The Valeant Saga: Your Inner Unfrozen Caveman Lawyer by Ben Strubel, Strubel Investment Management

The Unfrozen Caveman Lawyer was a character from an SNL skit. Phil Hartman played a caveman who fell into a crevasse and was frozen then later thawed out by scientists. He went on to law school and became the Unfrozen Caveman Lawyer. He was a suave, smooth lawyer who played up his caveman background with the catchphrase “your world frightens and confuses me…” for comedic effect.

When investing, you should always listen to your inner Unfrozen Caveman Lawyer. Your inner caveman is key to avoiding stock market disasters such as the saga surrounding Valeant Pharmaceuticals (VRX). When a company’s business model confuses (and maybe even frightens) you it is a good idea to just stay away. There are thousands of stocks out there so there is no need to invest in something scary that you don’t understand.

Valeant presented investors a very simple business model. It bought other pharmaceutical companies, stripped them of their R&D and other assets, laid off staff, hiked the prices on their drugs and collected nice, big fat profits. At its peak Valeant Pharmaceutical was valued at over $100B. There were major, big name investors who held large positions in the company. It was hedge fund manager Bill Ackman’s largest position. Famed mutual fund the Sequoia Fund made it almost 30% of their portfolio. Hedge fund gurus John Paulson and ValueAct’s Jeff Ubben also had large stakes in the company. Over the last few weeks the price of the stock has dropped by more than half. But, stakes by large investors mean nothing (unless it’s activist investors seeking to change management). No one is infallible.

There are a lot of questions about Valeant. (For which I most certainly do not have all the answers.) For its latest completed fiscal year the company had $8.2B in net sales. How much do you think the company spent on R&D? Now remember this is a company that sells high priced drugs. Valeant spent $246M or just 3% of sales on R&D. I cannot stress this enough, this is a pharmaceutical company spending only 3% of its money on R&D! By comparison, Novartis, a pharmaceutical company we own, had $52.4B in net sales from continuing operations in the past fiscal year. They spent $7.3B or almost 14% of the revenue they brought in on R&D.

Already the little Unfrozen Caveman Lawyer in your head should be telling you that Valeant’s business model confuses him. How can a pharmaceutical company sell a bunch of generic and specialty drugs at such high prices but invest so little in R&D? What economic moat do they have that always them to earn such high returns on such low value assets? Just what the heck is Valeant’s business model? I’m confused.

Now let’s get to the next part. Many short sellers and reporters have been warning investors about funny things going on at Valeant for years. The always excellent John Hempton at Bronte Capital posted a series of articles starting last year about Valeant strange sales model, it’s strange accounting, and more. There were rumbling in more mainstream media outlets as well such as the Financial Times as well.

Furthermore, when Valeant tried to acquire fellow pharmaceutical company Allergan in May of 2014 bankers in at Morgan Stanley in a leaked email asserted that Valeant was a “house of cards”. Allergan even released a presentation urging investors to vote against the offer (Allergan was ultimately acquired by another company). Allergan went to great lengths to criticize Valeant’s business model and point out many irregularities. Such strong language from management opposing a takeover offer is extremely rare. Allergan’s management was basically calling Valeant a “house of cards” as well.

At this point your inner Unfrozen Caveman Lawyer should now be both confused and frightened. Keep in mind I have no idea what is really going on at Valeant. I’m not interested in investing in the company and beyond reading news articles, blog posts, and some of the company’s filings I haven’t done a thorough investigation on it. All I know is it is a very strange business. It’s a (supposedly) super profitable pharmaceutical company that invests next to nothing in R&D, has some strange accounting, and now it seems has issues with its sales through its specialty pharmacy channel.

Valeant Pharmaceutical, your world both frightens and confuses me so I’ve chosen not to invest.

There is no rule in investing that says you have to know everything about every company. Sometimes, perhaps many times, it’s better to just listen to your inner caveman and admit you have no clue what is going on and move on to another idea.

We try to invest in simple, easy to understand businesses and diversify our portfolios to prevent a Valeant Pharmaceutical type event from happening to our client’s investments. We follow comedian Lewis Black’s advice: “You don’t want another Enron? Here’s your law: If a company, can’t explain, in one sentence, what it does… it’s illegal.”

Valeant


 

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