Stockpickers’ Blues
A leading market analyst finds that no particular style of stock selection is long successful in the current market.
Wall Street has gone passivist.
A few hedge-fund activists, including Pershing Square’s Bill Ackman, are having a good year, but less than 15% of the money managers who actively select stocks are ahead of their benchmarks. Active mutual funds actually lost money in the September quarter, on average.
Even at this tabloid devoted to stock-picking, the active voice has become harder to find. Sitting on our levee, we can only watch as rivers of money flow to passive investment vehicles and strategies, such as exchange-traded funds and smart beta. Back in my school days, I wanted skills to help me create jobs and grow the economy. So I took English courses. The instructors tried to teach me to build active, clear sentences and spurn the passive voice. Instead of writing “Twitter was overloved,” I learned to recycle Shakespeare and write, “Wall Street loved the stock not wisely, but too well.” With passivism’s triumph, all my practical skills have become moot.
Quantitative managers have done better this year than active investors following the ancient ways. That gives us yet another good reason to listen to Nomura’s quant strategist, Joe Mezrich, as he analyzes active investing’s malaise. In this stock market’s five-year rise, Joe notes that the returns of any one stock have had a low correlation with those of another stock. That would seem to favor stockpickers. Unfortunately, the spread of returns has also been small, which limits the rewards of successful stock selection.
“Managers may be smart enough to pick the right stock,” Mezrich told me, “but the returns are not there.” Ten years ago, a money manager might have levered up to boost returns in a low-volatility environment. But now, leverage is a dirty word. Instead, a lot of active managers seem to have hopped aboard momentum stocks, that is, whichever stocks have risen steadily in prior months. The momentum strategy worked well until March and April, when such stocks got crushed. Mezrich is a close student of investment strategies, and he’s found that no particular style of stock selection is successful for long in the current market; leadership keeps flipping from momentum to value to market-cap stocks, and beyond.
And the market has been even more fickle in rewarding investors for selecting industry sectors, he notes. Utility stocks started the year strongly, for example, then floundered in the summer. Telecom stocks started weak, then rebounded. When Mezrich looked at the stock performance of the market’s 10 broad industry sectors, as defined by the Global Industry Classification Standard of index firms MSCI and Standard & Poor’s, he found that industry leadership has been reversing from month-to-month at a rate unseen in decades of stock-market history. “Even if you’re picking the right stocks in a sector,” he says, “things are moving around so much that your performance doesn’t persist.”
Whatever the explanation–or excuse–for the average active investors’ underperformance, how can you blame a pension fund or endowment for wondering if they’ve been overpaying their active stockpickers?
History is being made. Wall Street’s propensity toward passivism gives it a rare chance to set a good example. If only the rest of our troubled world would follow suit.
While many professional investors look like overpaid clods this year, the stock market’s steady ramp-up has left a lot of people feeling like geniuses. Yet we live among market participants who indisputably are geniuses—for example, Stanford’s Nobel Prize-winning biochemistry professor Roger Kornberg and his financial backer Phillip Frost, a famous drug-industry entrepreneur whose name adorns South Florida schools and museums. One wondrous aspect of their joint venture is that it involves a 54-cent penny stock, by the name of Cocrystal Pharma (ticker: COCP).
Kornberg won the Nobel in 2006 -- 47 years after his father got one -- for elucidating the roundabout process that our genes use to implement their instructions. That same year, Frost became a billionaire with the $8 billion sale of his company, IVAX, to generic-drug giant Teva Pharmaceutical Industries (TEVA). A few months ago, Frost said he would step down as Teva’s director and board chairman at year end.
Frost’s retirement will give him more time to attend to his many other businesses, like the little investment bank Ladenberg Thalmann Financial Services (LTS) and Opko Health (OPK), a collection of development-stage medical projects about which I wrote skeptically a couple of years back, when Opko shares were at $4.18 and its market cap, about $1.25 billion (“Sweating Out the Results of a Blood Test,” Oct. 1, 2012). Opko’s sales and losses have since increased, but its shares have doubled, to $8.38.
