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Valeant’s rise and fall offers hard lessons from the momentum playbook

Norman Rothery is the value investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

Bill Ackman recently dumped his fund's stake in Valeant Pharmaceuticals International Inc., which ended a distressing period for his investors.

While it might be tempting to use the opportunity to wallow in an ocean of schadenfreude, it's more useful to step back and to try to learn from his misfortune.

Mr. Ackman was a high-profile bull on Valeant's stock in its heyday, but he wasn't alone. The firm attracted other notable value investors along the way like the storied Sequoia Fund, which, at one point, had more than 25 per cent of its assets in the pharmaceutical firm.

Valeant took investors on a wild ride over the last decade. It hit a low of $7.84 per share on the TSX during the financial crisis of 2008, but rebounded and moved up to an all-time high of $347.84 per share in the summer of 2015. Its subsequent decline was almost as dramatic with the stock dipping below $14.20 per share this week.

The curious can travel backward in time, thanks to the Internet, to get a sense of what investors were thinking about during Valeant's run-up and subsequent decline. It's a fascinating journey.

The problems at Valeant weren't entirely unexpected because the company had attracted a few bears before it peaked in 2015. The most notable negative voice proved to be Warren Buffett's sidekick Charlie Munger.

In early 2015, Mr. Munger likened Valeant to Harold Geneen's International Telephone and Telegraph Corp., which grew rapidly via acquisitions during the conglomerate craze of the late 1960s. The period ended badly for investors.

As a result, Valeant was a topic of heated debate among investors in 2015 when it traded at very high multiples of the sort common in the pharmaceutical sector. Indeed, it had the outward appearance of being an anti-value glamour stock based on simple multiple analysis. But the bulls set aside many traditional measures of value and focused instead on the firm's high growth rate, estimates of its free cash flow, and what – at the time – appeared to be able management.

Aside from paying attention to Charlie Munger's warning and the more traditional value measures, investors might have limited their downside by taking a page out of the momentum playbook. Momentum investors, and traders more generally, usually try to cut their losses short in a timely manner.

History shows that stocks in a downtrend tend to continue to perform poorly, at least in the short run. A similar pattern is observed when dealing with low-ratio value stocks or high-ratio glamour stocks.

Money-manager Patrick O'Shaughnessy wrote about the pattern in 2014. He split the stock market into 25 groups and calculated a five-by-five matrix of past returns based on value (using a low-ratio composite) and momentum (using prior six-month returns).

He determined that stocks with the best value and best momentum characteristics gained 18.5 per cent per year, on average, from 1963 through to the end of 2013. Value stocks with the worst momentum gained 11.8 per cent per year on average. Similarly, top momentum stocks with poor value characteristics gained 11.6 per cent per year on average.

The low-value glamour stocks with the worst momentum trailed with gains of just 1.2 per cent per year on average.

Investors could have avoided Valeant's decline by paying heed to Mr. Munger's early warning, or by considering its conventional value metrics. They could have limited their losses by getting out early when the stock's momentum turned negative.

Unfortunately, Valeant continues to suffer from negative momentum, which argues against a purchase in the short term. More positively, the price decline has improved some of the stock's value characteristics dramatically. However, the firm is struggling under a heavy debt load and a paucity of earnings, which in my view puts it into what Warren Buffett calls the "too-hard" pile at this time.

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