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.
Wall Street has always been captivated by controversial companies, controversial leaders, and controversial mergers. Tesla’s shocking offer to buy SolarCity on Tuesday featured all three, so it was no surprise that the deal instantly seemed like a bigger story than the presidential race, gun control, ISIS, and Brexit. It even managed to make the last controversial company that dominated headlines, Valeant Pharma, seem like an afterthought.
A few people have written in asking my opinion of the deal. The short answer is, I believe investors are well advised to avoid both stocks like the plague. As separate entities, these companies are wildly overvalued story stocks with a good chance of going broke. Together, they will form one wildly overvalued story stock with a good chance of going broke.
Earnings, as the old Wall Street adage goes, are “the mother’s milk of stock prices.” But not all earnings are the same. More and more companies believe they can hoodwink investors into accepting the myth that non-GAAP earnings are a better measure of corporate progress than numbers produced by generally accepted accounting principles. In 2016’s first quarter, 19 of the 30 Dow companies reported both GAAP and non-GAAP earnings.
In theory, filing non-GAAP numbers can give a clearer picture of a company’s health by excluding expenses managements consider (or hope) to be nonrecurring, such as charges for divestitures, acquisitions, and foreign currency adjustments. In practice, non-GAAP figures increasingly allow managements to present wildly distorted pictures of their firms’ financial health by omitting the most troublesome aspects of their balance sheets. Valeant is all over the news now for doing just that. But the biggest and, mystifyingly, least talked about expense omitted in non-GAAP numbers is stock based compensation.
With yesterday’s 300-point collapse, the Dow is now down 7.3 percent since January 1st. Other indexes have cratered as well. The smaller company Russell 2000 has shed over 11 percent. In the midst of this carnage, investors are understandably searching for “safe haven” stocks that generate dividends, are inexpensive, and offer less volatility than the overall market. Unfortunately, these ports in the storm are few and far between at the moment. People are looking for any excuse to sell stocks right now, which means anyone looking to buy has to be particularly sensitive to headline risk.
Today no sector faces greater headline risk than the biotechnology and pharmaceutical space, especially companies that have engaged in price gouging. In this toxic environment, names like Valeant, Shire, Vertex, BioMarin, and others are the financial equivalent of the Zika virus.
The Valeant saga is probably a long way from a resolution. Anyone that says they know how it will end is either delusional or looking to influence the stock. That being said, there are a few lessons to be gleaned:
I’ve always been intrigued by how seemingly small events can trigger sudden downturns in overvalued market sectors. In March of 2000, a Barron’s cover story did more than anything to accelerate the bursting of the dotcom bubble. Last week, a single tweet sparked a major selloff in biotechs and pharmaceuticals.