Position Crowding and Valeant

Position crowding is when a bunch of similar investors own a stock.  When those investors rush for the exits at the same time, the price drops a lot more than expected – perhaps to well below intrinsic value.  Note that we have published several notes on this on the Beachhead site (see Hedge Fund & Position Crowding and Equity Long/Short Post-Crisis: A Structural Analysis of the Decline in Alpha).

The poster child for position crowding in 2015 was Pershing Square Capital Management, a highly regarded hedge fund.  Pershing Square ended the year down around 20%, its worst year ever and stunning underperformance relative to the equity markets.  In the firm’s defense, and generally ignored in the press, is that the same funds were up 40% in 2014.  2015 was a blemish, but hardly a fatal one.

This darling of the hedge fund industry reached a peak of over $262 per share in August before plummeting over 70% in three months to a low of around $70 per share

In the Fall, media attention fixated Pershing Square’s investment in Valeant Pharmaceuticals.  Hedge funds liked Valeant for two reasons.  First, as a “platform” company, it supposedly could make acquisitions that would accrete to value.  If you trade at 12x cash flow and buy companies at 6x cash flow, each acquisition potentially adds value.  Add in cheap debt financing and aggressive accounting, and it starts to look like a perpetual money machine.  Second, when the targets have something called “local monopolies,” you can raise prices.  All this requires is chutzpah:  take a product selling for $20 and raise the price to $50.  If the customers have no other options, the price increase will stick.

This darling of the hedge fund industry reached a peak of over $262 per share in August before plummeting over 70% in three months to a low of around $70 per share.  The schadenfreude was palpable as some leading lights of the industry suffered billion dollar-plus losses.  The stock recovered to $90 recently, but is nowhere near where it was a year ago.

What happened?  Pershing Square’s own annual letter addresses this issue head on, arguing that having a following of other investors is both a blessing and a curse – great when a new position is announced but lousy when those same investors stampede out the door.  In support of this, the firm notes that all its stock holdings suffered much larger declines than the market as a whole, suggesting that those followers panicked in seriatim.

Implicit in Pershing Square’s explanation is that intrinsic value at Valeant remained roughly the same, while irrational followers were too skittish to weather the volatility.  This seems like half the story, at best.  While we are by no means expert on Valeant, its intrinsic value must have taken a bit hit starting last summer.  First, drug prices increases became a political hot button and regulatory scrutiny surged.  What worked well under the cloak of darkness might wither in daylight.  Second, the company appeared to have a highly aggressive (and, some might say, sleazy) strategy to get insurance companies to overpay for drugs through something called specialty pharmaceutical companies.  Another tough strategy when the tactics comes to light.  Third, the easy financing dried up as the platform business model was questioned.  If intrinsic value dropped in half, then widespread selling may have been quite rational indeed.  (See our prior post on value investors and buying dips for an analogous situation.)

Also missing in the explanation is that activism is a double edged sword.  On the one hand, you can influence the company and spur value creation.  On the other, you give up valuable liquidity and flexibility.  As noted in the letter, Pershing Square was legally prohibited from selling at a key time due to access to inside information.  Other investors had no such restriction.

In 2008, hedge fund holdings as a group declined a lot more than the market as a whole on fears of forced selling

The final point that is worth noting is the mercenary angle.  Hedge funds and other investors are ruthless when they smell blood in the water.  There were rumors last year that hedge funds and trading desks were actively shorting stocks held by Pershing Square and other hedge funds that were down for the year.  Those sellers aren’t weak-handed followers, but rather new entrants.  Arguably, this can exacerbate the risk of illiquid activist positions.

Position crowding is not new, nor is selling stocks held by potentially weak-handed investors.  Back in the late nineties, when Tiger Management suffered a very public multi-billion dollar loss on a Japanese yen position, unrelated holdings like US Air were crushed.  In 2008, hedge fund holdings as a group declined a lot more than the market as a whole on fears of forced selling, something that has been an issue for strategies that seek to replicate individual stock positions. More recently, high yield investors closely followed redemptions at the Third Avenue fund and either avoided its holdings or forced them down further.  Expect this for any fund with meaningful redemptions and drawdowns.

What’s not clear is whether this phenomenon is getting worse.  There are a few things to watch.  First, big hedge funds are much bigger today, so they often have to take billion dollar plus positions to impact performance.  Pick the wrong stock and you could be stuck in it for a long time.  Second, many investors share similar investing styles – they were, after all, often trained by the same people – so gravitating to similar stocks is natural.  Third, more people are aware of, and track, what smart investors are buying and selling.  In any event, we will continue to monitor this and report any updates.

January 30, 2016

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