Platform Value: The Fall?

| About: Canadian Pacific (CP)
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Summary

Discussion of the potential effects on equity, bond, commodity, capital and asset markets regarding:

Pershing Square Holdings, Platform Specialty Products, Canadian Pacific.

Valeant Pharmaceuticals, Platform Value, Leverage.

Index Fund Bubble, Liquidity Gap.

In Los Angeles, circa 1915, a silent movie "flickers" stunt man (Lee Pace) has his legs paralyzed while performing a reckless stunt. While hospitalized, the injured stuntman begins to tell a fellow patient, a little girl (Catinca Untaru) with a broken arm, a fantastic story of five mythical heroes. Roy's tale is about six heroes: a silent Indian warrior, a muscular ex-slave named Otta Benga, an Italian explosives expert called Luigi, Charles Darwin with a pet monkey called Wallace, and a masked swashbuckling bandit.

An evil ruler named Governor Odious has committed an offense against each of them, who all seek revenge. The group is later joined by a sixth hero, a mystic. Thanks to Roy's fractured state of mind (verbal input) and Alexandria's vivid imagination (visual output), as the line between fiction and reality blurs, together they build a preposterous world. A visually stunning epic fantasy (amazingly with no CGI) that the child in you will either hate or fall in love with.

A mad folly, an extravagant visual orgy, a free-fall from reality into uncharted realms. Surely, it is one of the wildest indulgences a director has ever granted himself. Filmed over four years in 28 countries and a movie that you might want to see for no other reason than because it exists. There will never be another like it. - Roger Ebert

Free falling mad folly?

From Bill Ackman's letter to Pershing Square Holdings' (OTCPK:PSHZF) shareholders: "Our biggest valuation error was assigning too much value to the so-called "platform value" in certain of our holdings. We believe that "platform value" is real, but, as we have been painfully reminded it is a much more ephemeral form of value... [which] depends on access to low-cost capital... and the pricing environment for transactions."

We pull no punches, what Ackman really believes but can't say is, his business model is based on keeping people in the market. Much like Roy (in The Fall) Ackman does not "Ack-knowledge" the market folly of the "platform value" paradigm which has obviously caused Pershing Square and his "Valeant Fall."

Platform Specialty Products

Above note, Platform (NYSE:PAH) jumped from $12 to a peak of $28 then collapsed to $5. Did someone play the greater fool with a speculative $5 stock, which jumped to $28, when they paid $25 a share?

Ackman: "Our most glaring, albeit small, unforced error was buying additional stock in Platform Specialty Products at $25 per share to assist the company in financing an acquisition. We paid too much... and because we assigned too much platform value to the company. Our assessment was incorrect."

Canadian Pacific (NYSE:CP)

Above note, Canadian Pacific going parabolic from $25 to $220 then pulling back to $145.

Ackman: "We made a similar error in not trimming our Canadian Pacific position when it reached ~C$240 per share. While we still believed CP was trading at a discount to intrinsic value at that price... it would have been prudent to sell a portion of our investment."

While we still believed CP was trading at a discount to intrinsic value at that tenfold price? Once is a shame on you, twice is shame on me, but thrice is a pattern of behavior...

Valeant Pharmaceuticals (NYSE:VRX)

Ackman on Valeant's intrinsic value: "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."

Above note, monthly chart of Valeant Pharmaceuticals 10/08 - $6.65, 08/15 $263.81, 04/16 - $25.27.

Observing a historical monthly chart, in 1994, VRX was a $0.50 stock. During the dot com run up, it spiked to $57.18 in January 2001, retracing to $6.65 by October 2008, by 2013 spiking back to the $60 level, then in short exponential fashion to $250.

Ackman on discounts; "it is rare for companies to trade at material discounts to intrinsic value for extended periods."

What part of this speculative overvalued penny stock's inflation, deflation and reflation is missed in viewing the chart? Does one need a team of analysts to consider the seven-year decline to $6.65 as an extended period? Yet, Pershing bought at an average price of $195? A high dive platform value indeed.

Platform Value?

Above note, as of October 15, 2015, of the $59.3B equity value, 81.5% being $48.4B in "platform value" from which to take a fall or swan dive. Why would any sane creditor or stockholder want to be long this risk? Graphic courtesy of Chicago-based hedge fund manager James Litinsky of JHL Capital.

Ackman on the Pershing portfolio: Contemporaneous with the decline of Valeant, the rest of our portfolio went into free fall, which has continued up until the present.

