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Minyan Mailbag: Where are the Fundamentals?


It depends on how you define them.


Professor Miller,

I read with interest your article
The Geopolitical Situation Trumps Fundamentals which seems 100% different than the view expressed by Scott Reamer Friday when he stated that "geopolitical events are heating up because stock prices are going down."

The latter argument makes more sense to me, but it is not just stock prices; it's housing prices, jobs, etc, while debt and interest rates have been ticking up.

Minyan Mish

Minyan Mish,

Ask yourself a few questions: Did Israel attack Lebanon because asset prices declined acrossthe board during late June and July? Did North Korea launch their missiles because US housing prices, in select markets, are declining?

Fundamentally, however, I don't particularly care what the answer is. While I appreciate Scott's quest to prove to people that oil has no *factual* correlation to equity prices (for example), I'm perfectly fine with the idea that people's perception that it does is enough to cause people to hit the sell button. As long as I'm flexible enough to understand that oil prices (again, for example) will matter to investors as long as they matter, and not matter when they no longer matter, I'm OK. That's not intellectually tidy, but I don't need to be intellectually tidy to show a profit in the markets.

Professor Miller,

I also question your assertion of "fundamentals." Risk aversion is a fundamental factor but even if one does not accept that argument, one has to look at many of these biotech plays (especially the small caps) as nothing much more than lottery tickets. What are the odds of some small company coming out with some new blockbuster drug? If they do well in a trial, stocks soar; if they do poorly the stocks are crushed. So where are the fundamentals here? If demand for bio lottery tickets relative to supply goes up, bios will rally. If not, then the price of bios is likely to drop. On the earnings side, how long will it be (if ever) for some of the companies to have any earnings?


It depends on how you define fundamentals. I've written often here that the dev-stage biotech stocks we cover have nothing resembling the fundamentals that most people are accustomed to. It is the primary challenge of investing in the sector. There are guidelines for valuations, however, that are collectively referred to by myself and others in this space as "fundamentals." This mostly involves comparisons to comparable valuations between companies, especially to companies whose valuations have been fixed by acquisition, as well as comparisons to historical values. We know, for example, the market traditionally values a company with an oncology drug in late-stage trials somewhere around $500 mln. When a great number of companies with that characteristic are trading under that figure, we say the sector is "fundamentally undervalued." Ditto for the reverse. It's absolutely not an exact science, somewhat akin to trying to agree what the "right" multiple is to plug into a G&D equation.

Beyond that, you can rank drugs according to their scientific validity and clinical evidence. Drugs with more are more valuable "fundamentally."

Outside the bio sector I continually hear talk of "great earnings." It is relatively easy to prove that risk acceptance or avoidance (via PE expansion/Contraction) plays a bigger role than earnings when it comes to stock prices. But even in a vacuum, if one just looked at earnings, one must also look at the quality of those earnings and the repeatability of them.

I don't disagree with this. Because there is no "right" multiple, valuations will always expand and contract according to investor psychology.

Yes, financial earnings have been very good. But enquiring Minyans might want to ask why.

That answer is simple. People have been willing to speculate on housing, speculate in the stock market, and go further and further in debt to buy things they arguably do not need and cannot afford. So yes, as long as that party continues and consumers keep borrowing those earnings will be good. OK so what next? Given that housing defaults have been low (primarily because of rising home prices), what happens to financial sector earnings when consumers pull in their horns. What happens when home prices fall?

Again, I don't disagree. My only disagreement with this general line of thinking has been timing. I wrote a piece two years ago pointing out that these issues were important, but they simply would not matter until they mattered. Until most investors work them into their risk profile, they would be ignored and stocks would continue to go up. Only a fool ignores the huge financial disconnects we are faced with, but that doesn't mean I should have gone short in 2004.

For what it's worth, I think they matter at this instant more than they have ever mattered since I've been writing for the 'Ville. But I'm not going to give back 2+ years of profit from the long side just because those trades flew in the face of the macroeconomic "facts."

There can be no doubt that the housing bubble has popped although serious declines have just started in only a few local markets.

Perhaps I am wrong, but I do not feel the market has come close to factoring in what is about to happen to earnings across the board, especially in the "safe" financial sector. Banks are more dependent on real estate and consumer credit than at any other time in history. Yet in spite of what I think are horrid looking fundamentals (looking ahead), this sector has been holding up.

I also don't disagree, but these stocks will only start reflecting this version of the facts when the majority of investors incorporate them into their investment strategies. Since none of us get rebates on losing short (or long) positions simply because we were "right" about such things, then we all have to acknowledge that being right makes no difference to profit and loss.

Should it color our risk profile? Absolutely, and I've written about that at length here and to my firm's clients. If these macroeconomic disconnects didn't exist, we would have been extraordinarily long the biotech sector last summer. Since they do exist, we were more measured.

If credit lending standards rise (and I think they will), and willingness to lend drops (and I think that will too), what will that do for funding of cash strapped bios with no earnings?

Nothing. Bios don't depend on loans, few carry any debt and almost none carry debt that is interest-rate sensitive as their rates are generally fixed and payable in shares. Rising interest rates can help biotech companies as the interest income off their cash balances go up. The only negative effect on biotech from this situation comes from any correspondong drop in equity valuations because it increases their cost of capital due to lower stock prices in their PIPEs.

In short, if there has been a secular shift away from risk, I am not sure one can say the fundamentals are good for much of anything regardless of the need for or development of "lifestyle drugs."

If you believe fundamentals = stock price, sure. But I don't see the market that way. I believe stock prices are divorced from the underlying fundamentals, with the two meeting only occasionally as the pendulum of valuations swings to and fro.

Investors desiring to profit from equity investing therefore have to keep an eye on two balls: The first is the underlying fundamentals of the stock itself. The second is the current investor psychology. I believe they are equally important for generating alpha though your balance between the two varies over time.

Thanks for the e-mail. I find this subject fascinating and important, and don't get to write about it as much as I would like to.


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