Trick or Treat 2: Can companies be un-analyzable?

Geofrey Marshall's picture

Valeant Pharmaceuticals comes close with a business model based on serial acquisitions and a lack of clarity on true underlying sales trends. With sales growth seemingly dependent on drug price increases and unique distribution relationships, and adjusted EPS bolstered by draconian cost cutting, the company’s real margins and cash flows and the ability to service debt are uncertain. However, if the capital markets are accommodating (thank you closet indexers and passive ETFs), equity and debt can be raised cheaply enough for acquisitions to replace any lost revenue and cash flow. Do this well enough and it looks like growth. However, is this business sustainable if it loses access to funding and its steady diet of acquisitions? In Jeff Elliott’s blog, Trick or Treat? Out come the skeletons, Signature’s health care equity portfolio manager goes into more detail on what we found lacking with Valeant’s business model. This blog is less about Valeant specifically and more about why we do not get scared into owning bonds of companies we do not like.

Volatility in Valeant across both the equity and high yield bond markets has been a spectator sport so far in the fourth quarter of 2015. This volatility is painful and unexpected for those markets (thankfully not for Signature) as health care is generally regarded as a defensive sector. This volatility is especially painful when the main reason to own the stock was fear of underperformance; where not owning the stock or even being underweight the stock, can cause performance relative to peers and the index to slip materially. From 1998 to 2001, Nortel showed Canadians the error in investing without conviction on the upside and the downside.

This “pain trade” mentality also applies in the bond market as Valeant is the third largest issuer in most high yield bond indices. This is a great reminder of the asymmetry of credit returns and our approach to investing. It is very easy to lose money in both stocks and bonds, but, whereas stock prices can double on improved growth prospects it is very difficult to double your principal in the bond market. Credit investing is not about capturing gains – it is about avoiding losses. A good outcome, and also the expected outcome in credit investing is getting your semi-annual coupons and principal back at maturity and avoiding the defaults that permanently impair capital. For us, this means deep due diligence and successfully marrying facts with projections and opinions.

Our clients entrust us with their retirement savings, RESPs, TSFAs, pension funds, etc. to generate returns and preserve downside risk. We do this by managing credit risk, not career risk. We continually hear from competitors or sell-side analysts that we “have to own” this bond or that bond because of its large index weight and the risk of underperformance. In fact, we heard this argument regarding Valeant bonds only one month before Turing Pharmaceuticals increased the price of an obscure drug from $13.50 to $750 per tablet. This prompted U.S. Congress to request subpoenas on a number of companies on orphan drug pricing policy. Justifying active management means getting off the relative weight mentality. Quit hugging the benchmark under the comfortable excuse of risk management. What is even less compelling about closet indexing in the debt markets is that this strategy forces you to invest the most capital into companies with the most debt – irrespective of their ability to pay you back. In the equity markets there is a more direct, though imperfect, relationship between earnings power and market capitalization and index weight.

Do not let index weights corrupt your investment process. Invest in what you understand and can value. What you do not own cannot hurt you.

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