Above note, weekly chart of Pershing Square Holdings' stock valuation 08/03/15 $29.45 - 03/21/16 -$12.78 - a 57% decline. It would seem that the "platform value" paradigm has had quite an effect on Pershing's portfolio and market valuation. Ackman can only hope said effect is as he put it: "much more ephemeral."

What's Leverage?

Ackman on leverage: "stocks can trade at any price in the short term. This is an important reminder as to why we generally do not use margin leverage...The companies in our portfolio that have suffered the largest peak-to-trough declines are Valeant, Platform, Nomad, and Fannie and Freddie. The inherent relative risk of their underlying businesses and their more leveraged capital structures partially explain their greater declines in market value.... In retrospect, in light of Valeant's leverage... we should have made a smaller initial investment in the company."

This isn't rocket science, but did the experts at Pershing forget the part where investing in a company with leveraged debt (capital structure), even without a leveraged margin position, is nonetheless investing in a leveraged position? As we Nattered in "Eminence Front?", it would seem that everybody has been snorting the "white powder" of financial engineering for quite a while, and all but forgotten the fundamentals.

The Index Fund Bubble?

With declining sales, revenue and profits, which do not match up with future P/E or EPS projections, why do the indices seemingly keep going up and up? Vanguard, BlackRock, and State Street are the biggest managers of index funds, which cumulatively own 12% to 20%, of almost every index component. Accordingly, last year, index funds were allocated nearly 20% of every equity's dollar invested. A reminder, as more capital flows to index funds, the valuation of the index components and the indices increase. There are several problems with this ownership and allocation scenario.

Much like professional financial advisors, index fund managers get paid not upon performance but based upon AUM (assets under management). Despite holding enough proxies (20% outstanding) to control most companies, these fund managers are obviously reticent to rock the boardroom vote or boat. The maintenance of the "status quo" translates into the level of long-term corporate business performance or "competition" as stagnant or compromised.

The "performance based" compensation and boardroom "status quo" problems are compounded by disproportionate capital allocation or "weighting." The larger the market cap of the company, the larger its weight in the index. As the stock price rises, the increased market cap weight forces index funds who already hold the component, large and small, to buy more of the company shares.

Ceteris paribus, value investors buy more as prices decline, while market cap weighted index funds do exactly the opposite, buy more of what they already hold, at prices rising higher and higher. Thus, the owners of 20% of corporate America, not only control the boardroom, but they are disproportionately misallocating capital as momentum rather than value investors. As stock prices and the indices rise, this forced buying herd behavior, amplifies the risk of overvaluation in heavily weighted index components, and the indices themselves.

Demonstrating that asset flows without regard to intrinsic valuation are just as big a threat, as deteriorating returns and underperformance are. Said threat is another problem, which presents in the form of a market "liquidity gap" caused by those price and valuation distortions vis. as Ackman wrote: "it depends on... the pricing environment for transactions."

The Market Liquidity Gap?

We can readily identify three recent major asset bubbles: 2000 dot.com tech equities; 2008 MBS housing market; the present central bank monetary policy QE, IOER, NIRP, ZIRP; in which price discovery distortions have affected investment decisions. In this tertiary bubble, rather than being isolated to a particular sector, due to monetary policies, all assets, valuations and prices have been inflated (distorted) and true price discovery has been made almost impossible.

Debt, in leveraged form and otherwise, is an economic derivative of price distortion. Corporations, households and sovereigns have been and are still taking on debt and leverage in record amounts. Learning from Pershing, when you buy, you inherit the underlying capital structure. Fund managers along with private and public investor equity and bond purchases assume the risk of the underlying capital structure.

In addition, from a group think or herd mentality, the effect of the investor's debt, leverage or balance sheet position must also be accounted for. Thus ETF, Index and Bond funds are effectively taking on that debt, leverage and balance sheet position, directly from the holding and indirectly from their investors' debt position. A subtle double whammy when it comes to how the collective reacts.

In both the cases, said exposure is not in relation to the buyer's cash position or any other liquid asset holding, but in relation strictly to inflated or distorted asset prices that they are paying to participate in the markets. Much like "results may vary" and "past performance is, of course, no guarantee of future results," remember given the "cover charge" or ephemeral "platform value" that "stocks can trade at any price in the short term." Again, it depends on... the pricing environment for transactions."

Resulting in another side effect of price distortion, from a balance sheet perspective, both the asset acquisition and credit making decision processes have been distorted. Price sensitive assets such as bonds, equities and housing are being treated the same as fundamentally sound, safe, liquid asset holdings and cash. A problem with this investment methodology, it only works as long as those asset prices continue to increase. Why? The purchase decision and price paid is based on the assumption that the valuation of the asset at the time of the loan will not decline.

