Bronte – Short Valeant Case StudyVW Staff
Bronte on Valeant from Q1 letter
The Bronte Amalthea Fund is a global long/short fund targeting double digit returns over the long term, managed by a performance orientated firm with a process and portfolio that is genuinely different. Objectives include lowering the risk of permanent loss of capital and providing global diversification without the market/drawdown risks typical of long-only funds. A highly diversified short book substantially reduces risk and enables profits to be made in tough markets. The fund is an alternative to equity investing, and complement to most portfolios, and is typically an excellent diversifier which may lower overall portfolio risk.
Commentary: This quarter the 100% long MSCI AC World Index benefited from strongly rising global markets (+6.9% in USD) but after allowing for the rise in AUD it fell slightly below zero for the quarter. By comparison this Amalthea long/short fund gained 0.5% – handily beating the index. We are particularly pleased with this performance given it has been delivered by a portfolio with substantially less beta (i.e. market risk).
Whilst beating a strongly rising global market while maintaining a substantial short book is pleasing it is in times of market disruption and decline—quite unlike the relentless multiple expansion that has powered the market’s recent ascent—that the strategy’s value is most apparent. Below we chart the worst months for the market (again using the MSCI World Index) against this fund’s performance showing the superior returns achieved in down markets.
These times of dislocation can be the times of greatest opportunity for purchasing shares of high quality businesses at a discount. While shorts are typically thought of as protection against market downturns (true), an often underappreciated but substantial benefit is having ready cash at times when valuations are reasonable. We are always adding to our list of “businesses we’ve analysed and would love to own” while we await the chance to buy them at attractive prices.
The fund maintained an approximate net exposure of 70% across the quarter. Shorts are predominately small to mid-cap stocks with a much higher beta than our longs. Thus our adjusted portfolio beta is lower yet. But as noted above, the fund behaved much better than its adjusted beta would suggest.
The sectors the fund is most long are financials, consumer staples and information technology, while the largest short sectors are healthcare, materials and energy. Geographically, the largest long exposures are to the USA, Germany and the UK, whilst the USA also provides the most short exposure followed by Canada and then Australia. After netting longs against shorts the largest resultant country exposure is to Germany.
Aside from individual stock picking, being long Germany and long large caps but being short small caps and short energy contributed to the fund’s performance over the quarter.
Enhancing our Toolset
Bronte has long sought to develop internal tools to enhance our research process. We have recently redoubled this effort, as we are deploying software that will enhance our short research process in particular. We have long followed malefactors in financial markets as part of our idea generation approach on the short side. Our new tools expand this capability, allowing us to analyze relationships among companies and people in greater depth and with greater speed.
For a good many of our “people-driven” shorts, we start with the following assumptions, established from years of observation:
a. History matters: if you were once a reprobate, there’s a good chance you are still areprobate
b. Associations matter: If you work with a lot of reprobates you might be a reprobate. (David, our employee raised in the American Midwest, heard a pithier version growing up: “You lie down with dogs, you wake up with fleas.”); and
c. Investing money behind reprobates is a good way to lose it (so be short instead).
We hope these tools will unify the many disparate sources of data we presently collect, as well as assist us generate new ideas and accelerate the fairly laborious research process. Though robots and artificial intelligence are all the rage in the investing world, these tools are neither primarily quantitative nor “black boxes,” instead augmenting our existing research approach.
We have long believed that diversification is the key to controlling risk in our short book. In practical terms, we built these tools to allow us to further broaden our shorts, with the goal of harvesting additional returns from finding new ideas and reducing fund volatility. In particular, we look to grow our short exposures in areas outside North America, including Australia and Europe.
We Welcome Andrew Reeves
Andrew Reeves joined us in late 2016. Prior to this he spent a decade in investment banking mostly in Hong Kong. Andrew’s different perspective has improved our process and our thinking in myriad ways. We are very pleased.
