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Rupert Hargreaves
Rupert Hargreaves
Articles (559)  | Author's Website |

What Does Francis Chou See in Valeant?

The value investor has built a huge position in the pharma giant

First-quarter 13F filings have been coming out over the past few weeks and, as always, they contain some very interesting insights into what famous investors are currently doing with their portfolios.

The portfolio movements of Francis Chou (Trades, Portfolio), a highly respected value investor, caught my attention this quarter. Chou added significantly to a stake in struggling pharmaceutical company Valeant (VRX) during the quarter, making it his third-largest position at 11.3% of his overall portfolio. This holding, worth a total of $26.3 million, is second only in size to a holding of Berkshire Hathaway (NYSE:BRK.A) and Resolute Forest Products (NYSE:RFP). Together, these two holdings account for over a third of Chou's portfolio.

Jumping back in

Chou has always been a fan of Valeant, holding on through the darkest of times when other investors were jumping ship. What is fascinating about his recent disclosure is the fact Chou Associates reduced its holding in the pharmaceutical business by 95% in the fourth quarter of 2017. So it appears as if, during the three months to the end of March, the value investor completely changed his view on the business and decided it was heading in the right direction as it is restructuring.

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Chou isn't the only well-known investor trying to profit from the Valeant recovery. Bill Miller of Miller Value Partners owns just under seven million shares, Jeff Ubben (TradesPortfolio)'s ValueAct Capital owns a legacy stake of 18 million shares, and Lee Ainslie (Trades, Portfolio)'s Maverick Capital owns just under 500,000. These investors have held on while the rest of the market has bailed out. In the second quarter of 2016, well-known investors like Sequoia, Glenn Greenberg (Trades, Portfolio)'s  Brave Warrior and David Tepper (Trades, Portfolio) all bailed out.

Over the next 12 months, Lou Simpson (Trades, Portfolio), Bill Ackman (Trades, Portfolio) and Chris Davis (TradesPortfolio) all followed suit. The company went from being a hedge fund hotel to a roach motel.

Still, it seems some investors continue to see value in the stock. This is interesting because it would appear they believe Valeant is a contrarian opportunity, one the rest of the market is clearly ignoring because of the company's tarnished reputation.

So what is there to like about this business?

What's behind the trade?

Digging a little deeper into the data, with Chou at least, it seems there's more to this position than first meets the eye. In his Aug. 14 letter to investors, Chou writes:

"As if Valeant has not given enough pain and anguish to our unitholders, we believe pharmaceutical stocks as a group are selling at attractive valuations. They generate their earnings in cash, and most of them are selling at less than ten times earnings...It may look like we are adding more emotional fuel to the fire from our experience with Valeant but we look at mispriced stocks on a case-by-case basis. Given our current favorable view of the pharmaceutical industry generally...we expect to invest in stocks of more than two or more pharmaceutical companies...in order to reduce the potential adverse effect on fund returns that could result from Food and Drug Administration (FDA) approval and patent expiration issues faced by a single company."

In addition to Valeant, the portfolio also contains Endo International PLC (NASDAQ:ENDP), Sanofi SA (NYSE:SNY) and Teva Pharmaceutical Industries Ltd. (NYSE:TEVA) -- the basket approach in action. Together, Sanofi, Endo and Teva have the same weight as Valeant.

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When it comes to valuation, Valeant certainly ticks the "cheap" box. The stock is currently trading at a forward price-earnings ratio of 5.8 and price-free cash flow ratio of 4.7. These ratios make it difficult to argue the company is not attractive as a value investment at this time.

Debt reduction

But what about the company's debt? Debt has arguably been the most prominent overhang for Valeant since its troubles first emerged in the third quarter of 2015, and the new management team has been working hard to reduce these obligations through asset sales and cash flow. Around $280 million in debt was paid down during the first quarter and, over the past two years, the company has reduced its debt load by 20% ($6 billion-plus).

Management also has extended maturities, so there are almost no near-term obligations to fulfill before the end of the decade. Nonetheless, despite these efforts, you're still looking at $25 billion in debt on $37 billion in assets. Free cash flow was only $385 million for the first quarter and $2 billion for 2017, not an impossible situation ( in fact, there are plenty of other companies with much worse financials), but it is clear the company faces an uphill struggle as it tries to rebuild its reputation and balance sheet.

That being said, if management does manage to pull off what, at this stage, looks to be almost impossible, the return for shareholders could be multiples of the current price. Maybe this is what Chou is betting on after all?

Disclosure: The author owns no stocks mentioned.

About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. Prior to his investing and writing career, Rupert was as a proprietary currency trader. Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

Visit Rupert Hargreaves's Website


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