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In investing, staying within your circle of competence can be tremendously valuable. Shane Parrish does a good job of discussing this mental model on his website, Farnam Street, in an article titled Understanding your Circle of Competence: How Warren Buffett Avoids Problems.
Investing in biotech companies is outside my circle of competence and I have no edge in analyzing which products in a company’s pipeline are likely to succeed, how they are positioned compared to competitors and the potential market opportunity even if the drug is approved by the FDA. I often reach out to a group of friends that have Ph.Ds in neuroscience, cancer immunology and molecular biology to help me understand certain opportunities. Despite their sage advice, I often come away thinking I am attempting to read tea leaves.
There are always exceptions to rules and an exception I like to make with biotech companies is where the company already has approved products, the financials make sense and most importantly an insider is buying stock on the open market. The specific kind of insider I am looking for is either a founder of the company or an independent director that has been on the board of directors for a very long time and is preferably an investor.
I have come across these kinds of opportunities a few times in the past including United Therapeutics (UTHR) that I wrote about in December 2011 following insider purchases by its founder CEO and more recently Vertex Pharmaceuticals (VRTX), which brings us to the story of two briefcases Bruce.
Vertex Pharmaceuticals showed up on my radar during the depths of the pandemic in November 2020 when an independent director, Bruce Sachs, purchased 15,000 shares at an average price of $217.36 for $3.26 million. Nearly twelve years had elapsed since Mr. Sachs’ last purchase of Vertex during the Great Recession in 2008. Clearly this was an opportunistic purchase and insider buying at Vertex was rare. The only insider purchase before his had occurred eight years earlier.
At the time of his purchase, Mr. Sachs had been serving on Vertex’s board for nearly 22 years. He had also been a general partner at early stage venture capital firm Charles River Ventures (CRV) for 21 years. CRV was founded in 1970 to commercialize research that came out of MIT.
The money shot was however when a subscriber who received an alert about the Vertex insider transaction from InsideArbitrage reached out to me and gave me some background about Mr. Sachs. He mentioned that Mr. Sachs was not only very smart, he was know for being extremely hard working. In the 1990s, when Mr. Sachs went home during the weekends, he would often take along two briefcases worth of work to pore over during the weekend.
While this anecdote about Mr. Sachs was fascinating, it was not sufficient to qualify Vertex for an investment. I decided to dive deeper into the company for our December 2020 Special Situations Newsletter titled The Gambler’s Den and an abridged version of what I wrote about the company in that newsletter is given below:
Company Overview
Vertex Pharmaceuticals is a biotechnology company that invests in scientific innovation to create transformative medicines. The company was founded in 1989 by Joshua Boger and Kevin J. Kinsella and is headquartered in Boston’s Innovation District along the South Boston waterfront. The origins of the company were outlined in the 1994 book The Billion Dollar Molecule: One Company’s Quest for the Perfect Drug by Barry Werth.
Product Pipeline
The product pipeline of Vertex focuses on therapies for cancer, pain, inflammatory diseases, influenza, and other rare diseases. The company has multiple approved medicines that treat the underlying cause of cystic fibrosis (CF).
Cystic fibrosis is a progressive, genetic disease that causes persistent lung infections and limits the ability to breathe over time. It is caused by mutations in the cystic fibrosis transmembrane conductance regulator (CFTR) gene that result in the CFTR protein becoming dysfunctional. This affects the cells that produce mucus, sweat and digestive juices. These secreted fluids are normally thin and slippery. But in people with CF, the defective CFTR gene causes the secretions to become sticky and thick. Instead of acting as lubricants, the secretions plug up tubes, ducts and passageways, especially in the lungs and pancreas.
Beyond CF, Vertex has of a robust pipeline of investigational small molecule medicines in other serious diseases including alpha-1 antitrypsin deficiency, an inherited disorder that may cause lung disease and liver disease, and APOL1-mediated FSGS, which is a severe kidney disorder that results in high levels of protein in the urine. Vertex also has a rapidly expanding pipeline of genetic and cell therapies for diseases such as sickle cell disease, beta thalassemia, Duchenne muscular dystrophy and type 1 diabetes mellitus.
A large part of a pharma company’s value is based on its pipeline and I reached out to two friends who are research scientists at pharma companies to get their assessments of Vertex’s pipeline. One of them pointed out the company’s reliance on its CF franchise while the other was impressed by Vertex’s pipeline and indicated that if the company’s drugs to treat sickle cell disease and beta thalassemia were to get FDA approval, they could be blockbusters for the company.
Valuation and Financials:
The expansion of Vertex’s CF franchise has resulted in a significant portion of the additional revenue dropping straight to the bottom line. For the third quarter of 2020, the company reported a 62% increase in revenue from $950 million in Q3 2019 to $1.54 billion. The $588.5 million increase in revenue caused a corresponding $571.7 million increase in operating income, which increased from $102.3 million in Q3 2019 to $674 million in Q3 2020. Operating margins of greater than 55% are the best in its industry. Consensus analyst estimates call for earnings to continue growing in each of the next four quarters, although the rate of growth is likely to moderate.
The company trades for less than 15 times 2020 EBITDA and has a strong balance sheet with almost $5.5 billion in net cash. Assuming moderate earnings growth from the expansion of its CF franchise, the stock would be downright cheap in a couple of years.
Conclusion
The insider purchase by an independent director of the company who has served on the board for well over 20 years is a strong positive signal. In many ways Vertex reminds me of Gilead Sciences, a company that benefited from its HIV drugs for a number of years and then enhanced its pipeline through acquisitions. The key difference with Vertex appears to be that its CF franchise is still growing rapidly while Gilead’s growth from both its HIV and Hep C drugs has moderated significantly.
I am going to add Vertex to our model portfolio and will also initiate a position in the company in my personal portfolio after this newsletter is published.
The stock is up more than 50% since Mr. Sachs purchase and over the years I have watched the company execute well, including its partnership with CRISPR Therapeutics (CRSP) to use gene editing to develop new therapies.
Vertex remains a core holding in my portfolio and the position reminds me:
i) how you have to understand your circle of competence
ii) learn to expand the circle over time by exploring concepts at the edge of the circle and
iii) sometimes make an exception for an idea outside the circle when a unique set of circumstances present themselves.