Valeant: Position Crowding, Intrinsic Value – an Update

In January, we wrote a post on Position Crowding and Valeant – the poster child in 2015 for a crowded hedge fund name.  One of the points we made was that “intrinsic value” can be highly uncertain when it’s based on forecasts of earnings and cash flow.  We expanded on this when we wrote about how value investing had changed – from asset based analysis that (still, generally) underpins the Value factor to the concept of “private market value” (see Is Warren Buffett a Value Investor? and Why Apple is Not a Top Ten Holding of 93% of Hedge Funds).  From the Valeant note:

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 big hit starting last summer…. If intrinsic value dropped in half, then widespread selling may have been quite rational indeed.

Yesterday Valeant announced additional cuts in guidance and the stock immediately began trading below $25 prior to the market open (vs. $90 when we wrote the first note and now down over 90% from the high last year).  Take a look at what’s happened to estimates of earnings for 2016 and it’s not hard to see why.  A year ago, analysts expected the company to earn $15.49 per share; today’s announcement from the company guides to $6.80 per share, a reduction of 56%. The chart below shows consensus 2016 earnings estimates in red along with Valeant’s share price in white.

Capture - June 8

The other point is that liquidity is valuable.  Arguably, it is much more difficult for an “activist” investor to abandon a stock position after so publicly defending the management team and business model.  As we wrote:

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.

We’ve spent some time talking to hedge fund investors recently about why share prices often react so violently these days to negative news.  The general response is that economic growth is tenuous at best and the best gains of the bull market are well behind us, so investors often don’t hesitate to sell stocks today.  There will be plenty of opportunities, goes the reasoning, to get back in later.  We can then infer that we should expect continued volatility in stocks widely held by hedge funds.

June 8, 2016