When American banker J.P Morgan was asked what he thought stock prices would do next, he sat up in his chair and said: ‘They will fluctuate’.
Acrux is the patent owner of a testosterone replacement therapy (TRT) called Axiron. When it gained regulatory approval from the US Food and Drug Administration (FDA) in 2010 its share price more than doubled from $1.80 to $4.40 over the following two years. But in January this year the FDA launched an investigation into the general safety of TRT. Acrux’s share price crashed back to 75 cents by June – it was trading at about half the level it did before it gained regulatory approval.
We thought the stock was trading below its intrinsic value and upgraded the company to a Buy. But sentiment had changed by August, and the stock rocketed back towards $2.00 where we sold half our position. Finally, on September 17 an FDA committee recommended Axiron’s labels should include extra risks, but there were still underlying benefits of TRT. Acrux’s share price fell nearly 20% in a day and we sold what remained of our position at $1.35, locking in a 110% profit including dividends.
These are our top three lessons from the rollercoaster ride:
1) Market fluctuations are your friend – they are a source of opportunity to find undervalued companies. When we upgraded Acrux it was the fifth most shorted stock on the ASX. But the miasma of bad headlines were a source of opportunity for the well-researched investor. You have to think for yourself.
2) Valuation is the only thing you can rely on – by having an anchor of the company’s fair value that’s independent of share price, we were able to buy low and sell high. By thinking of Acrux's shares as part ownership in a business – which is what they are – and not as bits of paper for trading, it was easier for us to tune out emotions and act swiftly.
3) Having a margin of safety is key – When we first came to Acrux, the investigation was just getting started and there were a wide range of potential outcomes. If the committee’s recommendation was favourable the stock would have been worth multiples of its price. If it was unfavourable it could’ve been worth zero. We considered the probability and payoff for each outcome and came to a base case valuation of $1.30 – but we still demanded a wide margin of safety to allow for any errors in our judgement and were only willing to buy up to 90 cents.
When the committee released its recommendation, it reinforced our base case valuation but diminished the bull and bear case. There was no longer a large difference between the stock’s intrinsic value and where it was trading, so we sold and locked in an excellent return. Had we been focused on charts, trends, headlines, momentum etc. we’d have probably lost money. But any investor who ignored the crowd, focused on valuation and demanded a margin of safety could have doubled their money in three months.