The Curious Case of Synta Pharmaceuticals

Synta Pharmaceuticals ($SNTA) is a small US biotech with a market cap $343m.  Their 'mission' is as follows (taken from their website).

Our mission at Synta is to extend and enhance the lives of patients with severe medical conditions, including cancer and chronic inflammatory diseases. We aim to create the best place for the best people to create breakthrough drugs that change medical practice.

Their lead drug candidate is a Hsp90 inhibitor Ganetespib which is currently in clinical trials for the treatment of cancer, such as phase III for non-small cell lung cancer NSCLC. However, before I go into their portfolio, I think it is worth looking at a chart first of the stock price.

Below is a weekly chart from the past 2 years, current price is at new lows, -35% just this year. The stock has fallen out of favour with the market, so I will try to fill in the gaps to understand what has happened the past year.

Firstly let's take a look at Synta's portfolio. We can see that they are not just an early stage research company, with Ganetespib as their lead candidate in phase II and phase III clinical trials.

I think it's fair to say this is the main project in the company and is driving most of its value. Indications being trialed against are NSCLC, breast cancer, ovarian cancer and AML (acute myeloid leukaemia). I think it's worth understanding a bit more about Ganetespib, I will summarise from their website:

"....a small molecule inhibitor of heat shock protein 90 (Hsp90), a molecular chaperone required for the proper maturation and activation of numerous client proteins. Many of these Hsp90 client proteins play critical roles in cell growth, differentiation, and survival. Relative to normal cells, cancer cells are more reliant on elevated levels of the active form of Hsp90 and, as such, appear to be selectively sensitive to Hsp90 inhibitors, including ganetespib."

This make Hsp90 a very attractive target for oncology as you are potentially inhibiting many pathways at the same time. This in turn potentially increases your success in killing cancer cells as well as overcoming resistance, as drug efficacy is not reliant on just blocking one pathway (see here slide 3 for nice diagram)

"Cancer cells often develop resistance to commonly used anti-cancer treatments such as chemotherapy and radiation therapy........ Inhibition of these client proteins supports combining ganetespib with chemotherapy or radiation therapy in order to investigate whether the combination reduces resistance and improves potential clinical activity. In preclinical models of cancer, ganetespib has shown synergistic activity with chemotherapies including docetaxel, paclitaxel, pemetrexed, gemcitabine, cytarabine, irinotecan, etoposide, doxorubicin, carboplatin, cisplatin, and vincristine as well as with radiation therapy."

So this is interesting from both a scientific and commercialisation perspective. The strategy is to combine Ganetespib with current treatments to combat drug resistance of the disease, as preclinical models have shown additional cancer killing effects by combining drugs. We can also see in the clinical trial designs Ganetespib has been used in combinations to compare with standard single treatments.

"In advanced stage disease, tumors develop properties that allow them to spread throughout the body. These include the activation of pathways that regulate new blood vessel formation (angiogenesis) and those that enable cancer cell separation from primary tumors and establishment of new tumor lesions (metastasis). Many Hsp90 client proteins play key roles in these processes.
....In preclinical models, ganetespib has shown an ability to inhibit these proteins and suppress these aggressive properties."

Another positive result for this compound in preclinical models. All this adds up to an interesting target, an efficacious compound and a drive for the clinic. 

A quick search reveals Vernalis also have a Hsp90 inhibitor, AUY922, in phase II trials in collaboration with Novartis and Cancer Research UK here and here.

So where has it gone 'wrong' for Synta's stock price? Well, to start we need to take a look at the results from the GALXAY-1 trial where Ganetespib was used in combination with docetaxel and compared with treatment of docetaxel alone as a second line treatment for patients with NSCLC. 

The update from the trial in June 2013 here, here and here was poorly received by the market, as any additional survival rates were not seen as statistically relevant unless the some patients were separated as 'normal progressors'. Deterioration in the positive data was also seen from the previous update of the trial, the stock tanked.

In October 2013 the company then released 1 year follow up results here, which were described as 'encouraging' (a hazard ratio below 1 means the drug has a beneficial effect compared to the control group).

