It's not every day that a company with a market cap of more than US$ 70 billion (almost same as India's largest company by market cap), and one that is favoured by a lot of savvy investors, loses 80% in nine months (65% in just the last one month). But that's what has happened with investors in the Canada-based Valeant Pharmaceuticals (NYSE:VRX), where a spate of scams has been discovered over the past few months - from bad M&A accounting, to wrongful income reporting, and now the company is facing a potential default.
Valeant is a typical case of a high-growth business where people think nothing could go wrong and overpay ignoring the complexities and fuzziness, and which ultimately presents itself as a classic case on what not to do in business and investing.
1. "Not Just One Cockroach" Theory Works
Problems at companies are never isolated. Like cockroaches, there is never just one problem. The first big cockroach from Valeant's kitchen emerged in September 2015 when the company was accused of jacking up prices for the drugs it had bought through several mergers and acquisitions, some as high as 500% to 800%.
Then, in October 2015, trading in Valeant's stock was halted three times as it declined by 28% in a day following a report that claimed that the company was using a pharmacy chain called Philidor to store inventory and record the transactions as sales. A major allegation was that, by controlling the pharmacy services offered by Philidor, Valeant steered the latter's customers to expensive drugs sold by it.
Another big cockroach in Valeant's kitchen is the huge amount of debt it holds on its balance sheet (US$ 30 billion), which has led to the company facing a looming default. Secondly, Valeant's loans are not owned by one bank or even a few large investors but by around 753 funds over 103 fund managers in the form of collateralized loan obligations, or CLOs (essentially loan funds that buy and hold lower credit debt). So, it's now a systemic risk and not just Valeant specific.
Warren Buffett wrote in his 2002 letter -
When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen.
It's a great lesson in case you own a company where the management has taken the low road - maybe too many acquisitions, or bad accounting. There is seldom just one cockroach in the kitchen.
2. Beware of Serial Acquirers
If the acquirer is not Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) that has a long-long track record of making sensible acquisitions, I am not willing to bet on a company that is trying to grow fast through this route. Most acquisitions are made not for any "strategic fit," but to satisfy the egos of top managers making the acquisitions. So, most acquisitions are brash, and thus expensive. Aswath Damodaran wrote this in his recent post -
The Valeant story reinforces many of my existing biases against companies that grow primarily through acquisitions. I am willing to concede that this strategy can pay off, if companies maintain discipline, but my experience with these companies is that they inevitably hit a wall, either because they become too large to stay disciplined or because the accounting creates too many opportunities to obfuscate and hide problems.
In this case, Valeant appears to have been both too large to stay disciplined and willing to surf on the non-transparency of M&A accounting. There are lessons galore from India on this front, Tata Steel, Suzlon and 3i Infotech being on top of my mind - though all of these cases were bad more for the indiscipline/overpaying than fuzzy M&A accounting.
3. Intrinsic Values Can be Permanently Destroyed
Often for companies that lose their reputation due to their own wrongdoings, it's very difficult to come back to business as usual. Their customers won't trust them anymore, and so would their suppliers. As more problems emerge - the "not just one cockroach" theory - and bad news leads to more bad news, business takes the backseat. Subsequently, the intrinsic value that is driven by the company's earning power is impaired, often permanently.
A lot of investors equate low stock prices i.e., cheapness, with value. This can be a dangerous equation for companies that actually deserve that cheapness owing to their deteriorated fundamentals. For instance, Aswath Damodaran has tried to calculate Valeant's intrinsic value using this excel file, but just the number of variables that need to go right - which is entirely based on whether Valeant would get its house in order - to justify the calculated intrinsic value would make you drowsy.
When you wear the Grahamian hat and buy cheap stocks believing they would revert to mean, you must practice extreme-extreme diversification. But when you are looking to invest only in high quality businesses, you must know how "high quality" looks like and must be willing to change your mind when that quality deteriorates.
After all, margin of safety in a stock may decline not always when the stock price rises to meet intrinsic value, but also when the intrinsic value falls to meet the stock price.
4. Biases are Impossible to Eliminate
In all my workshops when I talk about behavioural biases that effect investors, I end with a caveat that these biases are impossible to eliminate because that's how our brains are wired. One of the biases I talk about is that of Confirmation/Commitment and Consistency. This is how Robert Cialdini explained this bias in his brilliant book Influence -
Once we have made a choice or taken a stand, we will encounter personal and interpersonal pressures to behave consistently with that commitment. Those pressures will cause us to respond in ways that justify our earlier decision.
Charlie Munger uses the inverted version to represent the bias it causes and calls it 'inconsistency-avoidance bias'. He explains that the human brain conserves programming space by being reluctant to change.
This bias is especially at play when you are losing money on a bad business, but your internal "yes-man" continues to seek evidences that confirm your original thesis to conclude that you could not be wrong.
Now, one of the hardest things to do in investing is to find the balance between staying put with your high conviction ideas through unfavorable times, and realizing that you were wrong in your conviction and changing your mind.
Consider Bill Ackman's vociferous and continuous support for Valeant, while the stock was falling off the cliff as more cockroaches were jumping out of its cupboard. Here's what he wrote to clients in his Jan. 2016 letter (emphasis mine) -
The inception of the portfolio's decline began with Valeant in August. We have discussed at length the events at Valeant which catalyzed the stock's initial decline: political attention on drug pricing and the industry, regulatory scrutiny, attacks by short sellers, and the termination of a distribution arrangement representing ~7% of Valeant's sales. But, we would never have expected that the cumulative effect of these events would have caused a nearly 70% decline in the stock, nor do we believe that they will permanently impair Valeant's intrinsic value.