Holding debt and leverage based upon solid balance sheet fundamentals like cash or liquid assets, as opposed to strictly for the sake of holding inflated price sensitive assets, from a weakened balance sheet perspective, are two situations a world apart. The latter situation describing a large number of market positions, hedged or otherwise, is subject to potentially large and rapid price reversals. Again, it depends on... the pricing environment for transactions."

The popping of the two prior bubbles left the greater fools or last holders of the bag of assets, in a situation where net liquidity (perceived or expected) did not equal actual liquidity, as in ensuing fire sales, haircuts and mass liquidation. The price sensitive assets are tinder; the debt levels involved, including margin and leverage, are gasoline. Said "liquidity gap" is quite readily apparent in today's asset markets and awaiting a spark to ignite.

Hypothetical: With index funds already holding seemingly overvalued equities, what happens when deteriorating returns and underperformance truly take effect? Those funds rates of returns will likely decline, leading to divestiture and capital outflows, further declining returns, further divestiture and capital outflows. The spark that ignites, the house of cards that burns, the trapped jumping out the windows, and so the fall goes. Again, it depends on... the pricing environment for transactions." TBD.

Above note, like a blindfolded chimp throwing darts at a board, when the market goes up and things are good, the Ackmans of the world crow. When the proverbial "it" hits the fan, the "experts" make excuses, or file BK, leave others holding the emptied bag, and wipe out their investors' money. Its OPM, who cares? Worry not, Elmer Gantry's travelling show will be on the road, under a new shingle, selling hope to the needy once again in no time.

Some suggested reading: We covered potential causes and consequences in The New Paradigm For ETF, Mutual Fund, Bond Fund and mREITs Part 1 and Part 2, and in Contractions in Money Flows and Market Liquidity Part 1, Part 2, Part 3, Part 4, Part 5, Part 6 and Part 7.

Would like to thank you folks fer kindly droppin in. You're all invited back again to this locality. To have a heapin helpin of Nattering hospitality. Naybob that is. Set a spell, take your shoes off. Y'all come back now, y'hear!

This is the 28th in a series of thematically related missives, which will attempt to identify the macroeconomic forces with potential to adversely affect capital, commodity, equity, bond and asset markets.

I wish to dedicate this missive to one of my mentors, Salmo Trutta, who is a prolific commenter on SA. Without Salmo's tutelage, and insistence in not masticating and spoonfeeding the baby ducks, as in learning the hard way by doing the legwork and earning it, this missive would not have been possible. To you "Proximo"... "win the crowd and win your freedom" - Spaniard

Disclaimer

Investing is an inherently risky activity, and investors must always be prepared to potentially lose some or all of an investment's value. Past performance is, of course, no guarantee of future results.

Before investing, investors should consider carefully the investment objectives, risks, charges and expenses of an investment vehicle. This and other important information is contained in the prospectus and summary prospectus, which can be obtained from the principal or a financial advisor. Prospective investors should read the prospectus carefully before investing.

Market Plays

As for how all of the above ties into the potential and partial list of market plays below... the market as a whole could be influenced, and this could tie into any list of investments or assets. Those listed below happen to influence the indices more than most.

There are many macroeconomic cross sector and market asset correlations involved that affect your investments. Economic conditions, the eurodollar, global dollar debt and monetary policy all influence the valuation of the above and market plays below, via King Dollar's value, credit spreads, swap spread pricing, market making, liquidity, monetary supply and velocity, just to name a few. For a complete missive series listing covering those subject and more, click here.

The potential global economic developments discussed in this missive could affect numerous capital and asset markets, sectors, indexes, commodities, forex, bonds, mutual funds, ETFs and stocks.

A List of 17 Potential Market Plays (Long or Short?): Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG), Facebook (NASDAQ:FB), Microsoft (NASDAQ:MSFT), Citigroup (NYSE:C), General Electric (NYSE:GE), Cisco (NASDAQ:CSCO), Bank of America (NYSE:BAC), Amazon (NASDAQ:AMZN), Tesla (NASDAQ:TSLA), S&P 500 Trust ETF (NYSEARCA:SPY), Ford (NYSE:F), Starbucks (NASDAQ:SBUX), Intel (NASDAQ:INTC), AT&T (NYSE:T), IBM (NYSE:IBM), Exxon Mobil (NYSE:XOM).

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.