Wisdom of Charlie Munger: Collapse of Valeant inevitable – ITT, Enron redux

(Bloomberg) — Charles Munger saw it coming, and now he’s shaking his head.

Months before Valeant Pharmaceuticals International Inc. tumbled under attack from short sellers, Munger told investors in Los Angeles the company reminded him of the excesses of the 1960s conglomerate craze. “I’m holding my nose,” Warren Buffett’s longtime business partner said.

Turns out, those remarks were just the start of his concerns.

In an interview Saturday, Munger tore anew into the besieged drug company, calling its practice of acquiring rights to treatments and boosting prices legal but “deeply immoral” and “similar to the worst abuses in for-profit education.” In his role as chairman of Good Samaritan Hospital in Los Angeles, Munger said, “I could see the price gouging.” And speaking as a storied value investor, he said, its strategy isn’t sustainable: “It’s deeply wrong.”

Once a high-flying stock — and a darling of star money managers like Bill Ackman– Valeant has slid more than 60 percent since its peak in August. A short-seller accused it of using a mail-order pharmacy, Philidor RX Services LLC, to inflate sales and engage in accounting tactics reminiscent of Enron Corp., the power trader that collapsed in 2001. Lawmakers are examining how Valeant set higher prices for medications.

The company denied the short-seller’s allegations in a conference call on Oct. 26 and said Friday it would sever ties with Philidor. It also has said that price increases for treatments are often whittled down in negotiations with insurers.

‘Holding My Nose’

“We operate our business based on the highest standard of ethics, and we are confident in our compliance with applicable accounting rules, regulations and laws,” Laval, Quebec-based Valeant said in an e-mailed statement Sunday. “Our commitment is to the patients who use our drugs, the doctors who prescribe them, our partners who make them available across the country, and to our shareholders.”

Munger’s stance has extra significance, because some of the drugmaker’s largest shareholders follow the style of investing that he and Buffett, 85, popularized. Ackman frequently expresses his admiration for their firm, Berkshire Hathaway Inc. And Valeant’s largest investor, Ruane Cunniff & Goldfarb, which runs the Sequoia Fund, shares a decades-long history with Buffett.

Munger, 91, brought up Valeant in March, before an audience of about 200 people assembled to hear him at the annual meeting of Daily Journal Corp., where he is chairman. He was discussing a passage in Buffett’s recent letter.

Companies like ITT Corp., Munger said, made money back in the 1960s in an “evil way” by buying businesses with low-quality earnings then playing accounting games to push valuations higher. Investment managers looked the other way. And worse, he added, it was happening again.

“Valeant, the pharmaceutical company, is ITT come back to life,” Munger said at the gathering. “It wasn’t moral the first time. And the second time, it’s not better. And people are enthusiastic about it. I’m holding my nose.”

Unlike Enron

ITT acquired more than 350 companies during its years as a conglomerate, wrapping together Sheraton hotels, Avis Rent-a- