Sometime in 2007, the Board of Directors for Valeant Pharmaceuticals (NYSE:VRX) contacted the head of McKinsey's Pharmaceutical practice to help it devise a new strategy. The company had been founded in 1960 by a former Nazi resistance fighter from Yugoslavia who would ultimately be engaged in legal battles with Slobodan Milosevic, make a series of false claims about the benefits of a Valeant drug, and fathered a son with his secretary.
From the time the founder, Milan Panic, was forced out of Valeant until 2007, the company had drifted with little sense of identity or vision. Mike Pearson, the McKinsey consultant that the Board contacted, would give it one. He told the Board that they should focus efforts on niche areas that would not draw competition from large pharmaceuticals as well as cut unproductive research and development costs and instead buy products from other companies after the research had been proven.
The Board was so captivated by Pearson that it offered him the position of CEO in 2008 to implement the changes he proposed and set in motion events that over the next eight years would result in a ten times increase in revenue, several dozen acquisitions, a Congressional investigation, and fortunes and reputations made and lost.
Valeant Pharmaceuticals has received as much media attention as any company over the last year from both traditional as well as financial journalists. For an overview of the Valeant story, Bethany McLean has a terrific piece in Vanity Fair. The condensed version of events is that Valeant proved to be extremely aggressive in its accounting and business practices to drive performance.
This included the purchase of Biovail in part to lower its overall tax rate to below 5% by housing its intellectual property in an off shore corporation, purchasing drugs for the sole purpose of raising prices and exploiting the lengthy FDA generic approval process, using a specialty pharmacy to divert volume towards expensive drugs when cheaper generics were available, and paying consumers co-pay on drugs that had enormously marked up prices to gouge insurance companies. At this point, I do not think anyone is defending these practices by Valeant
The question I want to pose is what do we take away from such an ugly episode? Many of those that had invested in Valeant were extremely intelligent people. There are some obvious lessons in identifying the psychological biases that are most likely to cause irrationality. But, there is another question worth asking after the Valeant fallout since the implosion in the company's value is clearly the result of severe ethical lapses.
What role should social responsibility play when making an investment decision? And if social responsibility should have a place on an investor's checklist before committing money, how should we go about defining what exactly makes a company socially responsible?
What is social responsibility?
There is no concise definition of what it means to be a responsible corporation anymore than you could concisely define what it means to be a responsible person. Certainly, the managers of a corporation have a responsibility to follow all of the laws where they conduct business and to earn as high a return as possible for the owners of the business.
Some advocates of corporate social responsibility say that in addition to legal constraints, corporate managers have additional ethical obligations of behavior since laws cannot cover every conceivable situation. Other advocates put forward a stakeholder theory that states that corporations should consider the obligations to parties besides shareholders such as employees and the community.
I think most investors are likely to agree with Milton Friedman on the issue of corporate social responsibility. He wrote in a New York Times Magazine in 1970 that a corporate manager has no obligations beyond making a profit since it is not his money to spend. By making decisions as to what is or is not socially responsible a business manager would be usurping the rights of the owners of the business to make that choice themselves or of lawmakers to decide what behavior should or should not be regulated.
Friedman sums up his position by stating, "there is one and only one social responsibility of business - to use its resources and engage in activities designed to increase profits so long as it stays within the rules of the game."
At root, any instance of corporate social responsibility being the right thing to do purely on social grounds must involve an externality of some kind. The externality most commonly taught is the "tragedy of the commons" where common land is over-grazed by cattle to the injury of everyone since the depletion of the land was not factored into the cost of herding cattle. It would be nice in this instance for the herders to devise a system on their own to solve this problem. They are unlikely to do so, however. It is much more likely that some regulation is needed to solve the market failure.
Similarly, hoping that civic minded and socially conscious managers are the future leaders of pharmaceutical companies is not the best response society can make to the Valeant situation either. What it should do is address market failures. This could be done through policing tax shelters and entertaining corporate tax reform, finding ways to rapidly speed up the process of FDA approval of generics, considering making illegal all instances of co-pay assistance, and perhaps considering other reforms that would allow a free market to operate best.
But placing responsibility on the government for ethical behavior is still a deeply unsatisfying answer to the question of social responsibility from the viewpoint of an investor. Anyone is welcome to hold the viewpoint that the managers of a business should relentlessly pursue any legal means to increase profits, but I think this viewpoint is a kind of market fundamentalism that is inconsistent with reality. On the other hand, many companies that talk about social responsibility do so as nothing more than marketing and it would be a mistake to take these efforts too seriously.
If anyone attempted to come up with ironclad rules to define social responsibility, then it is only a matter of time before someone smart exploits them. Rather than placing a focus on traditional forms of social responsibility (which can be valuable in some instances), I think we are much better off using a few principles to gauge how responsible a company is behaving. Here are a few principles that I think are most important.