"Overall survival Hazard Ratio in the chemosensitive population was 0.75 (90% CI 0.56, 1.03; 1-sided p=0.065) and 0.72 (90% C.I. 0.52, 0.98; 1-sided p=0.040) in the Cox proportional hazards univariate (unadjusted) and multivariate (adjusted) models, respectively. Median overall survival was 10.7 months for ganetespib and docetaxel versus 7.4 months for docetaxel alone."

However, some were not convinced here and here referring to the hazard ratio of 0.75 even in the selected patients as 'non significant' and worries over the subsequent expansion of the phase 3 trial. It seems the overall market agreed, the stock tanked again, revisiting the $4 level.

Curiously in November an update here the company revealed they would no longer be involving patients from two Eastern European countries

"Analysis of data to date revealed that medical profiles from certain patients enrolled from two Eastern European countries differed from patterns typical of patients enrolled from other countries in this study, as well as patients enrolled in other clinical trials for the treatment of advanced second-line NSCLC. This observation informed the operational plan for the ongoing GALAXY-2 Phase 3 trial, including the decision to limit further enrollment from these two countries."

Reading the Q3 2013 conference call here it seems patients from these centres had less advanced cancer and skewed the results as they would need a longer time frame to see any benefits. The hazard ratio for just the Western countries fell to a far stronger 0.5.

Suddenly, in March this year, the CEO and co-founder Safi Bahcall resigned here without explanation. Some speculated this meant the GALAXY-2 trial was in danger of  being cancelled here. Since then a new CEO Anne Whitaker has been hired, however the question remains if this has removed uncertainty with investors, especially over the continuation of GALAXY-2 trial (see later).

Then in May this year the final analysis of the GALAXY-1 trial were released here. Favourable hazards ratios for the chemosensitive patients were released and it was concluded these type of patients would be used in the GALAXY-2 phase 3 trial.

It is not clear if and where the data from the Eastern European countries referred to back in November is included.

By now the stock price had already fallen again after recovering from November 2013 and hitting March 2014 highs. The stock has even dropped an additional 15% just this month, essentially on no news, well not any I can find anyway. Yahoo finance board members seem to be blaming the new CEO here.

I will try to summarise possible reasons for the recent decline

• Market simply doesn't like the GALAXY-1 results and are still selling off - low probability, markets shouldn't take so long to react to new information.
• Market is starting to believe GALAXY-2 won't go ahead, my understanding is the trial is still in enrolment phase - medium probability, (see thesis below)
• Momentum and biotech traders leaving the stock - high probability, value difficult to discern, many biotech buyers/sellers I believe are traders looking for price action.
• Investors not impressed by new CEO Anne Whitaker, badly enough to sell - medium probability, too easy to fall into 'blame game' but I believe her silence is odd and adding to doubts in the company (see thesis below)
• A new piece of negative information has reached some investors and I cannot find it - medium probability, my data sources of course and not unusual for a stock to move before a new announcement. 

It is also worth noting at this point that current cash resources should last until at least Q4 2015 (according to the company), this is sufficient to reach GALAXY-2 interim results but not the whole way through the study. The company strategy is the have the resources to finish the study before going into partnership to further develop the drug. This could mean another round of a stock offering to raise funds as was done in late 2013, however this has been clear to investors for a while.

I think it's fair to say sentiment in the stock is low, a year ago the market thought it was worth $7, now it will only pay half that. However, lets try to summarise all the above information to build a bullish thesis and bearish thesis that can be outlined for investors in Synta

Bullish
The GALAXY-1 phase II clinical trial did its job in highlighting which patients respond best to the Ganetespib (i.e. 'chemosensitive') and with better control over the patient population by removing Eastern European centres from the trial gives the best chance for a positive outcome in the GALAXY-2 phase III clinical trial (this of course is no guarantee of success, as is the case with all phase III trials). The market has over reacted to the changing and uncertain data, reacting in a knee jerk manner. The upside now outweighs the downside.

