headline risk is still poison for these stocks

Stock picking is hard. Most institutional and retail stock pickers underperform the indexes. But every investor could improve the likelihood they beat the market by following one rule:

Avoid high profile, controversial companies where an adverse news event could produce an overnight price collapse.

Three stocks have proven the utility of this investing rule in spades: Valeant Pharma, Wells Fargo, and Mylan Labs. All three have been scrutinized for behavior labeled unethical by some and illegal by others, and all three have cost their investors in a big way because of it.

In February, I cautioned that an upcoming Congressional investigation into Valeant’s pricing policies might unveil further malfeasance by the company’s management. VRX was $92 then. It closed at $22 today. While the hearings produced no bombshells, a few weeks later management reported disappointing fourth quarter earnings and drastically lowered earnings guidance for 2017. The stock dropped 40% to $36 in a single day, and has slid lower since.

Had folks followed my rule, they would have unloaded Valeant as soon as news surfaced that it had a lengthy history of buying prescription and OTC drugs (with money borrowed via multiple Wall Street bond offerings) and then drastically raising drug prices. The stock was still over $200 when these damning stories first emerged. But many investors—including a who’s-who of the hedge fund industry—held onto their Valeant stakes, betting that good times were sure to return as the negative press faded and headline risk abated. Even Wall Street ‘experts’ who openly acknowledged the company’s troubles refused to believe things could get significantly worse.

On September 28th, 2015, with Valeant’s stock still trading for $199/share, Nomura analyst Shibani Malhotra initiated coverage on the company. In a thorough 46-page report, Malhotra rightly called VRX a “controversial company that polarizes investors” and noted its “aggressive pace of M&A, which some perceive as an unsustainable ‘roll up’ strategy.” And yet, Malhotra still rated the company a buy, pegging its upside at $335/share and its downside at a mere $180—only $19 (or 10 percent) less than the stock was trading for on the day the report was issued.

Oops.

One year later, the rot within Valeant is still being unearthed, and its stock keeps on falling. Just this week Wall Street analyst David Maris dug up another example of quasi-criminal behavior. Apparently Valeant induced doctors to prescribe its second biggest product, the antidepressant Wellbutrin XL, through the obscure mail order pharmacy ‘Direct Success.’ Even though much cheaper generic competitors to Wellbutrin existed, Valeant increased Wellbutrin’s list price 11 times over the last few years to $17,000 annually. Who knows when, or if, another negative story around Valeant is discovered. But with over $30 billion of debt and now shrinking revenues, it’s an extremely risky stock that could very well zero out. Now that is a downside risk.

The recent Wells and Mylan scandals could drag on just as long as the Valeant saga, and potential investors in either company would be wise to remember all the false bottoms we’ve seen in Valeant’s stock since it first started sliding.

Mylan has followed the Valeant playbook: buying a much needed drug and then rapidly raising its price. Because Medicare and Medicaid are often the ultimate payors, a large portion of these price hikes have been borne by American taxpayers. In Mylan’s case the product was the epipen, used to avert anaphylactic shock for folks with severe allergies. Mylan’s CEO, who is among the highest paid CEO’s in America, was criticized for this price gouging at a recent congressional hearing, but she has retained her job, and her eight figure annual compensation.

Wells Fargo had a multi-year program of ‘cross selling’ products, like credit cards, to customers who had not requested them. Last week longtime Wells CEO John Stumpf resigned over the scandal, but not before first blaming, and firing, 5,300 employees and the head of Wells’ consumer operations. I suspect these were not ‘rogue’ employees; just folks following an internal culture that promoted unethical and illegal behavior in order to stay employed. Thankfully, the head of the consumer finance protection bureau, Senator Elizabeth Warren, lambasted Stumpf at a recent Senate hearing.

In all three examples the time to sell was the day these scandals broke. Even today all three stocks should be sold, as headline risk persists. The Mylan story is far from over and Valeant continues to prove Charlie Munger correct when he called it a “sewer.”

As for Wells, I believe our government would have been well within its rights— per the Treasury Department’s oversight of all FDIC insured institutions—to place it under conservatorship, as it did with Fannie Mae and Freddie Mac after the 2008 financial crisis. The company’s stock would have zeroed out, and that would have put the entire financial services industry on notice that predatory behavior will not be tolerated. While a drastic step, I fear such action is necessary to prevent further abuse. Instead Wells’ investors, including Warren Buffett, have remained silent. It appears protecting the company’s share price is more important to these folks than treating American consumers and taxpayers fairly


2 thoughts on “headline risk is still poison for these stocks

  1. Aleksander Hansen

    I unusually find myself in agreement with a lot of Scott’s writing, however, Here I find myself disagreeing with several key points:

    1) it is not at all clear that a rule whereby you sell on this sort of bad news is a good idea. Indeed, the opposite can often be a good idea – it depends on the situation and, more importantly, the quality of the underlying business.

    2) I don’t see a parallel between Valeant and Mylan. One firm grew pretty much exclusively by acquisitions, whereas Mylan has a very different strategy. On the issue of pricing, I see absolutely nothing wrong with pharmaceutical companies pricing drugs based on supply and demand rather than subjective notions of “fairness”. The former leads to an efficient allocation of resources and non-noisy long-term incentives, whereas the latter is one step down the road to serfdom. Price controls and government regulation of profit is never a good idea and makes us all poorer in the long run.

    3) Several employees of Wells Fargo clearly took a series of indefensible actions. However, this seems like an isolated issue, not a systemic one. Moreover, WFC has ample liquidity, reserves and is solvent, so conservatorship makes no sense. It is one of the best run banks in the US,
    and has been for years. Government agencies cannot seize private property based on popular outrage and congressional grandstanding.

    Reply
  2. CARLOS DESOUZA

    Warren Buffett is a HYPOCRITE who conveniently keeps his mouth shut when he wants to. Wells Fargo’s behaviour has been shocking to say the least. But, not a word from the mouth of Warren Buffett, who is only to happy to mouth off against Donald Trump.

    Reply

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