Buying Into a Whole Lot of Nothing

Theranos would 'democratize health care'... Big-name financial backers... Buying into a whole lot of nothing... Hiding the truth... Mimicking Steve Jobs... Theranos trial is happening now... 'Medical Madoff'... Lessons learned...

Elizabeth Holmes was terrified of needles...

And she's not alone. One in every 10 people suffer from what's called trypanophobia... For those folks, getting a simple blood draw is a petrifying experience.

Holmes, though, used her fear of the phlebotomist as motivation.

In 2003, as a 19-year-old Stanford University student, Holmes founded Theranos, a company that aimed to do blood tests, taking just a drop ‒ rather than a few vials sucked out through a needle ‒ at a fraction of the usual cost. Placing Theranos at the intersection of biotechnology and do-goodism, Holmes said her biotech startup would "democratize health care."

At its peak, Theranos – spearheaded by Holmes, who fancied herself as a female version of Steve Jobs, down to the signature black turtleneck – was valued at $9 billion. A long list of top Silicon Valley and tech investors – including venture-capital legend Tim Draper and Oracle founder Larry Ellison – eagerly invested in the company. Former Secretary of Defense James Mattis and former Secretary of State George Shultz, among other kingpins of politics, sat on the company's board.

Based on her 50% stake in Theranos, Holmes was touted as the world's youngest female billionaire. Time in 2015 named her one of the world's 100 most influential people.

She was featured on the cover of Fortune and of the Forbes 400 issue of the richest Americans, and was fawned over in the Wall Street Journal, Glamour, USA Today, and Inc. She appeared on CNBC, NPR, CNN, and Fox Business. Harvard Medical School asked her to join its board of fellows.

But as I (Kim Iskyan) will explain, it all fell apart... for Elizabeth Holmes and for Theranos investors. With the national media following every tantalizing detail, Holmes is currently on trial in federal court in San Jose, California, charged with wire fraud and conspiracy to commit wire fraud. These charges stem from deceiving patients and investors by making claims about Theranos' product and the company's finances. If convicted, Holmes faces up to 20 years in prison.

The collapse of Theranos, which was a private company, hurt only a small number of investors. But its rise and fall is a masterclass in the importance of understanding what you're investing in... in order to avoid companies that might be too good to be true.

Even as a young girl, Holmes knew she wanted to be rich...

When she was 10 years old, a relative asked Holmes the question adults often pose when confronted with the challenge of making conversation with a young person: What do you want to be when you grow up?

As explained in Bad Blood: Secrets and Lies in a Silicon Valley Startup, a 2018 book about Elizabeth Holmes and Theranos by former Wall Street Journal reporter John Carreyrou, the young Holmes replied...

"I want to be a billionaire."

"Wouldn't you rather be president?" the relative asked.

"No, the president will marry me because I'll have a billion dollars."

These weren't the idle words of a child. Holmes uttered them with the utmost seriousness, according to a family member who witnessed the scene.

Holmes carried that intensity – combined with a desire to lead a "purposeful life," which she'd learned from her father – to Stanford University. It didn't take her long to get on the good side of the head of the chemical engineering department, who would eventually join the Theranos board.

After the end of her freshman year, the precocious Holmes wrote a patent application for an arm patch that would diagnose medical conditions – and treat them at the same time. Soon thereafter, she dropped out of college...

The original company name was Real-Time Cures...

However, a typo turned that into "Real-Time Curses" on paychecks for early employees. Later Holmes changed the name to Theranos... which sounds vaguely mythological – but is actually a combination of the words "therapy" and "diagnosis."

One of the first investors in Holmes' newborn venture was Tim Draper, a legendary Silicon Valley venture capitalist, whose book How to Be the Startup Hero is a bible to many entrepreneurs. Holmes was a childhood friend of Draper's daughter – one of many serendipitous connections in the Theranos story.

Within months – thanks in part to the credibility conferred by Draper's support – Holmes had raised $6 million from a mix of family, friends, and well-connected investors.

Meanwhile, the vision of Theranos evolved. Carreyrou explained the company's product...

