If someone suggested that you should invest in a business based on the production of spider-silk proteins by transgenic goats, you might feel that they were weaving a bit of a tangled web themselves. In fact, such a company did exist.
Quebec-based Nexia Biotechnologies went public in 2000 while raising $40 million, and at its peak had a stock-market value of over $185 million. Shareholders included some of Canada’s savviest venture capitalists as well as a large number of individual investors. Nexia no longer exists, having been liquidated following a string of setbacks. But who should wear the goat horns in this case? Put differently, why do otherwise rational individuals move from healthy skepticism to outright infatuation? We all know that successful stock-market investors are, above all, rational and skeptical. They are also optimists but in a guarded and rational way, as opposed to the kind of optimism displayed by hard-core Canucks fans or Vancouver real-estate investors. The challenge is to make sure that this optimism does not override our critical thinking skills. At that point, optimism can mutate into greed and we enter a fantasy realm where all things are possible – like bulletproof vests made from spider silk. Unfortunately, there are public companies whose management teams seem more than happy to act as tour guides in this land of corporate hallucinations. They do their best to pump up their company’s share price in order to profit personally, or to raise capital at inflated prices and hope that reality eventually catches up to the illusions they have created. Here’s a list of warning signs that you are likely dealing with such a group. Any one of these symptoms is serious; three or more likely mean that management lacks objectivity, or worse. • Extra, extra, read all about it! I once met a CEO who proudly displayed a very crowded time-series chart of all his company’s news releases over the last two years. Apparently he thought he was a running a PR agency, not a biotech company. “Newsflow” is important, but do we really need to know about the New Zealand patent application? • That big contract in Upper Volta. Deals in countries a Jeopardy champ couldn’t find on a map can only mean trouble. Likewise product approvals by, say, the Ecuadorian FDA. (I’m not making this up!) My apologies to any Upper Voltans or Ecuadorians out there. • We only need two per cent of a $10-billion market. Right. And I only need 0.5 per cent of Bill Gates’ bank account, but it’s just not going to happen. A truly useful product or service does not garner only two per cent or five per cent of the market. • We have no competition. Only because the market you are after does not (and will never) exist! • We are the only people working in this space. No surprise, as loneliness is the hallmark of the delusional. Nexia, of course, was the only spider-silk company out there. • The ever-receding horizon. I once noticed a press release (see item one on this list) announcing the initiation of a Phase I trial. It sounded familiar so I checked and discovered that the company had issued a similar release six years earlier! Sometimes research programs are designed to never get an answer. Like old soldiers, they don’t die; they just fade away (along with your investment). • Revenues but no profits. Whether it’s software, medical devices or pharmaceuticals, profitability is the ultimate goal. Revenue can always be generated: just sell loonies for $0.95 and your top line will look great. When sales and marketing expenses continually chew up any gross margin the problem is clear: the company is paying people to buy its product. This is not a sustainable business model. • Brother-in-law on the board. A board of directors composed of the CEO’s relatives and golf buddies, or chaired by his divorce lawyer, is a bad sign. These relationships are not often obvious. Just look for directors that are either long retired (i.e., senile) or that have no real business accomplishments. • A mistake investors often make. It’s not always management’s fault. Taking a flyer on a single risky stock almost never works. If you want exposure to an exciting and growing industry, build a portfolio of five or 10 stocks that look promising. The one or two winners should more than make up for the flame-outs and zombies. Honest, hard-working and clever entrepreneurs need to be encouraged. Just be sure you avoid the web of hype that may be spun; otherwise you’ll end up being the goat. n Patrick Wolfe is managing director of biotechnology investment banking at Raymond James in Vancouver.