Don't underestimate the power of incentives
In retrospect, it's clear that the Valeant Board underestimated the effect the incentive system that was put in place would have on executive performance, despite the fact that at the time they held their incentive system up as a model of aligning executive and shareholder interests. It is not that the Board did not realize the risk of short-term thinking in designing the incentive structure as they did. They simply assumed that by not allowing Pearson and other executives to sell shares of stock that shareholders were protected from this risk. They were wrong.
For someone to become the CEO of a corporation it is unlikely that they are not an extremely competitive individual. The maximum bonus under Valeant's incentive plan was achieved if total shareholder return was 45% or greater. While it is possible for a share price to cross that hurdle for a variety of reasons, it is not reasonable to think there is a human being who could responsibly compound wealth at a rate of 45% over any meaningful time period. It is true that by holding a significant amount of stock, Pearson participated along with other shareholders in Valeant's downside. It is just equally true that Pearson himself underestimated the influence of incentives on his own behavior.
If you want to know what really matters in a company's culture, look first at how performance is incented. Ideally, the CEO would own a large enough stake in the company that his and shareholder interests would already be aligned, but this is not always feasible. In the absence of a sizeable ownership stake, there is no formula that tells you the best way to incent executives.
But always read the proxy statement carefully to understand what the culture at the company rewards and the effect of such a system on an ultra-competitive personality. Executives may believe that regardless of the incentives, their behavior will always be above board, but there is a good chance that they too are underestimating the influence that incentives will have on their conduct.
Sustainability, Second Level Thinking, and Competitive Advantage
Sustainability is a concept that is often linked to corporate social responsibility. Often it is the environment that is referred to when sustainability is discussed (again, of course it is not wrong to care about the environment). You should think about the concept much more broadly, though, and along the lines of "anything that cannot go on forever, won't."
Again, consider Valeant as an example. If you do not want to think about Valeant's choices in the context of morality, then think of them in the context of sustainability. What was Valeant doing that was creating economic value? A company that has pricing power or one that has brand strength that causes consumers to prefer its product over cheaper alternatives can have genuine and sustainable competitive advantages.
But, can anyone honestly say that this was ever the situation with Valeant? What was the likelihood that Valeant would be allowed to continually raise prices and have the government and private insurers happily continuing to pick up the tab? Most anyone would realize that by raising prices a company can also raise its profits, but the question that really needs to be asked is whether or not that practice is going to be sustainable. A true competitive advantage can make the answer yes, if it's illusory then maybe not.
This is a good example of what Howard Marks refers to as second level thinking. Or you could simply refer to it as trying to understand the influence of multiple variables rather than a single one. In any event, seriously ask yourself how a company is earning money and whether the practices contributing to it are sustainable.
Worthy of Esteem
Perhaps the hardest thing about the concept of ethics and responsibility to investors and managers is that it is hard to quantify. For good reason, these groups of people are taught to quantify nearly everything. The problem is, not everything can be quantified.
Abraham Lincoln first ran for political office when, at 23 years old, he sought to win a seat in the Illinois state legislature. He stated his goal was to become "truly esteemed by my fellow man by rendering myself worthy of esteem." I think that Lincoln had the proper idea of what should drive our conduct ethically and what should govern our ambition. It was not enough that others respected him. He wanted to genuinely be worthy of that respect.
It is not at all a bad idea to consider the companies you might invest in and ask yourself not only how much money they are earning and likely to earn but are they worthy of that? That is a strange phrase, but what I essentially mean is 'are they providing a commensurate value to society such they deserve the profits they make?' You cannot precisely quantify how deserving a company is of particular income, but you do not need to. If you can answer this question qualitatively then I think you have gone a long way in determining if those profits will be sustainable.
It is no coincidence that Charlie Munger has made a similar statement to Lincoln's since he has been so critical of the practices at Valeant. The Munger version is the "best way to achieve success is to deserve it." As an individual, you could spend all of your time thinking of ways that you could get rich or any other goal that you set your sights on. But you are almost certain to be better off by spending time thinking of ways that you can become someone deserving of wealth or success.
The same holds true of companies. Just as society is not looking to reward undeserving people, it is not looking to reward undeserving companies. Society would be glad to allow pharmaceutical companies to make huge amounts of money if they discovered new antibiotics, made advances in cancer research or developed new vaccines. But, society is not so dumb that it will perpetually reward companies who contribute nothing towards it.
In many ways, earned success is another form of the Golden Rule. Provide to others what you would value if you were in their situation. If we all thought about this more often, we could avoid a substantial amount of misery, in life as well as investing.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.