Getting caught off guard; Recro Pharma ($REPH)

If you’ve been in this game long enough you are going to get caught off guard once in a while (unless you are part of Fintwit where everyone bats 1.000). I would say that of all the executive functions, emotional regulation is probably my weakest. It is kind of funny given that I realize that it takes a higher EQ than IQ to be successful at this investing thing.

There are usually some minor positive or negative surprises on quarterly or annual financial statements. More often then not these lead to a minor reaction in the share price, say 5-10%. These “surprises” are usually easily explained on the conference call or in the MD&A. Once in awhile, you really get a surprise and the stock rises or drops by 25+%. The company releases numbers and the stock gaps up or down. You had no idea and where caught off guard. These are the moves that test your conviction in the company and in your process. It’s easy to take credit for the positive surprises and blame management for the negative ones. In reality it doesn’t matter who’s “fault” it is, but how you pick up the pieces and move forward is what is important. It’s so hard to remember that in 2 or 3 years, you won’t care about this specific quarter unless you did something you regret based on the results.

This recently happened to me with REPH as they released numbers and the stock gapped down 40%. I’m going to share how I am approaching the situation now.

Here is a good post on REPH. The author does a great job going over the business and valuation. Check it out before continuing.

Despite not being in an industry that I’m familiar with, the REPH investment thesis was fairly easy to articulate:

  • decently high barriers to entry
  • deep relationships with customers
  • producing drugs that are not going away anytime soon
  • split of the 2 businesses (CDMO and specialty pharma) to focus on core competencies
  • not immediately or materially affected by COVID (at least from what I understood)
  • discount to peers and previous buyouts
  • issued guidance for the business and previously beat guidance
  • there is likely to be a push for drugs to be produced in North America given some supply shortages of certain critical drugs during the Covid pandemic

There were some things to get comfortable with:

  • high cost debt
  • no CEO for the CDMO business
  • not cheap on an absolute basis
  • not expecting stellar growth (though I am not expecting negative growth either)
  • management communication has not been great
  • compensation seems high for a business of this size, but that does seem to be normal for pharma companies

Given all this, I took half a starter position or about 3%.

Now with shares about 45% lower than when I bought, I’m left with a pretty small position.  At a this point REPH is about 2% of my portfolio. When the shares crashed, REPH occupied way more than 2% of my bandwidth. I needed to take a step back and reassess. I could average down, hold or lick my wounds and blow out the position.

Here are some questions I ask myself whenever I get one of these surprises:

  1. Is this a temporary bump in the road or is this quarter indicative of the long term prospects of the business getting worse?
  2. Is there a reasonable explanation for the surprise? Did management do everything in their control?
  3. When communicating bad news, did management take accountability?
  4. If you didn’t already own shares, what would you do?

Here’s what I came up with:

  1. I don’t think the long term prospects of the business have changed and the barriers to entry have lessened.
  2. Yes and No. They were expecting a re-entry of a competitor into their market (Mylan) and seemed to have the underestimated the impact. Covid has led to delays in reorders as customers have worked through some inventory on hand. As well, business development efforts were paused due to Covid.
  3. I do feel that they took accountability for what they could control and revised guidance was issued. They have set up a Covid task force to help navigate the pandemic. They adjusted costs and are looking to save 2 mil.
  4. If I didn’t own shares, I would likely wait on the sidelines.

Given that the position is quite small and I don’t have a better use of the capital at the moment, I’m going to hold on to my shares and not add or sell. I realize that this means that I am missing out on a potential rally in the shares.

I have come up with tangible milestones to build confidence in management before adding to my stake and working towards a full position. To me, these should all be complete by the end of the year.

  • Have a better idea of how the new competitor in one of main markets
  • Hire new CEO for the CDMO business
  • Refinance high cost debt
  • Signs of significant growth in new products to fill existing capacity
  • Meet previously issued guidance

When’s the last time you got a negative surprise? What did you do?

Dean

*the author owns shares of REPH at time of writing

4 Comments

Filed under Company Analysis, Investing Lessons, Random Thoughts

4 responses to “Getting caught off guard; Recro Pharma ($REPH)

  1. omagh

    “…I realize that it takes a higher EQ than IQ to be successful at this investing thing. …”

    Hey Dean. I learned in the GFC that I need to maintain a cash reserve at all times. I read and re-read Klarman and Buffett to figure it out. As we rode the wave higher from 2009 where I committed all my cash reserves, it dawned on me that I should raise cash reserves at strategic points in time to give me flexibility to pull the trigger when bargains showed up. In 2008/9, I didn’t have enough in reserve to make all the purchases that I wanted and in the sizes that I wanted. The bargains were everywhere and when you have a clear head with cash to spend, it’s quite a lot of freedom.

    With a substantial amount of cash in the portfolio, it becomes a no-brainer when the opportunites to put cash to work at 20%+ annualized rates appear. In March 2020, valuations on some companies were low and were starting to hit ‘no bid’ — effectively, you can set your own prices with a ‘stink bid’. So, as prices have started to rise, it’s time to start raising a bit of cash, leave the ‘house money’ in play and revert back to a cash-positive stance.

    Taking the EQ part out of the equation by putting portfolio structure in place with ready cash has helped immensely. Having cash forces me to think clearly about whether the new money can be put to work at high rates and to think about whether the new opportunity (whatever it is) is better than every position that is already in the portfolio. If the new opportunity is not throwing off gobs of cash, it gets rejected. I’m wired a bit to be contrarian but some of it is structural as well. So, lots of quiet periods with cash at my side when markets are soaring, but intense activity when the markets are plunging and bargains pop up all over. The margins of safety seem bigger when markets are plunging, but I’m wired that way and I’ve created structures (cash percentage minimums) in the portfolio that force me to be disciplined about choices. HTH

    • Hey omagh,
      Agreed completely. I do find it hard sometimes to keep composure when the market is racing higher and I’m building cash. The most I’ve had is 20ish % cash. I probably put too much to work too quickly during the covid panic.

      Thanks for the comment.
      Dean

      • omagh

        Thanks Dean…The blog is a big undertaking and gives you the opportunity to write about a good range of topics. It seems like something more of us should do. 😀

        If spending one’s cash keeps one up at night, then maybe that’s an EQ issue. Usually it’s the losses that keep me up at night, but knowing that there’s cash on hand to put to work is comforting. Sitting on one’s hands is probably the hardest thing that one can do.

        With this recent COVID crash, I’ve gone from 20% cash down to 2% by picking a few companies to add to and picking up a few new positions from ones that have been on my watch lists for ages. On these last ones, it’s good to get to know a company in anticipation of finding an outstanding entry point. With some 50% and 100% moves in 60 days, now it’s mostly about whether the position is sized appropriately –> double-checking long-term business prospects, and re-examining the downside risk. So, sell out, sell-half and play with house or keep the full position.

        At this stage in our investing careers, it’s mostly about managing self and making good analysis in preparation for pulling the trigger at the price you want.

  2. “Sitting on one’s hands is probably the hardest thing that one can do.”
    So true.
    Something I don’t think I appreciated and spent much time thinking about managing was when I switched to being a full time investor and not having money regularly flowing into my savings. Managing myself and being prepared got taken to a whole other level.
    Thanks for the thoughtful comments.

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