Bearish
The results form the GALAXY-1 phase II trials are at best weak and possibly even statistically insignificant. Synta have repeatedly moved the analytical goalposts and changed the patent population to be able to find good enough data to progress the compound. Resignation of co-founder Safi Bahcall shows there is ongoing debate in the company whether to even continue with the GALAXY-2 trial. New CEO Anne Whitaker has not made any statements on supporting the trial (or anything else for that matter) increasing possibility it will be cancelled or at least it is being considered.

To be fair it would be reasonable for me for a new CEO to dive into the portfolio first to fully understand the companies projects before giving statements about future strategy. The flip side to that of course is that she is looking intently at the GALAXY-1 data to either be convinced or understand it enough to give it her backing. Until she says so otherwise it is my current conclusion that it cannot be ruled out that the GALAXY-2 study will be stopped.

Even if say GALAXY-2 was abandoned that does not kill Gatenespib as a drug, there are still trials ongoing to treat breast cancer (I-SPY), ovarian cancer (GANNET53) and acute myeloid leukemia  (AML-LI-1, AML-18, AML-19). You could always argue that the cash would be better off being spent on these studies instead.

Interestingly on the plus side, retired hedge fund CEO and current Synta director Bruce Kovner here is the largest shareholder owning a significant chunk of the company at 33%. He even increased his stake as recently as April 2014 buying another $5m worth of stock here.

I've not been able to fully connect the dots to understand fully how this works but Kovner used to be the CEO of Caxton Associates LP here, yet there seems to be a Caxton Corp which has 94% if its funds invested in Synta, see 13F here. Regardless of the details, Bruce Kovner has a significant sum of money invested with Synta Pharmaceuticals and would imply he believes in the future of the companies portfolio. 

At this point I would ideally like to come up with some valuation of the company. Purely looking at price action doesn't tell you if the stock has gone from very overvalued to just overvalued or ideally to undervalued.

Looking at some financials (trailing 12months) shows the options in valuing of this stock are limited as there are no sales and negative earnings.

• No revenues
• -$1.14 EPS
• $0.73 Book value per share (P/B= 4.7)
• $96.8m in cash and cash equivalents

The best option is a discounted cash flow method using assumptions on how much cash flow the company can generate if Ganetespib is approved and commercialised with a partner. Investment firm Jefferies has predicted peak sales of $425-$600m here but I've not been able to find any more information on these figures. It is unclear which types of cancer this is for and I am assuming these sales would be shared between Synta and any potential collaboration partner who would commercialise and use its sales force to sell the drug.

A valuation of Synta Pharmaceuticals will be the topic of a new piece in the near future.

Why I will be writing more about biotech and pharma companies

"Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word "selected": You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital." Warren Buffett

I recently wrote a blog piece on Kancera (here) in an attempt to try to understand what its stock investors were actually buying for their money. It was initially prompted by personal curiosity into their research and how, if possible, it could explain the huge increase the stock price has had over the past year.

My conclusion was I liked the research but I didn't like the price, or to be more accurate I couldn't understand the price considering the risks still involved. For some reason it has been my most popular post by far, perhaps it was fortuitous timing with it's recent fall in price or perhaps biotech stocks are even more popular than I realised (more on that later).

My personal background is from the pharmaceutical industry, so I felt I had some knowledge and experience in the area to research the company and come to an understanding of their R&D. So you could say, if I were to have any 'circle of competence' it should be here.

What I found was I enjoyed reading about biotech research projects more than I had expected. Plus what came apparent to me when looking at the company and other biotech's (more on that later also!), is that the challenge for investors is to not only understand the research but also the significance of the results being reported and then putting them into some overall context of the drug discovery process. That doesn't even start the valuation part!

Considering my background I've toyed with the idea of researching biotech's/pharma and writing about them before but have shied away for two main reasons

1. I like value investing, buying what is 'cheap' (of course there are many definitions of this). The biotech industry attracts a lot of speculative, 'get rich' traders and the biotech sector is in a huge bull market at the moment. Popular sectors are not exactly the best hunting grounds for value investors.