Andrew has also driven a renewed Bronte growth effort. John and Andrew have just completed three weeks on the road visiting companies and potential clients
Later this year (possibly September but the dates are uncertain) John and Andrew will be doing this again – mostly focused on our most critical task of company visits and general investment research but with some limited client meetings as well.
Going forward, Andrew will also focus on a few specific investment projects. He is an analyst first – and that is both why and how he was hired. He also is our lead point of contact for certain investor inquiries as well.
Some flattering attention on Valeant
While we occasionally attract our share of slings and arrows as short sellers, of recent times we have received considerable press coverage (e.g. in Canada’s Globe and Mail [paywall]) of our role in the disclosures at Valeant Pharmaceuticals International. Valeant is a huge pharmaceutical company which peaked at a market capitalization of over $USD90 billion. This stock was held in size by numerous sophisticated hedge funds, and it is possible they lost more money on this stock than any in history. Valeant was a core Bronte short and the most profitable short we have done in a few years. John (helped by David) wrote about thirty blog posts on the topic. But we will recap here.
Valeant bought drug companies – well over a hundred of them. It was foreign domiciled (and hence paid little tax), and post-acquisition it raised prices and sacked all the research staff and just about all the other non-revenue producing staff (such as accounting and compliance). Sometimes they even sacked the sales staff. Then they ran the newly acquired drugs at very fat margins through their existing sales channels—and, as it turns out, through a few obscure pharmacies.
The bull case was simple: Valeant had a repeatable process (a “platform”) whereby the company can make over 100 highly accretive acquisitions. Further, as the company is diversified (maybe 200+ individual drugs) there is no need for investors to analyze the drugs themselves as all pharmaceutical risks (such as patent expiration, competitors’ products, etc.) are broadly diversified away. Finally, many of the drugs were small in terms of revenue and out of patent, yet will be prescribed forever—and hence are genuine royalties.
This stock was beloved by Wall Street (though not by patients or the U.S. Congress) with some very well regarded managers having multi-billion dollar positions. Discussions with these managers showed us just how much respect the management team of Valeant had garnered after years of great financial success and with a roadmap for even more.
The diversity of products sold , it was argued, was one of the company’s key strengths. It also (seemingly) absolved investors from having to analyze the product set or the true sources of revenue growth post-acquisition. If no product was large, why worry about any individual product? Practically, this meant Valeant could be owned by investors who weren’t health care specialists (in fairness, neither are we), as the value was not in the chemical formulations but in the M&A apparatus built to obtain and exploit them. This was a pharma stock that allowed its owners not to think too hard about drugs. (Or GAAP compliant financial statements, it should be noted.)
Except, as is now well known, all was not as it seemed. Our favorite example was registering about 70 pharmacies in names borrowed from Stephen King novels so that, we suspect, insurance companies could be hoodwinked into paying for over-priced prescriptions. We were also skeptical of other numbers from Valeant—and sometimes playing around with simple numbers can provide remarkable insight. Here is a slide from April 2014, from a presentation made by an investor using company numbers.
From this slide, if the top ten products are 18% of sales they average 1.8% of sales each. If the next ten products are 12% of sales they average 1.2% each. Therefore, the tenth biggest product is going to be somewhere between 1.8% and 1.2% of sales.
If we guess that 10th biggest product is 1.5% of sales, then a single product above 3.3% of sales makes the above chart impossible. Revenues were about $8.2 billion at that time, so no product could be over 3.3% or $240 million – and even a couple of products at $200 million would be way too much. The company’s own disclosure provided counterexamples, such as Wellbutrin XL, a product that came with the Biovail merger.
We make an assumption when shorting stocks that is often but not always correct: there is rarely just one cockroach in the kitchen. It has an often forgotten corollary: if you spot one cockroach as an investor—whether long or short—it behooves you to go looking for more.
And in the Valeant case we did.
Sadly, this alone is insufficient to make money as a short-seller. Valeant stock doubled after we initially spotted it. We made money because our position was small and our risk management approach effective.
The Bronte Team