Drug Companies Play by Different Rules

I have found that one of the hardest things to do in the financial markets is to trade drug/biotech companies. I always like to play the markets based upon my perception of the underlying market psychology, but the problem with the drug/biotech companies is that they mostly trade upon hype about new drugs and clinical trials. This hype can be immediately killed by one negative trial result or one adverse FDA decision.

The problem with this is that it is virtually impossible to predict for anyone and, on the surface, doesn't that just mean that investors are just rampantly guessing and gambling when they put money into these stocks?

Everytime I have tried to apply my market psychology rationale to biotech companies, I have failed miserably. Initially I came to the conclusion that market psychology could not be applied to these biotech companies, but after careful consideration I now believe that market psychology may in fact be the most important factor in determining how the market prices the biotech companies.

My previous folly in attempting to trade these companies was that I tried to trade them hoping for a positive decision from the FDA or for a positive clinical trial outcome. In doing this, I now realize that I might as well have been playing blackjack in a casino because my odds were about the same. My decision was to never play the drug/biotech companies again in anticipation of an announcement, but that's not to say that I don't plan on playing them at all.

The drug/biotech companies are very much catalyst driven companies (those catalysts being clinical trial results and FDA decisions). However, it is the periods in between catalysts that the human aspect of the market, the market psychology, dictates the movements of these companies share prices.

While there are several companies that I look at regularly in this sector, there is one that continually attracts me, that is Myriad Genetics (MYGN).

I was actually attracted to Myriad initially because of the promise that their Alzheimer's drug Flurizan showed. Unfortunately, Flurizan was recently shown to have produced no effect on Alzheimer's patients abilities to complete tasks of daily life. This was a major setback for Myriad, but the stock price is has not really reflected this setback as one would expect. In fact, this stock appears to have a great deal of momentum which has Myriad near their 52 week high.

With Myriad currently in one of their in between catalyst stages, the question becomes "what will the market do with this stock price?". This is where an understanding of the market psychology can attempt to predict what the near term holds for Myriad.

From here, Myriad will either keep the momentum that it has had for most of this year or it will lose that momentum and suffer a significant collapse in share price. So, which of these two possibilities is more likely given all of the facts?

Myriad does have a solid balance sheet, with a high level of cash that has increased thus far in 2008 and a very low level of liabilities with absolutely no long term debt. This is a very positive sign for a company that relies so heavily on research and development of drugs that may not produce a revenue for years to come and sometimes never.

Working further to Myriad's advantage is the fact they have a diversified portfolio of drugs that are currently under development and testing. The cancer drug Azixa (currently in phase II trials) is likely their most promising drug, but it is still nowhere near production. Further down the pipeline are drugs for HIV/AIDS and Thrombosis, which are currently in phase I trials.

Myriad does have a fairly solid stream of revenues from their current royalties. Though they are projected to have a loss for the upcoming quarter and for the year 2008, their revenue stream is very strong especially when compared to some of their peer companies.

One possible issue that I see for Myriad based solely upon my knowledge of market psychology is that their stock price is very close to their 52 week high. The 52 week high can be a significant psychological resistance level and may pose a significant threat to the stock's momentum especially in light of the recent failure of the drug Flurizan.

So, what conclusion have I arrived at for Myriad Genetics and why is it that I cannot seem to ignore this company?

I think I am attracted to Myriad because they have a solid base of cash with few liabilities and such a tremendous long term upside. While I think that Myriad is due for a share price correction that will likely see them touch 60 a share, I believe that after that the market will give Myriad its momentum back and will see it break through the 52 week high.

This is based upon a careful study of the market psychology and particularly upon the option market open interest levels which heavily favor the call side of Myriad. In my observations, I have seen that the market has a difficult time abandoning a company that has had such strong momentum for such a long time and that is why I think that the market will come around to Myriad again soon.

This strategy is not without risk, but I think catching the surging momentum train that will return after a slight correction will be give traders a chance to make some quick money.

