Top Stock Pickers' Exposure To Valeant Pharmaceuticals

| About: Valeant Pharmaceuticals (VRX)

Summary

Top stock pickers tend to generate positive future idiosyncratic (residual performance).

Ownership by the top stock pickers is predictive of a stock’s future residual performance.

Top stock pickers net consensus longs (relative overweights) tend to generate positive future residual returns and net consensus shorts (relative underweights) tend to generate negative future residual returns.

Valeant Pharmaceuticals was a large overweight of the top stock pickers between 2011 and 2014, but these positions were mostly liquidated by 2015.

Neither smart nor dumb money is dominant in the stock, but rapid smart-money liquidation in 2014 was a visible warning.

In Early - Out Just in Time

Our recent article established that a portfolio of skilled stock pickers' ideas generates consistent alpha. This brief analyzes what the AlphaBetaWorks Expert Aggregate had to say about one controversial name, Valeant Pharmaceuticals (NYSE:VRX). In short, the smart money was in early and left almost a year before Valeant's recent headaches.

Performance of the Top U.S. Stock Pickers

Since genuine investment skill persists, top U.S. stock pickers tend to generate persistently positive returns from security selection (idiosyncratic, residual returns). This strong performance derives from the top stock pickers' individual positions. Their consensus exposures thus cut through the fog of panic and confusion, such as that surrounding VRX.

We track institutional ownership of Valeant by the AlphaBetaWorks Expert Aggregate (ABW Expert Aggregate). The ABW Expert Aggregate is sourced from all institutions that have filed forms 13F.

Nominal returns and related simplistic metrics of investment skill (Sharpe Ratio, Win/Loss Ratio, etc.) are dominated by systematic factors and thus revert. So for an accurate assessment of manager skill, we must eliminate the systematic effects and estimate residual performance due to stock picking. The AlphaBetaWorks Performance Analytics Platform calculates each portfolio's return from security selection - αReturn. αReturn is the performance a portfolio would have generated if all factor returns had been flat. Each month we identify the five percent of 13F-filers with the most consistently positive αReturns over the prior 36 months. This expert panel of the top stock pickers typically consists of 100-150 firms.

A hedged portfolio that combines the top U.S. stock pickers' net consensus longs (relative overweights) - lagged 2 months to account for filing delay (the ABW Expert Aggregate) - delivers consistent positive returns as illustrated below:

Cumulative Hedged Portfolio Return: Top U.S. Stock Pickers' Net Consensus Longs

Click to enlarge

Source: abwinsights.com

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

ABW Expert Aggregate

4.56

14.43

12.74

5.95

-1.25

15.35

2.20

2.24

15.47

8.81

13.16

1.70

iShares Russell 3000 ETF (NYSEARCA:IWV)

9.04

15.65

4.57

-37.16

28.21

16.81

0.78

16.43

32.97

12.41

0.34

-5.72

Click to enlarge

ABW Expert Aggregate

iShares Russell 3000 ETF

Annualized Return

8.36

6.40

Annualized Standard Deviation

5.25

15.50

Annualized Sharpe Ratio (Rf=0%)

1.59

0.41

Click to enlarge

Top Stock Pickers' Exposure to Valeant Pharmaceuticals

The positive idiosyncratic returns of the ABW Expert Aggregate come from its individual positions: Its longs (experts' relative overweights) tend to generate positive future αReturns. Its shorts (experts' relative underweights) tend to generate negative future α Returns. The ABW Expert Aggregate thus measures the top stock pickers' positioning which is predictive of the stocks' future performance.

The top panel on the following chart shows the performance of VRX. Nominal returns are in black and cumulative residual returns (α Returns) are in blue. αReturn is the performance VRX would have generated if all systematic factor returns had been flat. The bottom panel shows exposure to VRX within the ABW Expert Aggregate:

VRX: Cumulative αReturns and Exposure within the ABW Expert Aggregate

Click to enlarge

Source: abwinsights.com

Top stock pickers had negligible exposure to VRX until 2011. In early-2011 smart-money exposure to VRX grew rapidly, peaking between 2012 and 2014. Throughout 2014, as the shares appreciated, the top U.S. stock pickers sharply cut their exposure to VRX.

The panic hit a year after the top stock pickers dramatically cut their exposure. By 2015 smart-money exposure to VRX was a mixed signal as it tracked the stock's volatility. Ironically, this is when VRX became one of the most crowded hedge fund bets. Though VRX had a history of smart-money ownership, this vote of confidence was withdrawn by 2015. Future stock-specific returns to VRX, as predicted by the ABW Expert Aggregate, increased rapidly in 2011 and dropped rapidly by 2015.

Investors, allocators, and fund-followers, armed with our analytics, would have taken note. Those looking for the smart money to back their long or short views of VRX must now look elsewhere.

Conclusions

  • Top stock pickers' ownership is predictive of future stock performance, since their net consensus longs (relative overweights) tend to generate positive future αReturns and net consensus shorts (relative underweights) tend to generate negative future αReturns.
  • Valeant Pharmaceuticals was a large overweight of the top stock pickers between 2011 and 2014, but these positions were mostly liquidated by 2015.
  • Top stock pickers' current ownership of VRX is not a predictive indicator, but their rapid liquidation in 2014 was a visible warning.

The information herein is not represented or warranted to be accurate, correct, complete or timely. Past performance is no guarantee of future results. Copyright © 2012-2016, AlphaBetaWorks, a division of Alpha Beta Analytics, LLC. All rights reserved. U.S. Patents Pending.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.