Something akin to the handheld devices used to monitor blood-glucose levels in diabetes patients... The patient would prick her finger to draw a small sample of blood and place it in a cartridge that looked like a thick credit card. The cartridge would slot into a bigger machine... [and] produce a signal that would be... translated into a result.

The blood-testing machine, named Edison (and later, a different iteration, the miniLab), would sit in patients' homes and could run 240 different types of blood tests. Results would be automatically sent to the patient's doctor, allowing for real-time monitoring and treatment. The device would revolutionize health care by bringing higher levels of care to more people, at a significantly lower cost.

That is... if it ever worked.

Through pure charisma, she attracted big-time investors...

Carreyrou described Holmes' persona this way...

The way she trained her big blue eyes on you without blinking [made] you feel like the center of the world.

Holmes won over billionaire Fox News and Wall Street Journal owner Rupert Murdoch, who put $125 million into Theranos. Former Secretary of State Henry Kissinger called Holmes "striking" and "iron-willed" and hailed her as a tech visionary. General Mattis lauded Holmes' "well-honed sense of ethics." Former Wells Fargo CEO Richard Kovacevich bought in.

In anticipation of a deal that would put Theranos devices in hundreds of Safeway supermarkets, the grocery chain invested $30 million into the company – and spent hundreds of millions of dollars to renovate stores in anticipation of developing in-store clinics, in part built around Theranos.

Carreyrou wrote...

Like her idol Steve Jobs, [Holmes] emitted a reality distortion field that forced people to momentarily suspend disbelief.

They didn't know it... but most investors in Theranos were out of their depth.

It's what I call 'car-mechanic syndrome'...

That's when your car makes some funny noises, so – rather than watch a YouTube video and try to fix it yourself – you take your vehicle to the body shop.

The greasy, overalls-clad mechanic pops the hood, tut-tuts a bit, and declares that it will be $1,200 to fix it... rattling off something about the carburetor and the accelerator.

You don't even know what you don't know. But the car mechanic, who has a gift for gab and a winning smile, seems to know what he's talking about... So, you grit your teeth and pay the bill.

You follow the guidance of the "expert."

Now... investors in Theranos weren't suffering from car trouble...

But they were carried along by the confident charisma of Elizabeth Holmes. And they figured that someone else – Draper or Kissinger or Ellison – had done some real due diligence on Theranos... and on Holmes.

And there's an important distinction: The concept of the Theranos product might be straightforward ‒ use a few drops of blood rather than a vial, and then transmit the results of blood tests in real time. But understanding the mechanics of it ‒ or if it's even possible – is something else altogether.

The list of investors in Theranos, and members of the company's board of directors, included few actual experts in the fields of biotechnology, nanotechnology, or biochemistry – and they had little understanding of what was going on with Edison.

It was a $945 million oversight – that's how much investors put into Theranos altogether, according to the New York Times.

Holmes' management style was another red flag...

With the prestige conferred by an A-list board of directors and celebrity investors, Holmes attracted high-powered employees to make her vision a reality – PhDs and senior managers from NASA, IBM, SpaceX, and Panasonic, and designers from Apple... "It wasn't often that you found executives of that caliber at a small startup," Carreyrou wrote.

But few of those exceptionally well-qualified people stayed long... in part because of Holmes' dictatorial management style.

What we're doing "is the most important thing humanity has ever built. If you don't believe this is the case, you should leave now," she announced at the company Christmas party in 2011.

Holmes insisted on total secrecy – even within Theranos – which hurt efficiency and productivity. By limiting the information flow between groups – and making herself the nerve center of the company – Holmes was able to obscure the dire problems facing the company.

At other times, Holmes transparently mimicked Steve Jobs, borrowing techniques discussed in Walter Isaacson's popular biography of the Apple founder. Carreyrou revealed that Theranos employees could determine how far along Holmes was in the book based on which behaviors she was emulating.

But she took a business cliché too far...

"Fake it till you make it" suggests that by cultivating a pretense of competence, you can buy time until you achieve real success.