The bottom line is that deciding which way to play a biotech company can be a mind-numbing prospect and is one of the most stressful prospects in all of the financial markets in my opinion. If I listened to conventional wisdom I would probably stay away from the biotech companies that I have lost so much money on in the past, but I like the challenge. That challenge is what I find so exhillerating.
(Disclosure: none)
Happy Trading

InglefoX
(http://www.inglefox.com/)

Too Many Reillys, Too Many Issues: Why It May be Good to Short Lamar

Those of you who follow the company Lamar Advertising (LAMR) know that, with only two exceptions (one rather brief and one lasting roughly two years), the company's stock price has been extremely range bound. That range has been, more or less, between $30 and $40. After a recent bull run, which saw Lamar's share price touch $70, the stock has recently entered this range again.

With the shares trading at $37.53 as of Aug. 4, 2008, it is actually at the high end of this range and I think that Lamar's upcoming earnings report on August 6 may disappoint and send the share price back down to the low end of this range. This could give traders a chance to pick up some puts or short some of Lamar's shares and make what could potentially be a quick profit.

I do think that Lamar may miss their earnings target on August 6, but even if I am wrong about them missing their upcoming earnings, I still view Lamar as a good medium term short play, or at least until the share price touches the low end of what has been a consistent range. Traders can potentially play Lamar's shares over and over again, shorting the shares once they touch the top of the range (near $40) and covering once they touch the low end of the range (near $30).

First of all, the main reason that I see Lamar missing on their upcoming earnings is because of the high put activity that I am seeing in the options market. I have found that time and again, the options market is a reliable (but not infallible) indicator about upcoming earnings.

I compare the ratios of calls to puts by looking at the open interest levels for the single option with the highest open interest and also the total call/put ratio. For the August options, the August 35 puts are showing the highest open interest at 5,739. The straddle option for this put would be the August 40 calls which are only showing an open interest level of 1,496. This means that the straddle call/put ratio is a high 3.8 to 1.

I generally also look at the same strike ratio for the option with the high open interest as well as the opposite ratio which compares the option with the highest open interest against the option on the other side (call or put) with the highest open interest. In the case of the Lamar options, the same strike (35 calls) also happen to be the calls with the highest open interest, meaning that the same strike ratio and opposite ratio are the same in this case, the ratio being 1.8 to 1 in favor of the puts.

Lastly, the total put to call ratio adds all of the open interest up on the put side and divides it by the total open interest on the call side. In the case of Lamar Advertising the total put open interest is 14,197 versus a total call open interest of 5,647. This gives a ratio of just over 2.5 to 1 in favor of the puts.

These ratios are all on the high side and are an indicator that the options buyers, for whatever reason, are under the impression that Lamar may miss their earnings and that Lamar's share price will be below $35 by the third Friday of August.

The options open interest levels are why I think that Lamar may miss on their upcoming earnings report, but they are not the reason that I think Lamar will be range bound for a long while to come.

The first issue that makes me wary of Lamar Advertising is the prevalence of members of the Reilly family in corporate governance and operation. Though the company is publicly traded, the Reilly family controls 67% of the corporate voting power by virtue of their ownership of Lamar's class B shares. The class B shares, created by CEO Kevin Reilly Jr. and COO Sean Reilly, carry an incredible 10 votes per share. This means that the Reillys have free reign over the fates of Lamar Advertising and there is nothing that any discontented shareholders could do about it.

Reilly family members hold the aforementioned positions of CEO and COO. Furthermore, Kevin Reilly Jr. also holds the title of Chairman of the Board, Wendell Reilly holds a seat on the board of directors and Anna Reilly also serves as a director.

While the fact that the Reilly family holds stern control over Lamar is not an issue that should sit well with outside investors, it does not automatically disqualify Lamar from being a profitable company. The biggest issue with Lamar is the nature of their business in outdoor billboard advertising.

Outdoor billboard advertising can be a profitable business, requiring a large upfront cost followed by only minimal maintenance costs and a steady stream of revenues. The problem with the business is the lack of growth that the industry has historically shown.

Since the days of LadyBird Johnson, billboard advertisers have met resistance with virtually every new billboard that they attempt to erect. Many people view billboards as eyesores that detract from the natural beauty along the nation's highways and also as accident causing hazards that attract people's attention away from driving. The billboard opponents have been very successful in the courts at severely limiting the construction of new billboards. In fact, if you are to look at Lamar's recent headlines, there are always several news articles dedicated to legal battles that are currently ensuing regarding the construction of new billboards.

