Ever since Citron Research released a report questioning the past darling of the TSX’ accounting practices, a company we held in our model portfolio for members and took a healthy gain off the table some time ago, the drama around Valeant has been building. First with an interview of the author of the Citron Research report and next with an impassioned interview with Jason Donville. Both videos are worth a watch, if you have not yet seen them, and they bring up some interesting lessons or takeaways for investors. Special mention to Amber Kanwar for pushing the questions in what has been nothing short of heated discussions.  But first, let’s touch on a few points in these interviews that are worth a conversation: 

• Materiality – The Andrew Left interview is a bit sparse in facts but a comment worth noting revolved around the relative small impact that the revenues of the specific issue that was revealed have on the whole company. Materiality is an important thing to consider, as not every news item a company or analyst releases deserves an immediate reaction but we think the response is a gem worth keeping in mind.  Just because an issue discovered was small or at the time isolated, does not mean that there are no more ‘cockroaches’. Additionally, the habit of brushing small issues aside can have a tendency to build on one another. In isolation, a small concern may not be material, but multiple isolated small issues can quickly become material. While there are times to ignore factors due to materiality, what is worth further investigation is a judgment call and ignoring them (even if reasonable) is done at an investor’s own risk.
• Corporate response – One unfair area used as a defense in the Left interview, we felt, surrounded the speed at which a response is being given from Valeant. Anyone who has worked in a large company knows how slow things move. There are marketing and communications groups, layers of executives, bureaucracy and red tape, not to mention best practices, that all need to be followed and adhered to. We think companies need to come out quickly with a press release when there is abnormal stock price action (as Valeant did), if not simply to say that they are aware of it and are investigating the issue. This helps address the rampant speculation that can develop. However, after the initial recognition of a problem, one would want a company to take an appropriate amount of time to respond to any allegations. If a response were rushed and incomplete, it would only exacerbate the issue.  It is no secret that Valeant is a complicated company and any appropriate response will also likely require external accountants and presentations outlining the concerns and rebuttals. These are all things that take time and should be expected to take time. Valeant is addressing these accusations in a conference call on Monday, October 26^th at 8AM.
• Retail investors are the ones that get hurt – This point is well worth highlighting in the Jason Donville interview. These types of reports are often provided in the context that they are being done for the ‘little guy’, which probably could not be further from the truth. Often, short sellers in these types of cases have already established a position themselves or with a group of investors who received the report early. By the time retail investors know, the damage has likely been done, which is when selling at the worst time can occur. This is why we are often proponents of a do-nothing strategy. Once news is released, it is likely too late. We would far prefer getting all of the facts and letting the dust settle before reacting. Given the size of VRX, we imagine a large number, if not all Canadians were affected by this news to some degree which helps to highlight some of the issues with market-cap weighted indices as well as holding a portfolio concentrated in any single geography or industry.
• Credibility – Mr. Donville also brings up the issue of credibility and anyone, anywhere, anytime being given media attention. It is an interesting topic and can get pretty philosophical. If the market reacts, does that not provide anyone with de-facto credibility?  Other analysts that would be deemed credible have also reacted to this news and changed recommendations. If it was a ‘buy ‘a few days ago, would this change in price not make it a ‘strong buy’ today as nothing fundamental has actually changed (potentially)? If these types of reports end up being correct, does it even matter who produced it and why? Right is right and an easy parallel would be when little known Mudddy Waters released a short report on Sino-Forest. The problem, similar to the above point, is that even if these allegations are proven wrong, the short seller still wins. They have more than likely unwound their positions at this time and now will have infamy. Investors are likely to listen to them again, just because they moved a stock previously, regardless of how right or wrong they were. Mr. Donville does bring up the point that the higher regulations actually put the ‘long’ analysts’ at a disadvantage compared to those that are unregulated. One could argue either way for more or less regulations but we think everyone should be operating on a fair playing field regardless. We think the real focus should be on disclosure of conflicts of interest, something that is a facet of 5i Research given our truly no-conflict approach. With this type of information being everywhere on the Internet, how can it be prevented in the future? The best answer we can think of, without limiting free markets, would be that of investor education. Know what you are reading, who it is from, and the conflicts that are inherent, stated or otherwise. When you see a disclaimer such as this on a website or article “At any times the principals of [Company] might hold a position in any of the securities profiled on the site. [Company] will not report when a position is initiated or covered.” A cause for pause is likely warranted.

In life, it is always important to leave with a lesson, so lets see what we can summarize here:

• Bad news sells – The negative stories always get more attention in the media, for better or worse. People would have paid far less attention if another analyst were to come out and claim the stock was a ‘clear double’ in a year. This is really just human nature but an important thing to keep in mind when an investor feels like everyone is piling in on his or her losing investment. There is a buyer and seller to every trade; you just hear from the buyers a bit less.
• Diversification is key – Losing money is never good, but if VRX were left to a 5% position in a portfolio, damage would be mitigated for most investors.
• Do nothing, quickly – Sometimes reacting can be the worst course of action. In most cases the event is priced in almost immediately and reaction leads to bad timing decisions. We often prefer to let the dust settle and evaluate when we have all of the information.
• Understand the conflicts – If it is free and on an area of the Internet that is not a reputable source, assume that YOU or what action you take is/are the product. It is as true with Facebook users as it is with those who read free content on the Internet and do not take it with a grain of salt. It is important to understand what others have to gain and lose when taking these types of reports into consideration.
• KISS principle – We are very big proponents of the KISS principle and it is another reason why we actually like small-caps, which are often deemed higher risk. Small-cap companies usually have quite simplistic financials and business models. This simplicity can also be a risk in itself, but it can be far easier to understand what you are getting into compared to large-cap companies needing thousands of employ.

Regardless of the outcome, we hope this matter can be resolved quickly and that the retail investors are not the ones left holding the bag.