The key question facing jurors in Holmes' trial right now is whether Holmes "faked it" in a criminal kind of way. That's really the crux of the case. As the Financial Times asked recently...

Did [Holmes] lie and cheat to make money, as prosecutors alleged, or did she simply fail to deliver on an ambitious vision to reinvent blood testing?

All the reporting in the media and in Bad Blood points clearly to outright fraud. Demonstrations of the Theranos device were clearly deceptive... Holmes reported preliminary contracts as done deals... And she claimed support from a pharmaceutical giant – which in fact had explicitly not endorsed the Theranos product. And that's just the start.

But Holmes' uncanny knack for getting her way – by not letting anyone see the full picture of what was happening – meant that she was able to skirt the hard questions about the viability of Theranos for years. She fired employees who pointed out problems, and she blithely papered over challenges that investors or partners – wary of getting themselves on the wrong side of the explosive Holmes – raised.

That allowed Holmes to advance uber-optimistic, shoot-for-the-moon forecasts of profits and growth.

That's the bread and butter of startups looking to raise capital. And Holmes failed dismally to deliver on her projections. But "failure is not a crime," in the words of her lawyers.

There are similar characteristics with one of the biggest financial scammers of all time...

One of the most successful bogus investment schemes of all time was run by financier Bernie Madoff. His guise was a preternaturally consistent and successful hedge fund that returned between 10% and 12% every year, regardless of market conditions.

In an investment world where tech stocks and cryptocurrencies regularly post triple-digit returns, that might sound like pocket change. But a solid double-digit return with low volatility – that is, minimal swings in performance – over decades is extremely rare.

By using a legitimate brokerage house as a front, Madoff was able to scam 40,000 investors ‒ many of them friends and family members ‒ who were deceived into thinking they'd accrued $65 billion in profits over a period of more than 40 years. The reality was that he was running a Ponzi scheme, simply paying current investors with the cash from new investors.

Elizabeth Holmes was a kind of "medical Madoff," says Erin Arvedlund, who wrote the definitive book on Bernie Madoff, Too Good to Be True: The Rise and Fall of Bernie Madoff.

The similarities are striking. Madoff got away with vague explanations of how he was able to generate such strong and consistent returns... and, when pushed, hid behind the claim that his ideas were proprietary. Holmes similarly used jargon and fuzzy language, designed to confuse rather than clarify.

Like Holmes, Madoff had a long list of influential backers – investors who happily referred their friends and family to Madoff, thinking they were doing them a favor. Like Madoff, Holmes warned investors not to expect much information or frequent updates... and actively discouraged probing questions.

Madoff's investment results were simply mathematically impossible. Says Arvedlund...

There were those who suspected Madoff's magic was just an illusion. Among Wall Street option traders, the conventional wisdom was that Madoff's strategy could not be replicated by anyone in the marketplace – at least not so it generated the double-digit returns he claimed.

Like Madoff, Theranos couldn't reliably and repeatedly deliver results without cheating.

Madoff was sentenced to life in prison, where he died earlier this year.

Theranos took a long time to crumble...

In August 2015, the Food and Drug Administration nosed around the Theranos facilities, and medical regulators found inaccuracies in the company's blood tests... Soon after this discovery, the first in a series of bombshell articles in the Wall Street Journal ‒ which Holmes admitted trying to kill ‒ put Holmes on the defensive.

The Securities and Exchange Commission launched an investigation into the company. In late 2016, Theranos closed its lab operations. And in June 2018, Holmes stepped down as CEO and was charged with conspiracy and wire fraud.

The trial is ongoing, and Holmes recently took the stand for multiple days to defend herself in an effort to stay out of jail. Whatever the verdict, the takeaways from Theranos will last forever.

The lessons of Theranos are instructive...

Beware the "story stock"...

In the investment world, a "story stock" is a company that's valued based on a promise, a vision, or a cool idea... but which often lacks strong fundamentals or an actual business plan. Story stocks often have delusions of grandeur, but little revenue.