2. Evaluating biotech's, especially start ups, is challenging as they typically have no cash flows, earnings or sometimes even sales! In these cases classical valuation metrics are made worthless.

However, in light of my recent experience and thinking about it a little deeper I inverted the situation and realised that a strong bull market with wild evaluations could be exactly the right time to dig deeper into companies. Investors need level headed information to help them navigate and understand the stocks they are buying.

I will refrain from giving buy and sell recommendations but will try to help readers understand better the company and what a potential value could be. I will initially focus on Swedish biotech's but will expand it to include the Nordics. I have started researching another interesting Swedish biotech, this time already in phase 2 clinical trials.

Being the centre of the biotech universe the US will also feature now and then, there really is no avoiding it! In fact I am currently researching a US biotech that is the leader in it's field, currently has a drug candidate in phase 3 after positive phase 2 results. Despite this the stock is oddly trading at 52-week lows. Once I have gotten a better understanding of the company and what is going on I will write another blog entry.

SCA puts closed for a profit

Around a month ago at the end of August I suggested that there could be a put selling opportunity on SCA stock here. At the the time it was trading around 169 SEK, was near 52-week lows and had previously traded in a range of 165-160 SEK.

I decided to sell the two months out October 165 puts for 2.40 SEK but modified the strategy a bit by buying the October 150 puts for 0.4 SEK (this is now called a 'put bull spread'). This protected my downside, as these puts would increase in value if the share price fell below 150 SEK, and fixed my maximum loss to 1500 SEK per contract (i.e. (165-150)*100).

Total income per contract (100 shares) was (2.4-0.4)*100=200 SEK for the two months, 13% return on the money 'at risk'. Although to be fair this does not really accurately reflect the true return, I prefer to calculate using the money that would be required to buy the shares at 165 SEK if assigned. In this case the return would be 200/16500=1.2% for the two months, 7.3% APR.

Since then the share price fell a bit but never touched the 165 level and has recently had a nice run up to 177.5 SEK.

After a month the premiums on these October puts has fallen to just 0.25 SEK so I bought them back to close the trade. I didn't think it was worth keeping it open for another month for so little money and it would be better to use the money on other opportunities.

Total income was 175 SEK, 1.06% per contract but was over the 1 month instead, thus increasing the APR to 12.7%.

Kancera - Big gains but what are investors really getting for their money?

Kancera is a small biotech company traded on the NASDAQ OMX North that focuses on new medicines for the treatment of cancer homepage. Before I dig any deeper into the company and science I'm going to show a chart of the share price to show what massive gains this stock has had.

The mind boggling numbers can be summarised as follows

• 12 months +954%
• 3 months +375%
• 1 month +198%
• 1 week 144% (!)

It currently trades at a market cap of 773 MSEK ($108.3m) and P/B 22.9. It goes without saying that it has negative earnings, due to current investments in R&D.

I think it's fair to say this is a popular stock and probably attracting lot of speculative money, or worse people who think they are making fair investment but are not. We shall hopefully find out. So what are Kancera actually doing science wise? They have three ongoing projects in their research portfolio, which focus on cancer

• A ROR inhibitor described as follows

".....which can reprogram cancer to make it destroy itself. ROR inhibitors have been shown in the laboratory to be effective against both solid tumors and leukaemia."

The strategy has modified lately in which they plan to combine it with a ROR vaccine.

"Kancera´s strategy is to use its future small-molecule ROR inhibitors as a first line treatment for the disease to remove the main part of the tumor and the symptoms, and thereafter follow with a prophylactic ROR vaccine to prevent relapse. Thus, there are possible synergies between Kancera´s small molecule products and the vaccine against ROR."

• Small molecule PFKFB inhibitors 

".....substances capable of making cancer more susceptible to chemotherapy by modifying cancer cell metabolism in solid tumors using what are known as PFKFB inhibitors."

