And then it came right back down again. Sensing a great opportunity (after all, we had replaced optionality with certainty and the stock had to go up) I doubled my position.
The stock traded for another two hours. And. went.
Indevus Pharmaceuticals opened at 8.52 on May 28, 2004, received FDA approval for its first major drug around midday, and finished trading at 8.33, a 2.2% drop on a day when by any calculation the company's fundamentals had improved.
I spent the long holiday weekend trying not to think about Indevus Pharmaceuticals, and trying not to think about why the stock price dropped when the company became more valuable. I repeated to myself Warren Buffett's and Charlie Munger's observation that the market was a voting machine in the short term but a scale in the long run. But I was no longer convinced that I was right and the market was wrong. Coming from a science background, I knew scales and reproducibility and evidence-basis and knew that extrapolating patterns and trends from short-term volatility was not a good basis for drawing valid conclusions. But I also knew that the stock traded almost 13 million shares that day -- 18 times its normal trading volume. The share price change did not come from a statistical blip downward. There was an underlying cause-and-effect in play here, one that I would need to figure out and learn from if I hoped to master my new field.
So for the next several months I became the world expert in Indevus pharmaceuticals. I traveled to Lexington, Massachusetts to meet with management (Them: "We just flew under the radar! It was the day before Memorial Day weekend and no one noticed that we got approved!" Me: "Really? How do you explain the 13 million shares traded?") I listened to the quarterly conference calls, read the old 10Q's and 10K's, studied Pliva, learned about Zithromax, Ditropan, Detrol, as well as the other drugs buried back in the Indevus pipeline.
But none of the Indevus-specific information seemed to hold the answer. No -- the real truth dawned on me while discussing hedging strategies with the other Equitech traders. Supreo, the soft-spoken expert in convertible arbitrage, had given me a list of healthcare companies with large amounts of convertible debt and asked me to circle any with particularly poor fundamentals. He briefly explained to me the relationship between common stock and convertible debt, and how each was in some way a derivative of the other, and how you could hedge a long position in the convertible by shorting the common. Further, convertible debt that was "in the money" -- in other words could be converted to common stock at a price lower than the current market price -- provided an opportunity for a risk-free trade. As the common stock went higher, over and above the in-the-money strike price, that trade got more and more profitable.
I looked down the list and found -- you guessed it -- Indevus Pharmaceuticals, with close to 200 million dollars of convertible debt, with a strike price of 6.75 (200 million and 6.75 are as best as I remember.)
Finally -- I understood.
The debt holders had been waiting for someone just like me to come along and, knowing that the stock had to go up when the FDA approval was announced, buy stock well above the 6.75 convertible strike price on a high volume day. Armed with their convertible-debt and the get-out-of-jail free risk protection that it gave them, the debt holders could borrow shares and sell them short.
They figured -- correctly, it turned out, that Pliva would never mount a serious sales challenge to Pfizer and Johnson and Johnson. They figured -- correctly, it turned out, that IDEV would drift downward for a long time, would eventually use up the cash that the convertible debt generated and possibly never again reach the levels of May 28, 2004.
Which is exactly what happened. Indevus never again traded higher than its $8.52 share price when the market opened on the Friday morning before Memorial Day weekend in 2004. It was eventually acquired for $4.50 a share in 2009.
As for me, I left Deutsche Bank in 2005 to join my current firm and launch a life sciences fund that I still run, investing in good science and good companies, run by good management teams that maintain clean capital structures -- with no convertible debt.*
*Convertible debt can be a completely appropriate financing vehicle, but usually not with pre-revenue life sciences companies.