guidance issued on Friday was an unexpected negative surprise, as it suggested two pathways to generic approval, including a pathway that would not include clinical studies for the generics (“in vitro”). If FDA’s six criteria are met, the agency stated it could support bioequivalence of a generic product. However, the draft guidance also notes that if this data is not equivalent, clinical studies would be required (best case for AGN). AGN has previously stated that it does not believe that the non-clinical route is sufficient to guarantee that a generic is equivalent to Restasis, and it is expected that AGN will challenge the FDA’s guidance during the 60 day comment period.

Why this is such a big problem for AGN: 1) A generic form of Restasis could enter the market much sooner than anyone thought. 2) AGN is known as a pretty good protector of its patents/products, so this is a big surprise. 3) This is the second execution setback over the past few months. 4) Valuation has always commanded a premium, but if AGN continues to falter like this the multiple could be at risk.    

I have to reiterate that the FDA’s release is DRAFT guidance, so this is not yet set in stone but of course the markets are assuming the worst. There have been a few downgrades and AGN is in the penalty box until it reports on 8/1. AGN’s dividend is tiny (.24% yield) and it hasn’t raised the dividend in 7 years. 

 In general, I sell a stock for one of three reasons:

  1. If my initial analysis was wrong;
  2. If there is better opportunity;
  3. If something has fundamentally changed at the company.
Clearly the fundamentals at Allergan have altered, as Kelley's note indicates.  And so, with great pain and reluctance, I sold the stock in client portfolios.

One final point:  When a stock has a waterfall decline such as Allergan experienced in the last couple of days, it is not unusual for the stock price to experience a small bounce in the next few days.  Thus, when a stock experiences a precipitous drop, there is always the temptation to wait for a few days, and hope to exit at better prices.

After doing this for more than 30 years, however, I have often found playing for a "dead cat" bounce to be more aggravating than it is worth.  Better to simply sell and move on, and look for the next opportunity.