• Small molecule HDAC inhibitors

".......drugs aimed primarily at neutralizing leukemia by inhibiting epigenetic processes, such as those that control gene activity."

Sounds exciting, new drugs will always be welcome and needed in treating patients with cancer. The strategy seems to be to take these new treatments to a pre-clinical stage at which point they would partner with large or mid pharma who would have the competencies and assests in place to start the clinical trials. This makes sense, these trials can cost a lot of money and is a typical strategy for small biotech's.

We need to take a look at the latest 2014 Q2 report to get an idea at what stage these projects are at.

"Kancera has reported results from the collaboration on PFKFB3 inhibitors with Professor Thomas Helleday at the Science for Life Laboratory which was initiated in 2013. Within the framework of the collaboration a large-scale laboratory evaluation of synergistic effects between Kancera’s PFKFB3 inhibitors and a large number of approved drugs has been performed. The results show that synergistic effect against cancer cells can be achieved by combining PFKFB3 inhibitors and some defined classes of approved drugs. In light of the present results, new experiments are planned using preclinical disease models to verify whether PFKFB3 inhibitors can improve the treatment of advanced lung cancer and metastatic breast cancer."

Certainly promising results in proving how their PFKFB3 inhibitors can treat cancer but we are talking mid to early stage research here. It is possible to watch an interesting presentation by Thomas Olin VD here from the start of the year. From that I take these are experiments to prove a role of the target but they need to do more research to improve the inhibitors as drugs.

Next we have the HDAC inhibitors which also seem to be at early stage research

"Kancera hereby announces that the development of the HDAC6 inhibitors are progressing faster than previously estimated in the second quarter when HDAC6 inhibitors were developed that are more potent against cancer cells than Acetylon´s ACY-1215 and also better tolerated by healthy human blood cells."

Again promising results and I wish them every success but we are a long long way from a clinical candidate. If all it took was to treat cancer cells in a laboratory then cancer would have been cured a long time ago. There are still many challenges to go. It's difficult to put a probability of success on these projects, they could potentially never get beyond the early research stage. It happens all the time.

As an investor I think you are paying for what I would call 'optionality' with these projects. It's possible to loose everything but huge upside if the small probability event goes your way.

I would say their ROR project is the flagship of the portfolio and seems more developed than the others.

"Kancera hereby announces that animal studies are proceeding according to plan towards the selection of a candidate drug in Q3. The results so far support that an effective concentration of the ROR inhibitor can be achieved in cancer cells for long enough to reach the desired anti-cancer effect. Animal studies are currently being conducted in order to assess efficacy and safety, why risks in the development of the drug candidate in the ROR project remains."

This is more like it, we are now getting much closer to a clinical candidate that they hope to partner with established pharma in the future. It sounds like they are achieving the desired concentration of drug in the system, which is good of course, but no news as yet if it has any effect. This will come I assume after the end of the study.

A word of caution this still does not mean the desired effect will occur. There are 3 major likely outcomes - Nothing, cancer unaffected (the worst - what went wrong?), maybe the cancer shrinks but by not very much (then you have a debate on why?!) or the best scenario, it goes exactly to plan then it's full steam ahead!

These still doesn't address unexpected effects (good or bad) or a poor safety profile which may prevent further development of this particular substance tested. What will happen to the share price if this one animal study does not deliver to everyones hopes? This is a question that all serious investors must ask themselves. What is the downside risk or at least how do I limit it?

In terms of financial rewards Kancera point towards the deal done by Pharmacyclics and Johnson&Johnson for their new anti-cancer drug Ibrutinib. So far J&J have coughed up $150m in milestone payments and could pay out even more, another $825m (see presentation mentioned above and here)

Pharmacyclics is now valued as a $9bn company and trades at P/E 105, looking at their website they have the one drug launched. If Kancera matched that, then we are talking x83 fold move in share price from its current market cap, that though is a big 'if'!

To get a sense of perspective the success rate of cancer drugs from Phase 1 to launch has been recently shown to be about 10% here. From a preclinical stage the probability of success will be much smaller.

