Why Did Valeant’s Shares Plunge Yesterday?

Jim Grant is “confidently bearish” on the company. Will his bet pay off?

| More on:
The Motley Fool
You’re reading a free article with opinions that may differ from The Motley Fool’s premium investing services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn more

Jim Grant is one of the most respected financial minds on Wall Street. His newsletter, The Interest Rate Observer, is one of the most read publications by investment professionals. So when the most recent edition took aim at one of Canada’s highest-flying companies, Valeant Pharmaceuticals (TSX:VRX)(NYSE:VRX), it’s no surprise that the company’s shares plunged over 5% in response.

Mr. Grant referred to Valeant as a “financialized pharma company” that he is “confidently bearish on.” He even cited legendary short seller Jim Chanos for the idea. Mr. Chanos is most famous for shorting the shares of Enron right before its collapse.

There were some interesting arguments made by Mr. Grant. First of all, as is well-known, Valeant is a serial acquirer. As a result, the company only spends about 2.7% of sales on research and development. Meanwhile, industry leaders Johnson & Johnson (NYSE:JNJ), Pfizer (NYSE:PFE), and Merck (NYSE:MRK) collectively spend 13.8% of revenue on R&D.

The acquisition strategy can lead to some issues with accounting. Mr. Grant cites one instance where Valeant changed the revenue recognition policy of Medicis after acquiring the company in 2012. Valeant also focuses on cash earnings per share, which excludes things like acquisition-related costs. When looking at Valeant’s earnings according to generally accepted accounting principles (GAAP), the company actually is losing money.

In fact, Valeant uses many accounting metrics that do not conform to GAAP. The most recent quarterly call cited measures such as adjusted cash flow from operations and pro-forma same-store sales, among others. The problem is that management has complete discretion on how performance is measured. This can lead to abuse.

But this exact thesis could have been made years ago, and it would not have been good advice at all. The stock is up almost 10-fold over the past five years, and has more than doubled in the past year alone. Conversely, Jim Grant could argue that the skyrocketing shares are now much more overvalued than ever before.

Foolish bottom line

As mentioned previously, an investment in Valeant requires placing an enormous trust in management. The management team not only has discretion on which direction to take the company in, but also how to report progress. And if this discretion is abused, investors will pay a dear price.

Of course the exact same thing could have been said about Enron before it collapsed. In that case, Enron’s management did abuse its discretion, and manipulated manipulated earnings at will.

But betting against Valeant is a very risky move, one that would not have worked out well so far. And if Valeant’s leadership comes through for shareholders, Messrs. Grant and Chanos will be the ones paying a very steep price.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Benjamin Sinclair holds no positions in any of the stocks mentioned in this article. The Motley Fool owns shares of Johnson & Johnson.

More on Investing

Profit dial turned up to maximum
Dividend Stocks

1 Undervalued Canadian Dividend Stock to Buy for TFSA Passive Income and Total Returns

This cheap Canadian energy stock provides an attractive dividend yield for TFSA passive income and a shot at some big…

Read more »

money cash dividends
Dividend Stocks

Want Passive Income? 1 TSX Stock for $8/Day in Dividends

If you need cash right away, then this TSX stock can make you passive income from a stable dividend that…

Read more »

edit Balloon shaped as a heart
Dividend Stocks

My 3 Favourite TSX Dividend Stocks Right Now

Canadian dividend stocks make for great long-term buy-and-hold investments.

Read more »

value for money
Dividend Stocks

3 Incredibly Cheap Dividend Stocks to Buy for Dependable Passive Income

Now is an excellent time to load up on Canadian dividend stocks. Here are top picks that are all trading…

Read more »

A close up image of Canadian $20 Dollar bills
Dividend Stocks

3 Simple TSX Stocks to Buy With $25 Right Now

Canadians with capital of as low as $25 can purchase three simple stocks right now and earn recurring passive income…

Read more »

edit Person using calculator next to charts and graphs
Dividend Stocks

2 No-Brainer U.S. Stocks for Investors in August

Here are two undervalued U.S. stocks to diversify your investment portfolio. They both pay safe and growing dividends!

Read more »

TIMER SAYING TIME FOR ACTION
Tech Stocks

Got $300? 2 Simple TSX Stocks to Buy Right Now

Investing whatever little sum you have saved up as soon as possible is one of the best ways to keep…

Read more »

money cash dividends
Stocks for Beginners

Grow Your $2,000 and Get $160 Income, Too: Buy 2 TSX Stocks Now

What if a stock can give both dividends and growth? You can have your cake and eat it too with…

Read more »