The Valeant saga is probably a long way from a resolution. Anyone that says they know how it will end is either delusional or looking to influence the stock. That being said, there are a few clear lessons to be gleaned from the story thus far:
- Organic growth is superior to growth by acquisitions—especially when growth by acquisitions is financed with large amounts of debt and even more especially when that debt is fueled by Wall Street bond offerings.
- In industries that rely on intellectual property, research and development spending is critical for survival.
- Accounting transparency is a big deal. I’m not saying for sure that Valeant is Enron Part II, but I will say that unscrupulous behavior is a lot harder to detect when its wrapped up in complicated financial arrangements.
- The more a company works to highlight non-GAAP (AKA crap) results, the more investors should focus on GAAP results instead. As Gretchen Morgenson pointed out last week in the New York Times, Valeant earned $912 million in 2014 GAAP profits, while its non-GAAP reported cash earnings were $2.85 billion.
None of these lessons are new. They’re commonsense, investing 101, which leads one to wonder why so many successful money managers have risked huge amounts on such an inherently sketchy business. Sequoia Fund’s stake in Valeant is a staggering 34 million shares. Bill Ackman’s Pershing Square Capital owns 20 million; SF-based ValueAct, 15 million; NYC-based Paulson & Co, 9 million; NYC-based Lone Pine, 5 million; and Greenwich-based Viking Capital, 5 million. New York’s Brave Warrior Advisors (managed by Glenn Greenberg, son of legendary baseball player Hank Greenberg) has reportedly tied up more than a third of its assets in Valeant. These are massive investments from some of the biggest, best-known funds in the world—and that is exactly where the problem lies.
These outsized bets are a side effect of liquidity. As assets under management grow, liquidity constraints reduce the number of potential stocks and bonds where a manager might make a meaningful investment.