Bad Blood and Schrödinger’s Cat

Bad Blood is a great book.  It’s a fast read, it’s interesting and you should read it.  I want to only discuss one aspect of investing with regards to my takeaways from this book.

In November of 2006, Theranos raised money at a valuation of $165m.  Approximately 8 years later, in February of 2014, Theranos raised additional capital at a valuation of $9 Billion.  Was the investor that chose not to invest in 2006 right or wrong? Eight years is a long time to be considered a fool for not investing in one of the most high profile medical start-ups of this generation.  If you are CVS and your main competitor, Walgreens, has an exclusive relationship with Theranos, potentially driving significant business to their retail operations instead of yours, you can certainly be slightly worried about how badly you erred in passing on that investment in Theranos.

The investor who put $1m in Theranos in 2006, had made 54x his money in 2014.  That’s quite the investment return.

Does your mindset change during that eight years because this hypothetical Theranos investor made 54x his money on this investment?  Do you start to think, maybe I need to re-consider my process? Perhaps, I should be investing in more founders with passion (and distinct clothing styles?).

Looking back, we know a few things about Theranos.  It was a fraud from the very beginning. The technology it claimed to have that would revolutionize the blood-testing industry never existed–ever.  The blood results were either faked in demonstrations or done on traditional testing equipment modified to work with the lower volume blood taken from patients undergoing the “finger-prick” blood draw as opposed to the typical venous blood draws.

However, what struck me so clearly during my reading of the book was how long those on the outside had an incorrect perception of reality.   How many people changed their outlook on investment ideas based on what they thought they knew during those 8 years (really about 11 years before the entire house of cards fully collapsed)?

I want to discuss a specific type of being wrong.

This type of being wrong is when you have enough information and mental comprehension of the subject and decide against something.  For example, as a medical venture capital fund, who had the opportunity to look at Theranos at any point from 2006 to 2015-ish, you may have had the information and understanding to make a decision about investing in Theranos.   If you proactively decided against it and each subsequent year continued to decline this investment opportunity, despite the ever-increasing valuation, you may think of yourself as being “wrong.” The evidence mounts for the case that you are wrong: the valuation of Theranos continues to increase, the name-brand partners begin to sign relationship agreements with Theranos, high-profile investors continue to invest.

Looking like you are wrong for a long period of time and not changing your approach because you don’t think you are wrong is a case of high conviction in your process and approach.  I imagine some of the investors that passed had a requirement to tour the lab, and without such a standard lab tour, they weren’t going to invest. Or they wanted to see the peer-reviewed studies showing the evidence of the quality of Theranos’ results.

The point of my discussion is not that Buffett or other great investors can’t be wrong.  Buffett has been wrong on multiple occasions, most recently IBM, but part of having a great process is the confidence to stick to that process or line of thinking even if outwardly evidence continues to point to you being wrong in the short run.  In other words, the market can give you evidence, the main one being Theranos’ sky high valuation, that you are wrong in the short run. However, in the long run, in this case, it basically took 10 years for some of the early skeptics to be proven right.

Although few, if any, businesses that make it to the public markets are outright frauds, I do scratch my head at some of the valuations companies are being given with fast growing revenue numbers but little, if any, profit to accompany those revenues.  This idea isn’t particularly new, but it has taken on a stronger hold in the value investing community with the stock success of certain companies who have used this playbook.  I find myself sometimes wondering if I am in the middle of these eight years, whether these valuations will fall dramatically or maybe I am just wrong?  Theranos provides a great example of how long you can “be wrong” before things turn.

When thinking about the state of Theranos from 2006 to 2014 (or up until 2016), I am reminded of the thought experiment for called Schrödinger’s cat.  During that entire time period, the box was closed and it was unclear whether the investment was a good one or not.  The joy of investing is that you can chose to only invest when you can peek in the box and make sure the cat is alive.  If the box is closed off to you, you can walk away. And with a long enough time frame, someone will come along and open the box and write a great book that tells you all about the adventures of the cat and what in fact did happen to it.

Also, this was an “AMA” on Reddit with the author of Bad Blood, John Carreyrou with some interesting thoughts.


Matt Brice is the portfolio manager at The Sova Group and can be reached at matt@thesovagroup.com.

 

 

 

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