Bill Ackman (Trades, Portfolio)'s decision to sell his long-standing stake in Valeant Pharmaceuticals (NYSE:VRX) has attracted plenty of attention over the past week. His decision to throw in the towel may have come as a surprise to many considering his previous comments, and it is fair to say he has attracted lots of criticism both while in the position and after exiting.
It is hard not to feel at least a bit sorry for this former rock star hedge fund manager as he faced the same problem most investors will have to face at least once in their career: when to sell a loser.
If you are lucky, you will only have to make this decision a few times, but it is more than likely the problem will come up time and again if you are a regular investor.
A rocky ride
Ackman’s plight is easy to understand. He became involved with a company that was achieving record results, only to find the results were due to its shady business practices. Granted, a hedge fund manager like Ackman should have known better and done his due diligence properly, but all too often other investors make the same mistake.
The big question is, did Ackman extend his mistake by holding onto Valent for so long? There are two points to make here. First of all, Ackman believed the company could be turned around due to its drug portfolio and management's optimism. Management plays a vital role here because it is likely they convinced Ackman the business was getting back on track (or never came off the rails), which is a lesson to investors that management should not always be trusted.
Secondly, if you look at the Valent stake from a value investor's point of view, the declines in the stock alone would not have been enough to sell. The declines were prompted by the Philidor scandal. When it first emerged, the true scale of this scandal was not known and it can be argued Ackman made the right decision by not jumping out as soon as the details emerged.
Prior to the Valent debacle, Ackman had achieved years of impressive returns for his investors; he did not chalk up these returns by jumping out of positions at the first sign of trouble.
A long-term bet?
Ackman can be commended for staying with Valent for as long as he did despite all the flack the company was taking. And he can be commended for trying to turn the business around to produce better returns for his investors. Nonetheless, cutting the loss was the right thing to do. But should he have done it earlier?
There are three key reasons to sell a stock, all of which seem to have been breached by Valeant over the past two years.
First of all, you should consider selling a stock holding if the company in question's management has openly lied to or misled investors. Valent’s management broke both of these issues and should, therefore, have been sold much earlier on in the crisis.
Second, a company becomes a "sell" if its balance sheet deteriorates significantly. As Valent’s balance sheet was always weak due to the high levels of borrowing it took on, it can be argued the business was never attractive for this reason. What’s more, when the Philidor scandal broke, it quickly became clear the company's weak balance sheet was being propped up by shady business practices -- another reason to sell.
The third reason to sell is if the company’s business model has changed. From a top-down perspective, it can be argued Valeant's business model has not changed. The company still relies on selling high-margin, overpriced drugs to customers who are forced into it. So, nothing has changed there. The company has stopped (or so it says) artificially inflating sales. If you count this as part of the initial thesis, then yes, it has changed.
The final reason to sell is when there are better opportunities out there, which is certainly true for Valeant and has been for a long time.
All in all, with all the indicators for selling flashing red, Ackman should have sold Valeant a long time ago.
Disclosure: The author owns no stock mentioned.
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