As a result, new billboard construction is not a reliable source of growth, but Lamar has adapted to this over the past years and has produced growth by constant acquisition of smaller outdoor advertising companies. The issue with this type of growth is that it will eventually be terminal, and also one has to assume that Lamar and its competitors have already purchased the best of these available companies.

A new type of billboard, the digital billboard, is offering Lamar a new opportunity that will offer many times more revenue and much higher margins than the traditional billboard. Many on Wall Street are expecting that digital billboards will give Lamar and other outdoor advertisers a significant boost, but the problem is that digital billboards are meeting even stricter resistance from the public and local governments.

Lamar has faced a legal battle for many of the digital billboards that they have constructed in such cities as Omaha, NE, Mufreesboro, TN, Fayetteville, NC, Kansas City, KS and many more. Opponents claim that the flashing billboard signs cause an even greater distraction to drivers and still present just as much of an eyesore as their predecessors.

The end result is that Lamar's growth is stunted by an inability to construct new billboards. There certainly is an ample supply of customers for Lamar and other outdoor advertisers even under these weakened economic conditions, but without the ability to produce new billboards Lamar cannot recognize maximum revenue potential.

The bottom line is that many factors point to Lamar being a good short play in both the short term and the longer term. The August 6 report could shed further light on the current situation for the company, but I think that this is an excellent short play going into that report. The options market is pointing to the short side for Lamar's report and several other indicators are pointing to the short side for the longer term. In my view, Lamar simply has too many Reillys and too many issues.
(disclosure: author intends to take a short position in LAMR)

Happy Trading

InglefoX

Is the Goldman Sachs Pedestal Real?

One thing I've noticed among college students, academics and business professionals alike is that the name Goldman Sachs (GS) turns heads. People react with a sense of awe toward Goldman and most of these people probably could not even explain the first thing about Goldman outside of the fact that they are an investment bank. (Score one for Goldman's marketing and branding efforts) It had me thinking that if everyone reacted this way to Goldman, are there perhaps boatloads of people that put money into Goldman's stock not based upon a fundamental understanding of Goldman's business but based upon their name.

If you need proof of the blind investments that people often make then look no further than to any episode of Jim Cramer's Mad Money. All you need to do is watch one segment of Cramer's show and watch the live ticker at the bottom of the screen immediately run rampant with trades of whatever stock Cramer has just recommended. If this blind rationale occurs in the after-hours market based upon Cramer's name isn't it just as possible that this type of blind rationale occurs at an even greater pace based upon Goldman Sachs's name?

I don't want to doubt Goldman's ability to make money nor do I want to refute the claim that they are probably the strongest of the investment banks. What I do see though is that investors place Goldman on a pedestal and this pedestal perhaps doesn't allow Goldman's stock to trade at the level that it would be valued at without the pedestal in place.

Let's take a quick look at the numbers. Goldman Sachs has shown phenomenal earnings in some of the toughest market conditions. Their recent second quarter numbers were still down 11% despite their proven risk management abilities which have been heralded as some of the best in the business. The drop in their numbers still shows that they are susceptible to unseen market swings and that it is virtually impossible for them to make every single correct decision. That being said, their numbers are still far superior to anything that their peers are posting. The only number that Goldman posts which may be a turn-off for the more finicky investor is a negative enterprise value 463 billion.

If the Goldman Sachs pedestal is real then how could it come crumbling down and bring Goldman's share price with it? Well, the first thing that would bring them down would be weaker earnings and though it's certainly possible that the market could turn unfavorably, I don't think that would effect Goldman's earnings more than by 10% or so because they operate such a diversified business. Below is a graph provided by Goldman Sachs of their revenue sources by percentage.

Source: Goldman Sachs

The one issue that could hurt Goldman and its pedestal the most would be if somehow the high public opinion of Goldman which props up the pedestal were changed into public disfavor. If this were to happen then it would most likely arise out of the business model which has been Goldman's key to success. By this I mean that this business model, which may be perfect for Goldman to maximize earnings and decrease losses, can lead to a multitude of conflicts of interest many of which Goldman simply brushes aside.