Kancera also cite a deal between Celgene and Agios who payed $120m plus royalties for rights to their phase 1 candidate drug AG-221. The stock jumped 28% or around $330m on the phase 1 results.

Interestingly the investor website aktieinvest attempted to make a valuation of Kancera back in March and concluded a market cap of between 123-539 MSEK if both the ROR and PFKFB3 projects received milestones in the coming years. The current share price is about 50% over the higher end. I won't go into the details here (in Swedish) but they use a previous deal between KaroBio and Pfizer as it's basis, look at the probabilities of reaching different stages and even the possibility of both drugs being launched as 'orphan designated drugs'.

What else on top of the projects mentioned are investors getting for their money when paying  for Kancera with market cap if 773MSEK? Not much is the answer.

• 33.8MSEK in equity (P/B 22.9)
• Of which 6MSEK is intangibles
• Patents covering current research
• -17.93MSEK in earnings
• 7.5 employees

Despite the interesting research and desirable goal of new cancer treatments Kancera stock cannot be seen anything more than a speculation and must be traded as so. There are high hopes by investors of huge gains on the launch of a new drug to treat cancer yet the probabilities of those gains are very low.

Of course things could work out very well for Kancera and stockholders will end up being very happy with the results, even if they buy at these levels. However, if you run across a motorway and survive doesn't mean it was prudent to do so!

Put Selling Opportunity: SCA

Svenska Cellulosa SCA is a Swedish company that is one of the worlds largest in personal care products (e.g. babies nappies), the third largest supplier of tissue (e.g. toilet and kitchen paper) and one of Europe's most profitable producers of forest products.

The current stock valuation is around P/E 17, EV/EBITDA 12 and it pays a 2.8% dividend which has been growing nicely since 2010. Below is a chart of the share price from the past year.

The stock reached a peak around 200 SEK back in Jan and has been steadily falling since then and is now close to its 52-week lows. If however, we go back 2 years we can see there was a big run up at the end of 2012 before consolidation around 160-165. 

This look an interesting area for selling puts in SCA. At this moment the October 165 put can be sold for around 2.15 SEK or the 160 put for 1.05 SEK. The choice depends on how happy the investor is happy in holding SCA stock if assigned (the latter of course being less likely).

If the stock falls to these strike prices then the puts could be bought back and then rolled out to the next month and down at the same time. For example this would mean buying back the Oct 160 put and selling the Nov 155 put. This then would put the strike price of the option below the consolidation zone mentioned before. If the stock price then stayed above 155, the put would expire worthless and the investor would keep all the premium. Further declines would require further rolling down of the puts and potentially other strategies to keep the trade profitable.

An alternative strategy would be to accept the shares and then immediately sell a covered call to bring in more income. For example if assigned shares at 165 SEK, 'at the money' calls with strike price 165 would be selling for around 2.75 SEK for a month out. Adding the premiums from the put and call would total 4.85 SEK giving a cost price for the shares of 155.15 SEK. The shares would then be called away if the price finished above 165 at the end for the month.

Put Selling Income: Sandvik

Selling puts is a excellent strategy for generating income and building capital. The key is to avoid speculative companies and focus on stabile large cap stocks that ideally pay a dividend. We're pretty much talking about the stocks that many investors find boring!

This is important because if you are ever 'put' the stock (i.e required to purchase shares at the strike price) you must have confidence to hold the stock and that the price will eventually recover so you will at least get your capital back. Large cap dividend payers don't usually disappear quickly and the dividend provides a cushion to your investment.

As it is, most options in Sweden are only available on large caps anyway so the temptation to bet on the twitters and facebooks of this world is not possible. For example Sandvik is a global engineering group that i) sells tools and equipment to the mining and constructions industries ii) is a world-leading developer and manufacturer of products made from advanced stainless steel grades and special alloys for the most demanding industries.

