Lessons from Valeant by Investment Master Class
Pershing Square’s 2016 Annual report was released recently. While Bill Ackman’s long term track record is impressive, he lost a substantial amount of money in Valeant. He wasn’t alone as other high profile investors like ValueAct and Sequoia also took significant losses. Like all good investors, Mr.Ackman acknowledged his mistakes and highlighted the lessons he learnt.
The Investment Masters recognise the importance of analyzing past mistakes, so as not to repeat them. In most cases we can learn more from our mistakes than our successes. We can also learn from the mistakes of other.
“When we make mistakes, we always try to do post-mortems.” Lou Simpson
“The big difference between those who are successful and those who are not is that successful people learn from their mistakes and the mistakes of others” Sir John Templeton
Mr.Ackman recently exited the Valeant position. While he acknowledged he may have sold at a price that may look cheap with the benefit of hindsight he explained his rationale for the sale. Valeant had plunged more than 90% from it's peak. It was a permanent loss of investor's capital.
At the time of sale, Valeant was just 3% of the portfolio's assets. Even if the stock price increased substantially, Ackman felt the impact on the overall portfolio would have been modest and wouldn't compensate for the human resources and substantial mind-share the investment would have consumed.
Ackman stated "Clearly, our investment in Valeant was a huge mistake. The highly acquisitive nature of Valeant's business required flawless capital allocation and operational execution, and therefore, a larger than normal degree of reliance on management. In retrospect, we misjudged the prior management team and this contributed to our loss."
Ackman noted the many lessons from the investment and raised a few important reminders:
- Management’s historic ability to deploy capital in acquisitions and earn high rates of return is not a sufficiently durable asset that one can assign material value to when assessing the intrinsic value of a business
- Intrinsic value can be dramatically affected by changes in regulations, politics, or other extrinsic factors we cannot control and the existence of these factors is a highly important consideration in position sizing
- A management team with a superb long-term investment record is still capable of making significant mistakes
- A large stock price decline can destroy substantial amounts of intrinsic value due to its effects on morale, retention and recruitment, and the perception and reputation of a company
I remember reading Ackman's 110-page presentation titled "The Outsider" where Ackman detailed his thesis on Valeant and why it was such a compelling opportunity. Ackman saw similarities between Valeant and the highly successful companies profiled in William Thorndike's book 'The Outsider CEO's'. It was a pretty compelling sales pitch.
So with the benefit of hindsight, I've outlined some red flags that may help avoid the next Valeant disaster?
Valeant - Highly Acquisitive Company
Valeant was a highly acquisitive company, effectively a 'roll-up'. Such companies always carry more risks. Ackman has acknowledged past performance in acquisitions is not a durable asset. In the "Outsiders" presentation Ackman noted "Management has completed 100+ acquisitions and licenses, investing $19b+ since 2008" .. "Acquisitions have been highly accretive" .. "Valeant management expects the majority of the company's future free cash flow will be allocated to its value-creating acquisition strategy"
"There may be quite a high degree of investment risk in a company that as a matter of basic investment policy is constantly and aggressively trying to grow by acquisition.. It is my own belief that this investment risk is significantly still further increased when one of two conditions exist in a company's organisational make-up. One is when the top executive officer regularly spends a sizeable amount of his time on mergers and acquisitions. The other is when a company assigns one of its top officer group to making such matters one of his principal duties. In either event powerful figures within a company usually soon acquire a sort of psychological vested interest in completing enough mergers or acquisitions to justify the time they are spending." Phil Fisher 1960
Valeant had a track record of providing aggressive guidance. Guidance in 2012 was 40-45% EPS growth, 2013 was c35%, 2014 was c40% and 2015 was c21-25%.
“Be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no surprise environment, and earnings simply don't advance smoothly (except, of course, in the offering books of investment bankers). Charlie and I not only don't know today what our businesses will earn next year we don't even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future and we become downright incredulous if they consistently reach their declared targets, Managers that always promise to "make the numbers will at some point be tempted to make up the numbers” Warren Buffett
“Having a person running a company to please Wall Street can really be problematic” Jim Chanos
“Rejecting guidance is rare among public companies, though it’s a practice we applaud. We worry that providing quarterly guidance may tempt companies to publish aggressive growth targets to appease Wall Street. Our concern is not that the aggressive forecasts won’t be met, but rather that they will, at any cost! Earnings growth should be a consequence of sound strategy, not the object of it." Allan Mecham
Valeant business model in part comprised buying pharmaceutical companies, stripping R&D costs out and aggressively raising prices on older drugs. Valeant certainly wasn't a win-win proposition for consumers.
