These super investors tend to be a cold-blooded lot, but there is one company that does seem to get their pulses racing: Valeant Pharmaceuticals. I have to be honest, I had not even heard of this company until very recently but it seems to have become a gorilla overnight and so I thought I would look into it.
Anyway, regarding those superinvestors, have a look at the line-up below (numbers courtesy of Dataroma):
- Glenn Greenberg (Brave Warrior Advisors): 36.29% (Q1 2015)
- Goldfarb & Poppe (Sequoia): 29.881% (Q1 2015)
- Bill Ackman (Pershing Square Capital): 25.84% (Q1 2015)
- Jeffrey Ubben (ValueAct Capital): 21.28% (Q1 2015)
- Lou Simpson (SQ Advisors): 12.93% (Q1 2015)
- Wallace Weitz (Weitz Value): 7.26% (Q2 2015)
- Stephen Mandel (Lone Pine Capital): 4.72% (Q1 2015)
- Lee Ainslie (Maverick Capital): 4.08% (Q1 2015)
Granted, these positions are largely Q1 and may no longer be current (we will see the Q2 updates very shortly), but both the size of some of these holdings and the identity of the investors does demand attention.
Owners
There are Buffett connections here galore–Sequoia is a highly-respected old school value fund and was the investment recommended by Buffett to his departing partners more than four decades ago (it was then run by Bill Ruane). You might feel sorry for those investors who ‘off-boarded’ themselves from the Berkshire train before it even left the station, but you shouldn’t because they still fared much better than average (assuming they did take Buffett’s advice). Lou Simpson managed money very successfully for Buffett himself while serving as GEICO’s CIO within Berkshire and Wally Weitz is Buffett’s Omaha neighbour and another successful value-oriented investor in his own right.
But it is not just Buffett disciples on this list: Glenn Greenberg, Bill Ackman and Jeffrey Ubben are all also very successful investors whose every moves are followed closely in hedge fund land. Indeed, if a company’s ownership register is any indicator, then Valeant must be doing something very well indeed to catch the attention of this posse.
A lot of these positions have become outsized due to Valeant’s rapid and stellar past growth, whether future returns can come close is another question. It will be interesting to see how many of these positions were retained (or added to) in Q2.
The Business
So what does Valeant do? Well it is a pharmaceutical company without the essential drawback of being a pharmaceutical company–namely, of course, the huge and on-going outsized expenditure on R&D. As an example, GlaxoSmithKline last year spent 15% of sales on R&D, whereas Valeant spent less than 3%.
Valeant, run by Michael Pearson since 2008, seems to base its strategy on the assumption that spending on R&D–that huge black hole so familiar to Glaxo shareholders–is much more of a cost than an investment for shareholders. Therefore he has worked to minimise this as much as possible. Interestingly on this point (R&D as cost vs investment) he seems to flatly disagree with Neil Woodford, who I believe has recently said exactly the opposite.
Instead of spending its income on R&D, Valeant uses it to buy other companies or products and then aggressively restructures those assets to reduce costs and improve profitability. It is not afraid to buy assets approaching the expiry of their patent protection or even after patent expiry, in cases where that makes financial sense.
Pearson, on taking the reins, in addition to slashing R&D expenditure, also instigated another change in strategy–namely a move towards dermatological treatments and away from big blockbuster treatments. He correctly identified that dermatology was something for which there was huge demand and fewer government payers. (Individual customers and private benefit plans are less price sensitive.)
Ophthalmology became another target market for similar reasons, and in 2013 Valeant took over Bausch + Lomb. The acquisition has given Valeant a huge eye care product portfolio and a wide range of over-the-counter, prescription and ophthalmic surgery products.
In addition to changing the company’s operations and reshaping its product portfolio, Pearson has also focused ruthlessly on minimising its tax liabilities (and those of its acquirees). In fact, well before Pfizer made its high profile and botched play for AstraZeneca, Pearson had already successfully pulled off a similar stunt by taking over Canada’s Biovail Corp–the tax inversion that brought Valeant to Canada. According to one of Valeant’s own presentations, its effective corporate tax rate was successfully reduced from 36% in 2009 to 3.1% by 2013.
Who is Michael Pearson?
Valeant really seems to be the Michael Pearson show. Originally brought to Valeant in the form of a McKinsey management consultant, he impressed their board so much that he was soon invited to be CEO and, since then, embarked on his strategy of cutting R&D spending, acquiring under-performing assets (> 100 since 2008) and then managing them better (merge and purge).
In the years since he was appointed CEO (2008), Valeant’s total return with dividends reinvested has been approximately 45x (according to a presentation by Pershing Square). I won’t mention how the S&P has fared, to save its embarrassment.
Pearson has an unusual pay structure where he is paid zero salary but remunerated solely on the basis of Valeant’s stock performance. Interestingly, he is restricted from selling shares until 2017 but is currently a paper billionaire.
Granted, Pearson’s modus operandi (cutting investment on R&D and seeking maximum tax efficiency) is unlikely to gain him much popularity in political circles, but it has been effective and he seems to be an American version of Michael O’Leary (Ryanair) or Mike Ashley (Sports Direct). The quote below, taken from his 2010 letter to shareholders, is pure O’Leary:
We will operate a low-cost operating model in all that we do. In essence, we will continue to operate a low-margin operating mindset to a high-margin business. We will take pride in our frugality, our ability to make quick decisions based on internal resources, our willingness to wear different hats at all times.
How is it valued?
Valuing a company that moves as quickly as Valeant is not easy. Morningstar reports its Price/Earnings as 87 and its Price/Sales as 10.3. But, if you look at its forward Price/Earnings then it is a more palatable 15.5 (Valeant is expected to earn about $16 in 2016, which at the multiple of 15.5 gives $248, ten bucks lower than where it is now.
However, as Bill Ackman points out, this ignores the value that will be added by future acquisitions. If Valeant continues as it has been by improving the margins of its acquirees and slashing their tax rates, then it will continue to add value as it goes along (assuming it can find suitable targets, of course). Ackman suggests that it will be earning between $28 and $39 per share by 2020, which at a multiple of 16 would put the share price somewhere between $446 and $618. But then again, Ackman’s Pershing Square has a huge position in Valeant.
One for the FI Portfolio?
One of the concerns about Valeant is its very high debt. Currently its debt to equity ratio is 4.8 (source), compared with Glaxo or Astra with about 0.6 each by comparison. This has not been a problem so far because it is amply covered by the ever accelerating cash flow, but this level of debt would certainly be too high for some tastes.
All in all Valeant is a fascinating company. It is run very aggressively in terms of its use of debt, cost control, and tax planning. To date it has been indisputably successful for its shareholders, but whether I would want to buy into such a highly-geared operation at a time when interest rates seem finally set to move higher is another question. Higher borrowing costs must raise the threshold for takeovers and, if the target pipeline begins to dry up, then the potential for disappointment with Valeant must be great.
Disclosure: Long GSK and AZN. No position in VRX.
Disclaimer: This post is not a recommendation to either buy or sell. Please consult your investment advisor.