In the current rolling year it had 85000 MSEK ($12.4 billion) in revenue and made 4700 MSEK ($685M) in profits; although these are falling from 2012 highs which explains the stock price action. The company has a large exposure to the mining industry so business is being affected by the current downturn. It has a P/E 22 and pays a dividend yield of 4.1%. Expected profits for the year are 5.41 SEK per share giving a P/E 2014 16.6 at the current price of 85.4 SEK.

Below is a weekly chart of the share price over the past three years.

The price level of 80 SEK looks interesting; 5.8% below the current price. The stock last touched here in June 2013 before going sideways the past year between 85-95. Before that we have to go back to end of 2012 when Sandvik was selling at 80 SEK. 

Last week I was able to sell the Nov 80 put for 1.5 SEK. This means for every contract I sold (100 shares) I received 150 SEK but must be prepared, if assigned, to buy Sandvik stock at 80 SEK, costing 8000 SEK per contract, in the coming three months. This is a return of about 1.8% on my capital, 7.5% per annum.

It's not big money but I already have capital committed to other investments so instead of the usual goal of 1% per month I wanted a lower risk of assignment, so aimed for 0.5% return per month. However, the margin requirements to keep this trade open are roughly about 20% of the total (e.g. 0.2 * 8000 = 1600 per contract) increasing the return to a 'hypothetical 37.5%' per annum.

I say a 'hypothetical 37.5%' as it would be asking for big trouble to fully use the margin available all year round for these type of trades. A quick down turn in the market could mean being put a lot of stocks, more than you can afford and then a dreaded margin call.  Nevertheless the margin is available for use when required and comes interest free.

I have also decided to avoid being assigned Sandvik stock, I would rather use my capital for other investments, so if the stock price does reach 80 SEK, I will buy back the puts (most likely at a loss) then roll them down by reselling them at a lower strike price e.g. 77.5 SEK. I will also have to go further out in months to Dec or Jan to get my money back and keep the trade profitable.

The 'worst case' scenario is I unexpectedly get put stock early. I can either resell it and sell the puts as mentioned above or immediately sell covered calls to continue generating income. If the stock continues to fall I may have to apply more capital and/or other option strategies to get my money back and ideally still create a profit.

Cloning the cloner: Posco

"If there wasn’t a Warren Buffett, there wouldn’t be a Pabrai Funds… It is hard for me to overstate the influence Warren Buffett and Charlie Munger have had on my thinking… I can never repay my debt to them for selflessly sharing priceless wisdom over the decades." 

Mohnish Pabrai

Mohnish Pabrai is a fund manager I have followed a fair bit over the past years and who I think is very interesting in both his investing and life philosophy. He started an investment fund in the mid 90s after making money as an entrepreneur and he set out to copy Buffett in his value investing style and he even copied how Buffett initially set up the fee structure in his investment fund. He charges 25% for performance over the first 6%, so a 15% return on the fund would charge 2.25% (i.e. 0.25*(15%-6%))

His goal has always been to compound his wealth at 25% per annum, that's one hell of a target and he is pretty much on course for that. This even includes a severe downturn 2008-2009 where he openly says he compounded at minus 35% for a couple of years! In his own words 'I was handed my head on a plate'.

He has a modified his positioning strategy a bit from a 10*10 (ten stocks with 10% positions) to one where the more he is invested the higher the expected reruns must be. If I remember correctly the first 50% of the portfolio must be thought to return x2 fold, the next 20% x3 fold, the next 10% x4 fold. So to be 90-95% invested the investment must be expected to return x5 fold.

The idea is to avoid being fully invested in bear markets, unless there are very compelling ideas, as he was during the financial crisis. He was not able to buy stocks as they got cheaper and the problem was compounded by investors pulling money out of the fund. He found himself in the painful situation of being forced to sell when he wanted to buy more!

I can highly recommend his presentation videos that can be easily found on the internet. His most recent (but in my opinion not his best) was at google here. Another two which I enjoyed more are here and here.

His fund portfolio can be easily found on guru focus.com (for example) here. He hadn't added a new significant position since end of 2012 until now! I'd been waiting for this. The latest 13F for his fund for second quarter 2014 shows he has bought shares in Korean steel company Posco. The position is about 15% of his portfolio.

