Is This Hedge-Fund Manager Right to Short Big Pharma Stocks?

Hedge Fund Manager Kyle Bass is betting against big pharmaceutical companies based on what he calls “B.S. patents.” He makes a compelling case against these companies, though this is an incredibly powerful and well-connected industry.

Is he right to short big pharma stocks?

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I first heard of Kyle Bass in the opening lines of Michael Lewis’ Boomerang: Travels in the New Third World. Bass, who successfully foresaw and bet against the stock market collapse of 2008-2009, was left out of Lewis’ The Big Short, a book that chronicled several investors who successfully bet against the market and won during the crisis. But he found Bass’ story compelling, particularly his thesis that whole countries in Europe would ultimately fail.

As the economic situation became increasingly dire in Europe and Lewis realized Bass had been right about what would happen next, he revisited him at his home and office in Texas. Among other things, Bass discussed a trade in which a Greek default would be incredibly profitable for his firm. Right again.

Kyle Bass is certainly an interesting character as far as hedge fund managers go. But the reason I care what he thinks is that he has a knack for being right.

Bass, the founder and principle of Texas hedge fund Hayman Capital, announced his latest investment thesis during a presentation at a conference in Copenhagen earlier this week. Bass called the firm’s position regarding big pharma stocks a “short activist strategy.”

The “short” part of the strategy means that Hayman Capital is betting against big pharmaceutical stocks.

The “activist” part of the strategy means that Bass isn’t just going to sit back and wait for the market to realize he’s right. Rather, he and his team at Hayman Capital are going to actively challenge the validity of the “B.S. patents” to which Bass refers.

Pharmaceutical companies often spend many years and hundreds of millions – if not billions – of dollars to develop a drug and secure a patent that will only last for 20 years. As such, they often mark up the prices of these drugs in an effort to recoup the cost of research & development, cover the costs associated with failed efforts and, of course, to generate a healthy profit during their patent window.

As the expiration of the 20-year patent approaches these companies typically do one of two things, both of which appear to be in the crosshairs of Kyle Bass and his team at Hayman Capital.

One strategy big pharma stocks use is to modify one or more molecules of the original drug and release a new version of it. An example of this might be a company reformulating a popular drug to last longer and releasing it as an “XR” – extended release – version of the drug. A patent application is then submitted for the new formula, often enabling the pharmaceutical company to extend the 20-year window.

These patents are what Bass calls “B.S.” He stated that Hayman Capital will file inter-parties review petitions with the U.S. Patent Office, beginning a process to challenge individual patents.

A second strategy that big pharma stocks use is called a reverse payment patent settlement, commonly referred to as “pay for delay.”

As a drug’s patent nears expiration the patent holder will literally pay its competitors to not develop a competing drug for a period of time. If this sounds ridiculous, it is. It would be like Samsung paying Apple a few billion dollars to delay the release of the latest iPhone by a year. Imagine the outrage – and lawsuits – that would follow such an action.

This is another practice that Bass singled out in his presentation. He told conference attendees that “pay for delay” is coming to an end for big pharma stocks.

Bass mentioned that he expects his firm’s action to change the way drug makers and pharma stocks manage their patents. He also said he expects this to “lower drug prices for everyone.”

While this may be true, make no mistake: Kyle Bass has taken this position because he expects it to be very lucrative. “We’ve dedicated half of our resources over the past six months to this,” he told the audience.

Soon I’ll take a closer look at some of the companies that are most likely to be in Bass’ crosshairs. But when it comes to his overall plan to short big pharma stocks, I’m inclined to think Bass is on a path to success.

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