Frost recently told me that he met Kornberg when the Stanford scientist signed on as a Teva scientific advisor. They formed Cocrystal Discovery in 2008. “Roger told me about a technology idea he had to create new antiviral drugs,” Frost related. “He asked if I’d be interested. So we started Cocrystal.”
Frost and Opko put up seed money. Then, in 2011, Teva chipped in $7.5 million to fund Cocrystal’s development of Hepatitis C drugs, with options to invest another $37.5 million as time went by. By the end of last year, however, most of Teva’s options had expired unexercised, and the privately held Cocrystal was down to its last million bucks of cash.
So, in January 2014, the little company came public through a process just slightly less convoluted than genetic transcription, known in the penny-stock trade as a reverse merger: Kornberg’s brainchild merged itself into a publicly held shell company partly controlled by Frost and Opko, called Biozone Pharmaceuticals. The renamed Cocrystal Pharma bolstered its balance sheet with some cash from investors, while exchanging Biozone’s old operations for stock in another Frost-financed outfit called MusclePharm (MSLP), which sells nutritional supplements to jocks and bodybuilders.
Cocrystal has remained in penny-stock purgatory all year, sliding in over-the-counter trading from around 75 cents to 25 cents, before perking up in October to reach last week’s level near 50 cents, and a market cap that was all of $60 million. Then, on Monday, Cocrystal said it was merging again.
This time, the Frost and Kornberg outfit is merging with a privately held company founded by Raymond Schinazi, an Emory University professor with a proven record of developing antiviral drugs and starting companies, such as Pharmasset, which Gilead Sciences (GILD) acquired in 2012 for $11.4 billion. The merger announcement spent a lot of detail on the impressive pedigrees of these talented guys, but said practically nothing about the deal’s capital structure.
I don’t know about you, but I find myself wondering what all these giants of research and industry are doing in the penny-stock market.
I didn’t hear back from either Frost or Kornberg when I queried them on the topic. I was able to talk to two other substantial investors in Cocrystal and Opko, by the names of Barry Honig and Michael Brauser. Over the past few years, these two South Florida gents have invested alongside Frost in a couple of dozen micro-cap companies. Scanning the list of those companies last week, I calculated that their average market cap was about $75 million. The middle of the pack (in other words, the median company) had a valuation of under $30 million.
While Honig works out of Boca Raton, Brauser has his business in the same Biscayne Boulevard address in Miami as Opko Health and Frost’s own investment operation. Brauser calls Frost a mentor, but like Honig, Brauser says they make their investment decisions independently. “We’ve invested in a lot of the same deals,” Brauser tells me, “because we run in the same circles.”
Frost first invested with Brauser and Honig when they were running the Internet marketing company InterClick, which Yahoo! (YHOO) acquired in 2011 for $270 million. Their other ventures have ranged from mineral plays to biotech. As noted, they’re all small.
“A lot of the greatest entrepreneurs,” Brauser says, “have created wealth by starting small companies that became very large companies.”
Controversy has occasionally followed these fellows’ deals. The credit-reporting company Equifax (EFX) bought an e-mail marketing business from Brauser in 2002 for $135 million, and the parties traded blame for its subsequent decline until settling their lawsuits some years later. A Biozone founder sued Brauser, Honig, and Frost after they became involved with the predecessor company of Cocrystal. The suit was settled, but the founder is fighting on in a California state court.
Companies that come public through reverse mergers tend to work out poorly for everyone except the insiders, but Brauser defended the technique as a way for a company’s founders to avoid the predation of big venture-capital financiers. In separate interviews, he and Honig reminded me that Berkshire Hathaway came public via a reverse-merger.
Penny stocks don’t deserve their bad rap, Honig says. “I’d rather invest in a penny stock going to a dollar,” he says, “than a dollar stock going to a penny.”
“Frost is probably one of the smartest men on the planet,” adds Honig. “This world needs a lot more people like him.”
Honig then challenged me to a pair trade. He’d go short Apple (AAPL) and long Opko -- a penny-stock promoter’s epic challenge to the mega-cap gods.
“You don’t bet against Phil Frost,” Honig says.