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Grahamites
Grahamites
Articles (214) 

Valeant: It's Not a Game of Chess - The Lessons

Six lessons from the Valeant case study

April 16, 2017 | About:

In my previous four articles on Valeant (Part I, II, III and IV), I went through my findings regarding Valeant’s (NYSE:VRX) business model and what went wrong. We all know that Valeant’s shares have plummeted more than 90% since the peak they reached in the first half of 2015. There’s some ongoing debate as to whether there’s any value in Valeant’s stock at today’s price. I’m not going to attempt to value Valeant because I’m not even interested at this point. On the other hand, there are quite a few lessons we can learn from the debacle of Valeant and why so many high-grade people it took in.

Lesson 1 – never forget about the human side of investing

We are all humans. As investors, we are not buying and selling stock certificates. Whenever we make an investment decision, we are investing in the business and businesses are made of humans. No matter how great the financial side looks, we should always remember Google’s motto: “Don’t be evil.” Valeant is almost the exact opposite of that.

Wallace Weitz (Trades, Portfolio) said he decided to sell Valeant after he found out Pearson was pushing his people during his dinner with then-CEO Mike Pearson. You may ask how can you judge the character of management team if you are not Weitz. One of my favorite research tools is Glassdoor. There are many reviews about Valeant on the website and it doesn’t take long to notice all the red flags.

There are also quite a few articles on Valeant and Pearson. Most of them are free. If you read them, you will see how bad Valeant (NYSE:VRX) is.

Lesson 2 - always be aware of the roll-ups

There are companies that are great at making great acquisitions and there are companies that are just roll-ups. Danaher (NYSE:DHR) and Berkshire Hathaway (NYSE:BRK.B) belong to the former group and Valeant and Enron certainly belong to the latter group. Most of the time you can tell just by counting the number of acquisitions a company has made during say a three-four year period. In Valeant’s case, it acquired more than 75 companies just within a few years. Berkshire Hathaway, in Charlie Munger (Trades, Portfolio)’s words, may “make two decisions a year.” The financial statements for a roll-up are also much messier. I don’t think most investors can understand the accounting for roll-ups.

Back in May 2014, short-seller Jim Chanos went on CNBC and said:

"We're short Valeant because it's a roll-up. And roll-ups present a unique set of problems. Roll-ups are generally accounting-driven, and we certainly think that's the case in Valeant. We think Valeant is playing some very aggressive accounting games when they buy companies, write down the assets and also engaged in what we call spring-loading.”

Lesson 3 – use a simple checklist or a simple list of filters in an industry before you make any decisions

For every industry that we can understand, we should have some general filters to help us make some quick decisions. Berkshire Hathaway portfolio manager Ted Weschler mentioned the three filters he uses when investing in health care company stocks. 1) Does the health care company deliver better quality of care than somebody could get anywhere else? 2) Does it deliver a net savings to the health care system? 3) Do you get a high return on capital, predictable growth and a shareholder-friendly management? If you follow Weschler’s advice, you’ll immediately rule out Valeant.

Lesson 4 - always ask yourself whether you can understand the drivers of the business and the sustainability of the drivers

It’s extremely important for you to dissect the drivers of the fundamental growth and evaluate the sustainability of the underlying drivers. In Valeant’s case, as I laid out in Part III of the article, Valeant’s business model is predictated upon three key drivers:

  • Use of innovative and complicated offshore tax structure to reduce cash taxes to the largest extent possible.
  • Avoidance of high value R&D. To quote Mr. Pearson: "Valeant doesn’t invest in science. We invest in management."
  • Leverage up using cheap debt to acquire other specialty pharmaceutical companies and raise the prices of the drugs Valeant acquired immediately.

You may not be able to tell the sustainability of the tax structure and the R&D strategy, but any rational investors will immediately tell driver three is absolutely unsustainable.

Lesson 5 – stick with your circle of competency

For most investors, I think Valeant’s straight out of their circle of competency. It’s in the pharmaceutical business which requires some special knowledge about drug development and commercialization. The accounting is obscure to say the least. The distribution channel is opaque. There are a lot about Valeant that’s very difficult to understand. But if you falsely think you can understand Valeant from a platform company point of view, like one big-name investor has suggested, you will fall into a trap.

Lesson 6 – incentive, incentive, incentive

You always have to think about what incentives are at play and how they may drive behaviors. In Valeant’s case, there are some obvious incentives that don’t bode well. For instance, as Weitz shrewdly pointed out, Valeant’s middle managers have huge incentives to cheat because if they don’t, they know they will be fired. This is not much different from Wells Fargo (NYSE:WFC)'s recently disclosed sales scandal. It’s the damn incentive system.

I can list a few other lessons from the Valeant case study, but I think the above six lessons are the most important ones. In the end, I think it might be appropriate to end this article series with the quotes that I used in the beginning:

“I think there are times when you should be satisfied with less based on just the ideas of decency, and at Valeant they just looked at it as a game like chess. They didn’t think about any human consequence, they didn’t think about anything but getting what they wanted which was money and glory, and they just stepped way over the line and of course in the end they were cheating.”

“Interesting thing is how many high-grade people it took in.”

- Charlie Munger (Trades, Portfolio) at the 2017 DJCO Meeting


Rating: 5.0/5 (2 votes)

Voters:

Comments

Thomas Macpherson
Thomas Macpherson premium member - 2 months ago

Great stuff Grahamites. One issue I might add is that most successful healthcare companies add to the human experience of patients and physicians. Whether you are an EMR provider like CPSI, a traditional pharmaceutical company like BMS, or run hospitals like UNH, a company should provide something that brings greater health to the patient community. (I think this rings true for almost any industry though. Long term capital growth usually takes place in a company that adds to its industry vertical rather than subtracting value). Valeant made no attempt to add to the patient experience (other than costs). Through financial engineering, the company used corporate greed as its economic north star. Eventually, this subtraction of value usually catches up with companies over the long term. Wonderful article Grahamites. Best. - Tom

DISCLOSURE: The Nintai Charitable Trust that I used to manage owns CPSI in its portfolio.

Grahamites
Grahamites premium member - 2 months ago

Tom - Wonderful insight, what a great point! Now that I think about it, indeed the most successful players in healthcare are the ones who actually add to the human experience of patients and care providers. Most of the busted ones are in for the money game and financial engineering (Endo is another one that comes to mind).

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