The following will be a brief outline of the company to try to understand his motivation for buying. I will not claim to have done a very deep analysis (I've actually just found more detailed analyses here by Swedish bloggers this year here and here).

To start with Posco (PXR) is a steel company that manufactures of hot rolled steels, steel plates, wire rods, cold rolled steels, galvanized steels, electrical galvanized steels, stainless steels, titanium products, magnesium products. However, it doesn't stop there, it's kind of an conglomerate that spans a trading business, commercial and residential property, operation of power plants and distribution of energy.

In Jan this year the ex-chief technology officer Kwon O-joon become the new CEO and he seems intent in ushering a new strategy of cutting down the debt (0.65 debt/equity ratio), increasing ROE and dismantling his predecessors 'empire' by selling off non-core assets here and here. This is a potential catalyst that Pabrai could be banking on, but that is speculation on my part. 

It didn't take too long to find out that Pabrai has followed Warren Buffet and Charlie Munger into this stock. Berkshire Hathaway bought about 4% back in 2007 here whereas Munger has invested about 4% of the investment portfolio at Daily Journal Corporation here and here. It's interesting to note that this portfolio only has 4 stocks in it; talk about a concentrated strategy!

That's think about that for a moment. Of all the stocks to choose from in the world, he has chosen just four - Wells Fargo 61%, Bank of America 30%, US Bancorp 5% and Posco 4%. That's a pretty strong ringing endorsement. I've not found at what price the shares were bought, but that should not really matter. Ideally the stocks you have in your portfolio should be the exact same ones you would buy if you started over and had cash.

A small glimpse of Munger's thinking can be seen here in the following quote back in 2007 at the Wesco annual meeting

"I would argue that what POSCO does is not a commodity business at all – it’s a high-tech business. They learned from Nippon Steel and they’re now even more advanced. I’d argue that if you have the most technologically advanced steel company in the world making unusual, [non-commodity] stuff, then business can be quite attractive for a long time."

If we look at some financials, it is not a pretty sight with shrinking margins as well as ROA and ROE which now sit at 1.4% and 2.9% respectively. It is not surprising to read that it trades below book value P/B 0.6. Historically the stock has typically traded around book value which is being suggested as a reason for potential upside in the stock. 

A quick check shows the book value of equity increased at an annual 12% from 2009 to 2013, so some value has been returned to shareholders over that period.

Posco has very little intangibles on it's balance sheet so trades below tangible book value at a ratio of 0.8. This is implying you could sell of all its hard asses such property and plant, pay off all its loans and still have cash left to pay equity holders at around $107 a share here. This of course assumes the book value of these assets is the same as their market value. I would need to check deeper, for example the depreciation and amortisation methodology. Equipment and plant could be less, especially in a forced sale but property could be worth a lot more. This also doesn't put any value on Posco's technology, R&D and in-house knowledge.

Oddly enough Posco's Q2 results are a mixed bag depending on which time frames are used. Earnings were down 20% and below expectations here when comparing to same quarter last year but nearly doubled compared to previous quarter here.

Interestingly Posco will also start to share in the profits from the Daewoo Myanmar gas fields, which will start to kick in this year at around $150M and next year at $300M here. This would represent about a 15% increase in the reported 2013 pre-tax profits. This could add a buffet to the income statement if the steel business continues to suffer.

On a final note, Pabrai has interestingly stated in a couple of videos (I'm paraphrasing here so I hope I don't misunderstand what he meant) that buying the best companies (e.g. lowest costs, best pricing power) in a struggling and consolidating industry can still end up a good investment. It's possible that's what he's thinking in this case. It is worth mentioning that Posco was recently voted the No. 1 competitive steelmaker in the world for the 5th year running here. 

In the interests of transparency I bought shares in Posco on Wednesday 13th Aug soon after reading the latest Pabrai fund 13F and doing a quick check on the company. One purpose of this blog article was to force me to go through the process of understudying the company better before deciding to buy any more shares.