Billionaires are not normally known for their humility.
So you know things have gone awfully wrong when a billionaire hedge fund manager – one of those “masters of the universe” – has to publicly admit that they were wrong. But that’s exactly what Pershing Square Capital Management founder and chief executive Bill Ackman did this week in a surprising apology he wrote to his shareholders.
After riding Valeant Pharmaceutical’s stock down from a peak of $279 in 2015 to around $11 this month, Bill Ackman had something to say to his investors. In Pershing Square’s 2016 annual letter, Ackman wrote:
“Clearly, our investment in Valeant was a huge mistake. The highly acquisitive nature of Valeant’s business required flawless capital allocation and operational execution, and therefore, a larger than normal degree of reliance on management. In retrospect, we misjudged the prior management team and this contributed to our loss. We deeply regret this mistake, which has cost all of us a tremendous amount, and which has damaged the record of success of our firm.”
Here’s a brief summary of Valeant’s demise:
Valeant is a pharmaceuticals company based in Quebec and owns Bausch & Lomb, among many other brands.
J. Michael Pearson, a former McKinsey consultant, became CEO of Valeant in 2008. Pearson quickly grew Valeant through M&A to a market value of $90 billion. At one point Valeant was the most valuable company in Canada.
However, how Pearson grew the company was very telling. He cut funding for costly research & development – yielding fewer new products – and instead bought up older drugs on the market and jacked up the price. His motto: “Don’t bet on science – bet on management.”
Wall Street loved this model… until it dawned on investors that short-term profits don’t necessarily lead to long-term financial health – especially if that short game draws Congressional scrutiny.
In November 2014, Valeant along with Bill Ackman made a bid to acquire pharmaceutical company Allergan but failed when Allergan was ultimately sold to a white knight. Investors started to realize that Valeant’s growth was overly reliant on acquiring other companies.
As early as 2014, investor Jim Chanos, the founder of hedge fund Kynikos Associates, was calling Valeant a rollup, i.e. a company that needed a steady stream of acquisitions to show growth and survive.
In October 2015, Valeant crashed under the weight of scrutiny over its pricing practices and accusations of malfeasance from a short seller.
That same month, management also revealed that it was hiding a secret mail-order pharmacy within the company called Philidor — a pharmacy that is now being investigated for fraud.
In Pershing’s 2015 annual letter, as Valeant was crashing hard, Bill Ackman wrote that he continued “to believe that the value of the underlying business franchises that comprise Valeant are worth multiples of the current market price.” He even blamed traders who followed him in and out of his trades for adding more volatility to the stock.
In March 2017, Ackman finally accepted defeat and completely exited his Valeant investment. In his 2016 letter, Ackman wrote:
“My approach to mistakes is that I personally assume 100% of the responsibility on behalf of the firm while sharing the credit for our successes. While I and the rest of the Pershing Square team have suffered significant losses from this failed investment as we are collectively the largest investors in the funds, it is much more painful to lose our shareholders’ money, and for this I deeply and profoundly apologize.”
These guys even had a bit of a feud over Ackman’s investment in Valeant. Charlie Munger called Valeant a “sewer” in early 2016 and Buffett said “I don’t think you’d want your son to grow up and run a company in the manner that Valeant was run.” Still, Ackman continued to defend Vaelant and fired back at the two, criticizing their judgement of the drug company and Berkshire Hathaway’s investment in Coca-Cola, calling Coke a “product that causes harm.”
Warren Buffett clearly would never have invested in Valeant. Buffett’s third investing principle is that he only invests in companies that are “operated by able and trustworthy management.”
And whereas Bill Ackman eventually admitted that Valeant’s business “required flawless capital allocation and operational execution, and therefore, a larger than normal degree of reliance on management,” Buffett does NOT invest in companies that are reliant on any single person. Here are a couple of Buffett quotes pertaining to this point:
“When a management team with a reputation for brilliance joins a business with poor fundamental economics, it’s the reputation of the business that remains intact.”
“I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.”
[Tweet “”I try to buy stock in businesses that are so wonderful that an idiot can run them.” – Buffett”]
That being said, Warren Buffett has made his fair share of mistakes (which, unlike Ackman, he’d be the first to admit).
Taylor Tepper from Time.com points out 3 lessons you can learn from Bill Ackman’s and Warren Buffett’s most epic failures.