Note that even as Ackman wrote about the multiple serious issues faced by Valeant, he maintained that all this would not "permanently" impair the company's intrinsic value. Now I have no idea if Ackman is right or wrong here. But I know how hard it is to admit being wrong after sinking a lot of money into one idea (he recently increased his holding in Valeant by 30%, and now owns a 9% stake).
There is a big difference between patience and stubbornness, and not admitting that you are wrong even when all the facts are against you, is being stubborn. But admitting that you were wrong, which indirectly is an admission that all the hard work you did in the past has come to zero, really hurts. And that's why it's basic human nature to remain committed to and consistent with your old ideas. But then, as Charlie Munger said -
Failure to handle psychological denial is a common way for people to go broke. You've made an enormous commitment to something. You've poured effort and money in. And the more you put in, the more that the whole consistency principle makes you think, "Now it has to work. If I put in just a little more, then it 'all work." People go broke that way, because they can't stop, rethink, and say, "I can afford to write this one off and live to fight again. I don't have to pursue this thing as an obsession in a way that will break me."
It's difficult for even the smartest of investors to avoid falling into this trap of holding on to their old, bad, losing ideas… but then you don't need to be so smart to understand the implications of such thinking, given the long history of how others have destroyed wealth under the spell of this bias.
Morgan Housel wrote this in his recent post -
How do you avoid this trap?
It's so difficult. But here's an idea to help reduce errors: Avoid investments of such vague appeal that a team of Harvard MBAs needs three years and $50 million of research to get to the bottom.
I see people whose investment beliefs rival religious passion. They believe so strongly in their views that they literally can't understand why you'd disagree with them. The basis of their passion is usually years of deep study, which creates the impression of expertise but may actually just be a supernova of confirmation bias and self-delusion. "Expertise is great," investor Dean Williams once said, "but it has a bad side effect: It tends to create an inability to accept new ideas."
5. Humility is a Big Virtue
It's important to stay humble when you have had a successful investment track record in the past… and especially when you have had a successful track record.
Consider Warren Buffett and Charlie Munger who have what they call a "too hard pile." Here's Munger on this idea -
If something is too hard we move on to something else. What could be simpler than that?
We have three baskets: in, out, and too tough. We have to have a special insight, or we'll put it in the 'too tough' basket.
Buffett and Munger have made it quite clear at several times that they do not have methods to value every company in every industry. If they can't determine a basic fact like the present value of the business with the degree of accuracy they desire, they just move on to the next opportunity. That's humility served on a platter.
Compare this with most other investors - big or small. People often get enchanted by complexity, or shiny stuff that is outside their circle of competence. Consider Valeant for instance. As I read more about the company, it has always been a difficult stock to analyze for a number of reasons. Its serial acquisitions make for difficult financial comparisons across years. It doesn't provide sales data for its major drugs. The management has often emphasized clumsy figures like "cash earnings per share" in their reporting, which exclude some very legitimate costs. And then its scamming relationship with Philidor, the impact of which most people don't know about.
In all, as more and more bad news emerged from Valeant's stable, the company became too complicated to figure out, and thus too complicated to own. Bill Ackman, considering his long investment experience, should have known this.
Here is what I read from his note on "humility" in his latest letter, where he described the reasons for poor performance of his fund in 2015 and his thoughts for 2016 -
…in order to be a great investor one needs to first have the confidence to invest without perfect information at a time when others are highly skeptical about the opportunity you are pursuing. This confidence, however, has to be carefully balanced by the humility to recognize when you are wrong. While no one here is enthusiastic about delivering our worst performance year in history in 2015, it certainly does a good job reinforcing the humility-side of the equation that is necessary for long-term investment performance. In 2016, we would like to generate results that reinforce the confidence side of the equation. Humility and skepticism will help get us there.
Ironically, in Valeant's case, Ackman has neither been humble nor a skeptic… and this has caused his downfall.
6. Concentration Can be Hugely Risky
While I am a diversified investor and have nothing against concentration, I believe the latter is a relatively risky strategy for small investors because blow up in 1-2 stocks could wipe out a large amount of your net worth.
In Valeant's case, many previously successful fund managers put a huge portion of their clients' assets in the stock. Apart from Ackman, the Sequoia Fund, a mutual fund that Warren Buffett had recommended in the past, put around 30% - that's almost one-third of their clients' money - of the fund into the stock.
Of course, all investing involves risk, and everyone makes mistakes so I'm not criticizing any of those money managers for taking a chance on Valeant's brilliantly made up story. All I am saying is that a company with so many moving parts and unknowns and with so many potential downsides (with more emerging by the day) shouldn't make up such a large part of your portfolio. Because when that is a case, and you lose big money on that company, you tend to remain consistent and committed to your original decision because a large amount of money is at stake, and accepting the mistake would hurt a lot.
The Trouble is…
If you know the future of your investments, it's silly to play the defensive game. You should behave aggressively - employ maximum leverage and concentrate in the greatest potential winners. After all, there can be no loss to fear.
But then, if you don't know what the future holds, it's foolish to act as if you do. Amos Tversky, the noted cognitive and mathematical psychologist and a collaborator of Daniel Kahneman said -
It's frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what's going on.
Then, Mark Twain supposedly said -
It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.
In investing, overestimating what you're capable of knowing or doing can be extremely dangerous. Acknowledging the boundaries of what you can know - and working within those limits rather than venturing beyond - can give you a great advantage.
Bill Ackman, and a host of other leading investors in Valeant did not pay heed to this aspect, and they have paid the tuition fee in billions of dollars. I am sure the lessons from the Valeant fiasco would cost you cheap in case you are open and willing to learn from the misadventures of others.
It's a random, crazy world out there. Play it safe. Play it sensibly. It's your money after all. Isn't it?