Five lessons for investors from the Valeant debacle

You no doubt know that Valeant Pharmaceuticals blew up pretty badly this week, down 90 per cent since its August high. We are sorry if you owned the stock. There are some lessons to be learned from this though, and we present five below.

1. Support for ‘ cockroach theory’ We are strong believers in this theory, which implies that problems at companies are never isolated. Like cockroaches, there is never just “one” problem. Valeant has proven this in spades over the past five months or so.

2. It eventually comes down to debt One reason Valeant dropped so much this week is slowing growth, but for some companies this would not be nearly as big as a problem as it is for Valeant. The reason: Valeant’s US$ 31- billion debt position. It needs growth in order to be able to pay down this debt faster, and reduce its investment risk profile. This week, it was forced to defend its liquidity position, and likely needs to talk to debt holders to waive some covenants.

3. It does not pay to “hunker down” on losing positions Bill Ackman of Pershing Square’s long position in Valeant has been discussed at length. He has defended the company numerous times and published bullish reports to back up the long thesis. With a six per cent position in the company, Pershing lost $ 1 billion on Tuesday alone. But Pershing was also defending the company when it was more than $ 200 per share, versus todays mid $ 30s. Sometimes, doubling down or defending a losing position just makes no sense. If VRX declines further, not only will Pershing lose more money, but also Pershing will have some serious egg on its face for losing so much money, so publicly. Its reputation will be hurt. For investors, sometimes a losing position is just going to be a losing position.

4. Market weighted indices are flawed At one point, not very long ago, Valeant was the largest company in Canada, by market cap. The TSX index is a market- cap- weighted index, so companies with large market caps get large weightings in the index, regardless of quality. Last year, big moves in VRX were responsible for big moves in the index, and one company was able to move the index significantly. Just like Nortel before it, though, Valeant’s index weight made it difficult to ascertain how the overall market was really doing. This is one reason ( along with the overweighting of financials, energy and materials) that we do not like the TSX as a customer benchmark index.

5. There are always opportunities within a sector dragged down by one company Valeant’s decline this week brought down the whole healthcare sector, but of course its problems are mostly specific to itself ( other than perhaps fear of regulation over price changes on drugs). Thus, more- solid companies such as Concordia ( CXR on the TSX) and Prometic ( PLI on TSX) got dragged down with it, even though their fundamentals are entirely different. This sector association can create some decent buying opportunities: despite VRX’s woes, nothing has changed at other health care companies.

So, while we can’t do much to help Valeant now, investors can at least keep these factors in mind when looking for new investments. Perhaps this will help you avoid the next Valeant.