Lesson #1: Long-Term Strategy Matters More Than Short-Term Results
As noted above, Valeant got great results… for a while. But their strategy was way too focused on the short-term vs. the long-term. By shifting to a strategy of buying up drugs and then increasing their prices, Valeant (1) became exposed to external factors that they could not control (availability of deals), (2) became overly reliant on management’s aptitude for closing deals, wisely allocating capital, and then efficiently executing on its business plan, and (3) drew scrutiny from customers, the media, and ultimately the government for its pricing practices.
Here’s more on these three problems and how they affected the long-term future of the company, despite boosting its short-term results:
1. Exposure to external factors out of the company’s control
As Ackman notes in his annual letter:
“Intrinsic value can be dramatically affected by changes in regulations, politics, or other extrinsic factors we cannot control… In retrospect, our investment in Valeant was too large a percentage of capital in light of the greater risk of these factors having a negative impact on intrinsic value.”
2. Over-reliance on management’s aptitude
One of Valeant chief executive J. Michael Pearson’s mottos during his time in charge was “Don’t bet on science — bet on management.” Bill Ackman clearly shouldn’t have bet on management. In the Pershing letter, Ackman writes:
“The highly acquisitive nature of Valeant’s business required flawless capital allocation and operational execution, and therefore, a larger than normal degree of reliance on management. In retrospect, we misjudged the prior management team and this contributed to our loss.”
Ackman expands on this later in his letter:
“A management team with a superb long-term investment record is still capable of making significant mistakes. We had the opportunity to work alongside Valeant management for nearly one year… and were favorably impressed. In retrospect, it appears that the company substantially overpaid for Salix [Valeant’s largest acquisition which occurred contemporaneously with the substantial majority of Ackman’s investment in the company], and it has not yet achieved the results anticipated by prior management.”
“Wells Fargo analyst David Maris, who soon put a ‘sell’ rating on the stock, noted in a report that he dug through the company’s financial statements and found that in almost every quarter most of its growth in the U.S. had come from price increases.””
This ultimately led to both a Congressional and a Senate hearing.
In the end, it’s important to remember:
[Tweet “”Long-term consistency trumps short-term intensity.” – Bruce Lee”]
Lesson #2: It Pays to Follow Your Own Advice
In a discussion with University of Kansas students in 2005, Warren Buffett was asked if he thought investor Eddie Lampert could turn the struggling retailers Sears and Kmart around. His response:
“Turning around a retailer that has been slipping for a long time would be very difficult. Can you think of an example of a retailer that was successfully turned around?””
As Taylor Tepper from Time.com notes, Warren Buffett began buying shares of the retailing giant Walmart the same year he made the above comment. Walmart at that time was already experiencing slowing growth and drawing comparisons to Kmart. Still, Walmart’s revenues jumped 10.1% to $285 billion back then, compared to just $8.5 billion for Amazon. Since then, however, Amazon’s revenue has grown by 1,411%, dwarfing Walmart t’s 118% gains. Investors, meanwhile, enjoyed an annual return of 26.6% on Amazon’s stock over that time period, compared to 4.5% for Walmart shares and 6.5% for the S&P 500.
Warren Buffett finally sold most of his stake in Walmart last year.
“Walmart’s a fabulous company. And what Sam Walton and his successors did, I mean, that’s one of the great stories of American business.
I think retailing is too tough for me. We bought a department store in 1966 and I got my head handed to me. I’ve been in various things in retail. I bought Tesco over in the U.K. and got my head handed to me. Retailing is very tough.”
Maybe Buffett should have listened to his own advice back in 2005?
Lesson #3: Be Careful with Aphorisms
Finally, Tepper points out that when Ackman was still in the thick of the battle, he reportedly defended his Valeant bet to Pershing Square investors by quoting a famous Buffett line: “Be fearful when others are greedy, and greedy when others are fearful.”
It’s such a simple quote that makes so much sense. But this is easier said than done, of course. For example, everybody knowsto buy low and sell high. But how often do investors – when their backs are really against the wall – do the exact opposite, quoting other memorable aphorisms like “don’t want to catch a falling knife” or “the trend is our friend.”
When you find yourself in a reflexively defensive position, it’s helpful to answer a seemingly simple question: Why do I own this thing in the first place?
If the company’s financials and narrative no longer align with what you think you bought in the first place, it’s time to move on. And quickly.