The Inside view about the truth of a hypothesis rests on the perceived accuracy of the available evidence. For example: how long will it take us to complete a certain project? More or less than three months? In answering this question, we tend to rely on our experience and sensible judgement to come up with our best estimate. And if the estimate is, say, two months, we confidently conclude that we’ll most likely be done within three. Only to find out, to our great surprise, that even our most prudent assessment quite often turns out to be woefully inadequate. Kahneman and Tversky called this the Planning Fallacy.
An important cause of our misjudgement is that we tend to disregard the Outside view. While it may come natural to recall the time it took us to complete similar projects in the past, and even to allow for extra time in order to prevent excess optimism, we often fail to ask a simple question: How long did it take other people? This external yardstick, independent of our own experience, eludes us, as we find it difficult to place ourselves in an appropriate reference class. But an Outside view is essential, as it provides the Base Rate. Without it, we fall straight into prior indifference. Making the effort to establish a Base Rate, however little relevance other people’s experience may appear to have, gives us a much firmer ground on which to lay our own experience.
A friend of mine has a useful rule of thumb. A few years ago, after showing him a carefully laid out plan of a property renovation, which my architect had estimated it would take eight to nine months to complete, I told him I had prudently rounded up the estimate to one year. To which my friend, who had just completed a similar work on his property, replied: “Take your most careful and cautious estimate. Then double it.” Boy, was he right.
Disregard of the Outside view is closely related to availability and, more in general, to what is known as the Affect heuristics: the tendency to form judgements and take decisions on the basis of emotions (Thinking, Fast and Slow, Chapter 13). As with aviophobia, the predominance of introspection on the external assessment of Base Rates may result in unsound outcomes.
Bearing in mind the Outside view can greatly help investment decisions.
In the summer of 2002 I bought the ADR of Elan, an Irish biotechnology firm that had seen its price collapse from 60 to 2 dollars, following a messy history of rash acquisitions, rampant debt and accounting irregularities, emerged shortly after the Enron scandal. It turned out to be an excellent investment. Through management change, debt restructuring and asset sales, the company managed to accomplish a successful turnaround, allowing it to concentrate on its most valuable assets: a multiple sclerosis drug then called Antegren and today Tysabri, owned 50/50 with Biogen Idec; a nanotechnology drug delivery business; and a promising pipeline of anti-Alzheimer therapies. As a result, the stock had a ten-fold appreciation, ending 2004 just below 27 dollars.
By that time, Tysabri had received FDA approval, on the back of proven superior efficacy in stemming the progression of multiple sclerosis, a highly debilitating neurological disease affecting more than two million people worldwide. Translating efficacy into sales, hence profits and valuation, was not, therefore, a wishful flight of fancy, but a solid expectation: gaining just 10% of the MS market would have made Tysabri a highly profitable drug.
Despite cutting several times the exploding weight of my position, at the beginning of 2005 the stock was still in my portfolio, when on 28 February, out of the blue, Elan and Biogen announced a voluntary suspension of Tysabri sales. The reason was that two Tysabri patients had contracted a rare but life-threatening condition known as Progressive Multifocal Leukoencephalopathy (PML). As a result, the stock price plunged to under 8 dollars. And, as a third case emerged at the end of March, the drop continued to just above 3 dollars. The drug had been on the market for just a few months, so all three cases were among the 3,000 patients who had taken part in the Tysabri trials in the past several years. The Base Rate of PML was therefore very low – one in a thousand, just as in our child footballer and virus stories. But, struck by a completely unforeseen risk for a drug which, until then, had demonstrated a high safety profile, the companies chose to play it safe and temporarily suspended sales, with a view to gaining more clarity on the issue.
By cutting Elan’s capitalization by almost 90%, however, the market took the Inside view: the PML menace was so frightening that Tysabri would not be allowed back or, if back, would only be able to aspire to a much smaller market share. Such emotional response ignored the Outside view: with a Base Rate of 0.1%, PML risk was small and manageable. The sale suspension was a cautionary measure aimed at ascertaining the Base Rate – making sure that the 3,000 patients were an appropriate reference class – but it had the unwelcome effect of feeding PML fear.
Banking on the Outside view, and after a helpful meeting with Elan’s CEO, which convinced me that PML risk would remain contained, I rebuilt a large position in the stock. That also turned out to be a very good investment. Despite market fears, and on the wave of strong pressure from patients and doctors clamoring for reintroduction, Tysabri was readmitted in June 2006. By that time, the stock had gone back up to 18 dollars, and continued to rise in 2007, ending the year at 22 dollars. As was to be expected, had one kept the right balance between PML worries and the available data, Tysabri sales started a rapid and steady climb, which is still ongoing.
In the meantime, Elan had made good progress on the Alzheimer front, accelerating the trial of a promising new drug, developed in collaboration with Wyeth, called Bapineuzumab. This helped the stock to continue its rise well in 2008 when, right in the midst of the market turmoil, it reached 36 dollars in mid-July, up 64% in the year.