Valeant Pharmaceuticals (VRX) – you can do DCF!

Uncertainty, both imminent and resolved, has been on my mind these last two weeks. I posted my valuation of Valeant Pharmaceuticals on April 20, making the argument that, at least based on my expectations on what could be revealed in the delayed financial filings, the stock was worth about $44, approximately $12 more than the prevailing stock price. Many of you were kind enough to comment on my valuation, and one of the more common refrains was there were too many unknowns on the stock to be taking a stand. In fact, one of the comments on the post was that “regardless of the valuation, a sufficient margin of safety does not exist (on the stock)”. On April 21, we got news that Volkswagen had come to an agreement with US authorities on the compensation that they would offer buyers of their cars and a day later, the company announced that it would take an $18.2 billion charge to cover the costs of its emissions misrepresentations. It was a chance for me to revisit my valuation of Volkswagen, in the immediate aftermath of the scandal in October 2015, and take stock of how the the investment I made in the stock then looks, as the uncertainty gets slowly resolved. All through these last two weeks, there were signs that Yahoo’s journey, that was starting to resemble the Bataan Death March lately, was nearing its end, as the company reviewed bids for its operating assets. Since it is a stock that I valuedalmost two years ago (and brought after the valuation) and labeled as a Walking Dead company, I am interested, both financially and intellectually, to see how this end game plays out. As I wrestle with the resolution of uncertainties from the past and struggle with uncertainties in the future on every one of my investments, I thought it would be a good time to look at good and bad ways of responding to I uncertainty in investing and valuation.
The Uncertainty Principle
Uncertainty has always been part of human existence, though it has transitioned from the physical uncertainty that characterized the caveman era to the economic uncertainty that is more typical of today, at least in developed markets. Each generation, though, seems to think that it lives in the age of the greatest uncertainty. That may be partially a reflection of a broader sense of “specialness” that afflicts each generation, where it is convinced that its music and movies were the very best and that it had to get through the biggest challenges to succeed. The other is a variation of hindsight bias, where we can look at the past and convince ourselves that what actually happened should have been obvious before it occurred. I am surprised at how many traders, investors and portfolio managers, who lived through the 2008 crisis, have convinced themselves that November 2008 was not that bad and that there was never a chance of a catastrophic ending.  That said, uncertainty not only ebbs and flows over time but also changes form, making enduring fixes and lessons tough to find. As investors bemoan the rise of uncertainty in today’s markets, there are three reasons why they may feel more under siege now than in prior decades:
  1. Low Interest Rates: In my post on negative interest rates, I pointed to the fact that as interest rates in many of the leading currencies have dropped to historic lows, risk premiums have increased in both stock and bond markets. The expected return on the S&P 500 in early 2008, before the crisis, was 8% and it remains at about that level today, even though the treasury bond rate has dropped from 4% to less than 2%, but the equity risk premium has risen to compensate. Even though the expected return may be the same, the fact that more of it can be attributed to a risk premium will increase the market reaction to news, in both directions, adding to price volatility.
  2. Globalization: Globalization has not only changed how companies and investors make choices but has also had two consequences for risk. The first is that there seem to be no localized problems any more, with anyone’s problem becoming everyone’s problem. Thus, political instability in Brazil and too much local government borrowing to build infrastructure in China play out on a global stage, affecting stock prices in the rest of the world. The second is that the center of global economic power is shifting from the US and Europe to Asia, and as it does, Americans and Europeans are starting to bear more of world’s economic risk than they used to.
  3. Media/Online Megaphones: As an early adopted of technology, I am far from being a Luddite but I do think that the speed with which information is transmitted around the world has allowed market risks to go viral. It is not just the talking heads on CNBC, Bloomberg and other financial news channels that are the transmitters of these news but also social media, as Twitter and Facebook become the place where investors go to get breaking investing news.

I am sure that you can add other items to this list, such as the disruption being wrought by technology on established businesses, but I am not sure that these are either uncommon or unusual. Every decade has its own disruptive factors, wreaking havoc on existing business models and company values.

The Natural Responses to Uncertainty
Much of financial theory and a great deal of financial practice was developed in the United States in the second half of the last century and therein lies a problem. The United States was the giant of the global economy for much of this period, with an economy on an upward path. The stability that characterized the US economy during this period was unusual, if you look at long term history of economies and markets, and much as we would like to believe that this is because central bankers and policy makers learned their lessons from the great depression, there is the very real possibility that it was just an uncommonly predictable period. That would also mean that the bedrock of financial practice, built on extrapolating from past data and assuming mean reversion in all things financial, may be shaky, and that we have to reevaluate them for the economies that we operate in today. It is unfair to blame the way we deal with uncertainty entirely on the fact that our practices were honed in the United States. After all, it is well chronicled in both psychological annals and behavior studies that we, as human beings, deal with uncertainty in unhealthy ways, with the following being the most common responses:
  1. Paralysis and Inaction: The most common reaction to uncertainty, in my experience, is inaction. “There is too much uncertainty right now to act” becomes the refrain, with the promise that action will come when more of the facts are know. The consequences are predictable. I have friends who have almost entirely been invested in money market funds for decades now, waiting for that moment of clarity and certainty that never seems to come. I
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