"There was a lot wrong with Valeant. It was so aggressive and it was drugs people needed… I don’t think capitalism requires you to make all the money you can. I think there times when you should be satisfied with less. Valeant looked at it like a game of chess, they didn’t think of any human consequences. They just stepped way over the line and in the end of course they were cheating” Charlie Munger
"We want our operations and the businesses we invest in to pass the “Win-Win Test” with all six counterparties: customers, employees, suppliers, stewards, shareholders, and the community. Win-Win is the only system that is sustainable over the long-term – any fatal flaw with any counterparty will inevitably self-correct. We believe by striving to eliminate Win-Lose, Lose-Win, and Lose-Lose situations we can go far in removing many of the blind spots that those unsustainable relationships nurture." Christopher Begg
Valeant's acquisition spree was funded via a massive increase in corporate debt. Fortune magazine note "Its debt-to-equity ratio, a measure of a company's financial leverage, is nearly eight times that of other big pharma companies like Pfizer, Novartis and Merck".
"I turn down many otherwise down attractive investments because of their weak balance sheets, and I believe that this discipline is a material reason for our success over the years. " Ed Wachenheim
"Staying away from excessive leverage cures a lot of ills" Thomas Gayner
Ackman reflected that given the risks facing Valeant that were outside of his control, the position size was too large. Ackman had previously acknowledged in Pershing Square's 2015 Interim Report that Valeant was at odds with the usual principles he applied to investments. In part this was because Valeant required continued access to capital markets to achieve accelerated growth. With lower conviction and higher risks it's important to structure position sizes accordingly.
"Our lack of strong convictions about these businesses [Salomon, USAir Group, Champion International], however, means that we must structure our investments in them differently from what we do when we invest in a business appearing to have splendid economic characteristics" Warren Buffett 1989
“Make your position size more a function of not how much you can make, but really how much you can lose. So manage your position based on your downward loss perspective not your upward potential.” James Dinan
With the benefit of hindsight, it's easy to suggest Ackman should have cut his position earlier. Ackman's close proximity to the company may have blinded him to the problems that were starting to surface within the company. The "Outsiders" presentation noted Pershing Square had executed a confidentiality agreement with Valeant in 2014 which allowed them to conduct "substantial due diligence" including in-person meetings with the board, extensive management interviews, review of R&D pipeline, selective local due diligence at the country level and review of bear thesis. Ackman was all-in.
"One of the most difficult intellectual confessions is to admit you are wrong. Behaviourally we know we are subject to confirmation bias. Eagerly we wrap our minds around anything and everything than concurs with our statement. Too often, we misjudge stubbornness for conviction. We are willing to risk the appearance of being wrong long before a willingness to personally confess our own errors" Robert Hagstrom
Falling In Love
When investors have made a large commitment to a position and gone on the public record as to why it's such a great investment it can be psychologically challenging to change tack. It's paramount to stay open minded and not fall in love with a position or management. As Ackman acknowledged, even a management team with a superb track record can make a mistake.
“If we only confirm our beliefs, we will never discover if we’re wrong. Be self-critical and unlearn your best-loved ideas. Search for evidence that dis-confirms ideas and assumptions. Consider alternative outcomes, viewpoints and answers.” Peter Bevelin
"One thing my father taught me at a young age was not to fall in love with companies or the people running them" Lloyd Khaner
Valeant had collapsed dramatically before Ackman finally sold. Sometimes when investing, the best option can be to sell. Running concentrated positions in a multi-billion dollar portfolio reduces flexibility. In the end, Ackman acknowledged the position was taking an emotional toll on the firm and it was in the best interest to move on. The small position size after the stocks collapse meant it's contribution to future returns was going to be marginal. Profits and losses are not symmetrical. If you lose 80% of your money you need to earn 400% to get back to break even. Better to cut your losses and focus your energies elsewhere.
"Large permanent losses can dampen the confidence of an investor - and I sternly believe that a good investor needs to be highly confident about his ability to make decisions, because investment decisions seldom are clear and usually are muddled with uncertainties and unknowns" Ed Wachenheim
"Even the most conservative investors can be paralysed by large losses, whether due to mistakes, premature judgements, or the effects of leverage. If losses impair your future decision making, then the cost of a mistake is not just the loss from that investment alone, but the impact that loss may have on the future chain of events. If a loss freezes you from taking full advantage of a great opportunity, or pressures you to make it a smaller position than it should or would otherwise be, then the cost may be far greater than the initial loss itself" Seth Klarman
All investors make mistakes, even the great ones. The key is to address them early and take action. Then learn from the mistake.
“In every great stock market disaster or fraud, there is always one or two great investors invested in the thing all the way down. Enron, dot-com, banks, always ‘smart guys’ involved all the way down.” Jim Chanos
“Quickly identify mistakes and take action.” Charlie Munger
"If you feel you have made a mistake, get out fast" Roy Neuberger
“Whatever the outcome, we will heed a prime rule of investing; you don’t have to make it back the way you lost it” Warren Buffett
Ultimately an investor is only as good as his or her next investment. Being on the lookout for red flags can help an investor from taking undue risks and impairing capital. It's important to remain open minded and continually test a thesis to ensure the outlook hasn't changed. Remember the first rule of investing is don't lose money. And rule number 2 …. don't forget rule number one.