Hot Internet stocks in the dot-com boom of the late 1990s, for example – Pets.com, anyone? – were big-time story stocks... Investors who employed "eyeballs" as a valuation metric and ignored negative cash flows learned the hard way when these sorts of stocks collapsed under the weight of their own faulty narrative.

Of course, some story stocks – Tesla (TSLA) and Amazon (AMZN) are two prominent examples – go on to change the world and make investors rich along the way. But chances were that Theranos was not going to be among them.

Do your due diligence...

There's no substitute for the hard work of research... something that investors in Theranos simply didn't do. As the New York Times recently asked, in reporting on the Holmes trial...

As investors have testified at Ms. Holmes's trial, a central tension has emerged around due diligence. Could these investors have avoided disaster if they had simply done better research on Theranos?

That's about checking in with customers, suppliers, and partners about a company's product and production... getting expert insight on the sector, and on the strengths and weaknesses of the company... reviewing past forecasts to see if they were met... talking with former executives from the company and managers of competing firms... stress- and reality-test financial statements and projections.

Though it might seem obvious, all too often investors, including those who should know better – with visions of huge returns and under the spell of the car mechanic – don't do basic research on prospective investments, even with millions of dollars hanging in the balance.

It's a lesson that investors in Theranos learned the hard way.

Don't put all your eggs in your company basket...

Holmes was – on paper – a multibillionaire. But she never sold any of her shares in Theranos. Perhaps it was a show of her own faith in the enterprise, or possibly a way to avoid revealing the uselessness of her product.

At some point, she knew that her billion-dollar product would not work... And instead of pivoting and using her hundreds of millions of dollars in funding to find a product that did work, she lied to cover her failure. Surely, with all those scientists, PhDs, and engineers, Theranos could have developed something that ultimately did work.

She didn't diversify. She bet it all on one product... and that product failed.

She was like the investor who doesn't balance his portfolio after a big win... or doesn't follow a stop loss on a stock that moved up quick and fast.

As a result, Holmes apparently lost it all when Theranos went bust.

New 52-week highs (as of 12/1/21): Lam Research (LRCX), Lynas Rare Earths (LYSDY), NVR (NVR), and Telekomunikasi Indonesia (TLK).

In today's mailbag, two subscribers write in with more thoughts about our Monday Digest on the "Marshall Plan" and how it relates to COVID-19 vaccines... while another praises our colleague Dan Ferris for his Tuesday Digest on how humans can't control nature. What's on your mind? We'd love to hear your thoughts, comments, and observations on the markets at feedback@stansberryresearch.com.

"Hello there! A quick thought in response to the idea of America vaccinating the world...

"I would draw your attention to the use of totalitarian strategies in countries such as Australia and Austria having to do with 'vaccine passports' – and to the entirely appropriate response by the populations of these countries.

"I'd rather not see the U.S. promote the thing (often being called a 'bioweapon') that's being used to enslave these people.

"And we're perilously close to the same tyranny and oppression here in the U.S.!

"Just a thought... Thanks for all the great work you do!" – Paid-up subscriber Barbara H.

"I want to echo the sentiments of the letter from Phill N. questioning Kim Iskyan's suggestion that the U.S. should pay to give the world COVID-19 shots.

"The question we are each answering is, 'Is it wise for me to get a shot for a disease that is rarely fatal by itself when the shot is a first-time experiment in human genetic modification, has known possible serious short-term side effects, has unknown risks to my long-term health, lasts only a few months, and doesn't prevent me from getting or transmitting the disease?'

"We don't all answer this question the same way in the U.S., so we certainly shouldn't be answering this question for others." – Paid-up subscriber Tim S.

"Dan, it's far more important for me that you guys all remember the Stansberry mantra – 'being told what you would want to hear if our positions were exchanged.'

"I value integrity and honesty and your experience even when negative more than getting some '10x' big gainer.

"Thanks for your comments in the November 30 Digest. I would rather be prepared for a big fall than I would for a big run up." – Paid-up subscriber Al M.

Kim Iskyan
Ashton, Maryland
December 2, 2021