Look to last May for an example of this when Goldman gave a "sell short" recommendation on Washington Mutual's stock (WM). Though a "sell short" recommendation is a fairly rare occurrence on Wall Street, what made this particular one even more rare is that Washington Mutual is a client of Goldman Sachs. It was not long after Goldman had underwritten Washington Mutual's 7 billion dollar recapitalization and earned millions in fees from WaMu on this deal that Goldman was now telling their clients to sell WaMu's stock short.

Goldman Sachs also was dismissed from contention by the government of the city of Chicago for an advisory role on the possible sale of Midway Airport after Chicago's government had learned that Goldman was actively pursuing ownership into UK based airport operating group BAA, which was viewed as one of the potential bidders for Midway. Many might argue Goldman had an ethical responsibility to inform the city of Chicago of this potential conflict rather then letting them find out about if for themselves. Instead Goldman of doing so, Goldman pursued the advising deal without informing the city of this possible conflict of interest.

Goldman's conflicts of interest with their attempted BAA deal goes deeper than their Midway advisory bid. Just after the Spanish group Ferrovial launched a hostile bid for BAA, management at BAA invited Goldman Sachs to do a pitch for an advising role that would advise them about how to fend of Ferrovial's bid. Instead of doing a pitch for the advising role, though, Goldman banker Bill Young recommended to BAA's management that they sell themselves to a special investment vehicle spearheaded by Goldman Sachs. Needless to say, Goldman did not get the advising job and launched their own bid for BAA.

In all of the above cases Goldman Sach's will defend itself by claiming that they are protected by the firm's "Chinese Wall". For those of you not familiar with the Street lingo of the "Chinese Wall", it is the ethical responsibility of members within the various divisions of financial institutions to remain separate from the other divisions of the institution to prevent leaks of information that may lead to conflicts of interest. In the case of Goldman Sachs, a Chinese Wall is said to exist between the corporate advisory business and the mergers & acquisitions business.

The problem with the Chinese Wall in firms as large as Goldman Sachs is that they are never really airtight. The conflicts of interest problem is not solved by the Chinese Wall which leads to the greater question "can a financial institution combine M&A activities and advising/underwriting businesses and truly avoid conflict of interest?"

With the government beginning to play a greater role in oversight of the investment banks, it seems as though it is only a matter of time until the multitude of the conflicts of interest at the investment banks is brought to light and brought under public scrutiny. If this happens then I see the Goldman pedestal crumbling and their share price crumbling with it.

As mentioned earlier in this article part of the reason that Goldman has been so effective at risk management is that they are extremely diversified in their various businesses. The problem with this is that many of the various businesses fall on opposite sides of the Chinese wall. If government oversight increases drastically (and it is already beginning to) it is not outside the realm of possibility that new, radical laws could be enacted along the lines of Glass-Steagall, which in this case would separate M&A from advising. If this were to happen then the diversified business model which has led to superior risk management for Goldman would be in serious jeopardy.

Government scrutiny over the manipulation of short sellers could also be a thorn in the side for Goldman and a potential threat to their pedestal. Though it was Goldman complaining recently that their own shares were being manipulated by short-sellers, they have found themselves on the other side of this table as well. Goldman's executives were confronted by executives from Lehman Brothers (LEH) and Bear Stearns, which is now part of JP Morgan Chase, regarding Goldman's manipulation of their respective stocks. Bear Stearns CEO Alan Schwartz confronted Goldman CEO Lloyd Blankfein to ask if Blankfein had any knowledge as to the rumors that Goldman's London office engaged in manipulation (false rumor spreading) of Bear Stearns's stock just prior to its collapse. Lehman's Richard Fuld contacted Blankfein just recently and told him he was "hearing a lot of noise" that false rumors about Lehman, which was experiencing all time lows in its share price, were coming from the Goldman traders. If these issues are made even more public and the government launches a full scale investigation into them then I would certainly look for investor confidence to put downward pressure on Goldman's share price and deteriorate their pedestal.

