Valeant, Short Selling, and the Too-Hard Pile

Valeant, Short Selling, and the Too-Hard Pile
Chart via S&P Capital IQ

Valeant — In general, I find reading short reports to be a very valuable exercise. I don’t do much shorting in my partnership, but I find that for the most part, short sellers provide a useful service to the capital markets and I think that the good short sellers (who are few and far between) often do more thorough investigative analysis than the vast majority of long-only investors.

For a good book on shorting, I recommend reading Scott Fearon’s book called Dead Companies Walking. Even if you don’t short, I think it’s useful to read and listen to short sellers—if you can identify the good ones.

I don’t like shorting because I think it’s a difficult task. The best short sellers often are 100% correct in their analysis, but if they are “early” (meaning the stock keeps climbing for months or even years before their thesis comes to fruition), they can lose all (or more) of their money that they allocated to that short trade. So it’s generally an uphill battle when you are betting against stocks.

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But special situation shorting can be very productive, and with mass media outlets and platforms such as Seeking Alpha where a short seller can now publish his own research, a good short seller can create his own catalyst. That’s what Andrew Left at Citron does, along with numerous other short sellers. There are a lot of people that cry foul or talk about manipulation when it comes to published short write-ups, but the good news is that the market generally is a pretty good judge of what is good work and what isn’t. Shorts can often successfully knock a stock down 10% or more simply because of fear generated from an article (some investors will always “sell first, ask questions later”), but if the short thesis isn’t based on sound fundamental analysis, the market will quickly correct itself.

Where short sellers really do good work is when they put the effort in and summarize their research on companies that turn out to be engaging in destructive business practices, fraudulent accounting, or operating a business model that isn’t sustainable. Often the market doesn’t understand these situations immediately, but the market always will get these situations right in the end. Short sellers simply expedite the timeframe. They speed up the time it takes for the market to discover these frauds on its own. But short sellers—the good ones—don’t create frauds. They simply discover them and tell the market about them.

So although short sellers often get a bad rap, the good ones provide a valuable service. The bad ones are the ones that deserve bad raps—the ones that simply try to drive stock prices lower by spreading rumors or fear mongering. But in my experience, these types of short sellers a) don’t ever make any money over time, and b) although they might successfully manipulate a stock price lower temporarily, the market will always quickly correct itself. Innocent companies might see their stock prices fluctuate, but won’t permanently be damaged by short sellers if they truly aren’t doing anything wrong. I know there might be occasional exceptions to this, but by and large I believe this is true.

One of the things Ted Weschler once mentioned—he said when looking at health care companies, one of the checklist items he asked himself is whether or not the company adds value to or takes value from the health care system. If the company doesn’t add value to the health care system, then it probably will eventually run into problems.

The Valeant Saga

Last month, Valeant Pharmaceuticals (VRX) was all over the front pages. Short sellers questioned many aspects of the business such as its accounting (which has been in question for years now), its controversial practice of significantly hiking prices of newly acquired drugs, its relationship with a specialty pharmacy and the volume of drugs that Valeant sold through that channel—not to mention broader questions regarding the sustainability of its business model (there are legitimate questions regarding the company’s ability to grow “organically” through volume increases as opposed to price increases and acquisitions).

In other words, one general argument is that if Valeant has a legitimate growth model it should be able to increase revenues and cash flows by selling more drugs over time, not by using more and more debt to buy drugs and then jacking up their prices.

Valeant is used to being attacked by short sellers who for years have questioned its accounting. Andrew Left is probably the most well-known short seller in this case, although his work to me is much more sensational than it is useful (I’m not saying Left is wrong—often times he does good investigative work and is correct, but to call Valeant the next Enron is probably a bit sensational).

However, one blog that in my opinion has done the best work on Valeant is AZ Value Investing Blog. His write-ups are much longer and use far less BOLD FACED CAPS, exclamation points and multi-colored fonts than Left uses, but I think his work is very substantive and worth reading. In fact, pharma is a business that I’ve never really considered for investment, but I learned a lot just reading his analysis of Valeant.

Valeant Sits in My Too-Hard Pile

Let me say that (luckily), I’ve kept Valeant in the too hard pile. I don’t know the pharma industry well, and although I’ve learned a lot reading about it recently, I just couldn’t quite understand the relationship between Valeant and its distribution channel, and how that relationship (or lack thereof) will impact revenue going forward. There are some questions I have a hard time answering.

I understand Valeant’s general model: Buy drugs that have inelastic demand and raise prices. Don’t use a “shotgun” approach to R&D. Instead, focus R&D dollars on drugs that have a much better chance of approvals and future sales, and thus higher returns on capital. So buy drugs that are undervalued, raise prices, slash spending on R&D, and try to grow organically through more focused spending on drugs with a higher probability of success.

But how is it that Valeant is able to raise prices so significantly for these drugs without any pushback from the parties who are paying these prices? Are the insurance companies really just too bureaucratic to notice? Or are these drugs really worth the prices Valeant is charging in a fair and transparent market? If the latter is the case, then I think Valeant has a legitimate model. If the former is the case, then Valeant’s model might be profitable in the near term, but is doomed at some point. This is because insurance companies—for all of their faults—aren’t stupid. They understand that a toenail fungus cream that costs 50x the price of a generic that is just as effective is not worth paying for. Eventually, the insurance companies (or other large payers) will have the largest say in the matter and the cheaper drug will get dispensed. Most health care providers will prescribe the cheaper drug if they understand the price disparity, and most pharmacies are incentivized to dispense the generic brand as well (they generally have much lower margins on the branded drugs and will fill generics unless the script is marked “dispense as written”).

So although there is a lot of bureaucracy among government payers and insurance companies, eventually they will correct these problems by not paying for overpriced drugs that aren’t adding any value. Companies like Valeant might be able to take advantage of this bureaucracy in the short-term, but it’s not a way to produce lasting value for shareholders.

If you’re not adding value to customers, you’re probably eventually going to destroy value for shareholders.

That’s a principal that I try to keep in mind when evaluating investment opportunities, and I’ve learned this through the school of hard knocks. But I find that it is almost always a rule that should not be disobeyed.

Similarly, if a health care company is taking value from (rather than adding value to) the overall health care system, it likely is not going to reward shareholders in the long term either. There might be exceptions to this “rule” as well, but I generally wouldn’t want to bet against this concept.

Whether Valeant is breaking this rule, I don’t know for sure. But the fact that I can’t answer it will keep me on the sidelines. Michael Lewis is probably working on a book right now about Valeant and he will feature the next Michael Burry who either “knew” Valeant was a fraud and shorted it to $0, or “knew” Valeant was the buy of a lifetime and loaded up as he tripled his money. The story of the Valeant saga has already has seen a very interesting plot unfold and it has included some big name characters such as hedge fund titans, government regulators, and even presidential candidates. I will read the book with great interest, but unfortunately will not be a subject in it.

Regardless, it will be fun to watch unfold.

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