A quick look at the price to book value of the company based upon the book value for the most
recent quarter and the price as of July 18, 2008 shows a value of 1.71. If that is compared to the industry peers of Citigroup (C), Lehman Brothers (LEH), Merrill Lynch (MER), Morgan Stanley (MS) and JP Morgan Chase (JPM) the Goldman Sachs value is much higher than any with the above companies reporting .87, .54, 1.18, 1.27 and 1.10 respectively.
With a price to book value that much higher than that of its peers, I am left to wonder just how much of that, if any can be attributed to the Goldman Sachs pedestal. Perhaps part of it is attributable to the Goldman Sachs pedestal, but it is also very possible that part of it is due to investors pulling money out of the stock of Goldman's competitors and putting their money into Goldman, which is viewed as far more stable.

If anything were to happen to the Goldman pedestal I think they would still trade at a price to book value of at least 1.4, which would still be better than all of their peers. At a price to book of 1.4, the stock price would be at $150. This price certainly wouldn't signal an end of the world to Goldman or to Wall Street and would still reflect Goldman's superior capabilities it just wouldn't reflect the pedestal any longer.

When all is said and done I cannot deny that Goldman Sachs is indeed a profitable and well managed company. I do believe that they trade on a pedestal in the minds of investors and that pedestal is working to inflate the stock price somewhat. If it this pedestal were to crumble either from government action or negative public opinion then the stock probably would fall and be a good opportunity for a put option investor to pick up a quick chunk of cash. That trade would certainly carry some risk, but if you're not willing to take any risk then the options market certainly is not where you belong anyway.

Happy Trading

InglefoX

Trouble on the Horizon for the Brokers?

We all know that the brokers play an integral part in both trading and investing. Everyone who trades needs a brokerage account and some people have multiple accounts with various brokers. These brokers make their money based upon the commissions that they receive, generally on a per trade basis. This has been a profitable model for these brokers as the market conditions of years past have been bullish which encourages people to put their money to work in the financial markets. The more money people put to work in the markets the more commissions the brokers can earn. But with thoughts of a recession looming a recent rash of people pulling money out of play in the markets should mean that the brokers' main source of revenue, their commissions, will fall drastically.
This expectation should lead the stocks of these brokers such as Optionsxpress Holdings (OXPS), The Charles Schwab Corporation (SCHW) and Interactive Brokers Group (IBKR) to fall. In fact, the thought of recession has led to recent declines in the prices of all three of these stocks. What is the problem then? The issue is with the market expectations that these companies are still going to make windfall profits. Under the conditions of tough credit and a market that has seen capital fleeing over the past quarter, it is baffling as to how the analysts can still claim that all three of these brokers (OXPS, SCHW, IBKR) are going to exceed their earnings from the same period last quarter. The stocks are falling for a reason right? And a stock price generally shouldn't fall on a company that is making more money every single quarter.
For the quarter ended June 8, 2008, analysts have given OptionXpress a mean earnings estimate of $0.39 a share versus actual earnings of just $0.35 a share for the same period last year. For The Charles Schwab Corporation that estimate is $0.26 per share versus an actual of $0.23 for the same period last year and Interactive Brokers Group has been give a $0.49 a share mean estimate despite just earning $0.33 a share for the same period last year.
It is important to realize that these companies have other sources of income other than just their brokerage commissions. They operate some proprietary trading and collect a significant amount of interest from margin accounts. The margin interest is also likely to suffer from having a lesser amount of capital entry into the markets and even if these companies were able to keep interest and trading income equal to last year's levels, there is still no possibility that they could have brought in the same amount of brokerage commissions.
The bottom line is that it seems as though these companies are set up to disappoint the market when they report for this most recent quarter. OptionsXpress will report on July 15, The Charles Schwab Corporation on July 14 and Interactive Brokers Group on July 21. If one of them reports lower than expected earnings look for the market to then price in lower earnings for the entire group, but until that happens this can be a great opportunity particularly for you traders out there. These look like prime put option opportunities if you can get in before any fall in expectations takes place. In the long run though the market will rebound and that is the time for those of you who are long term investors to swoop in and pick up these companies, which are actually quite well managed companies, at bargain prices.
Happy investing...happy trading

InglefoX
(disclosure: author is short OXPS)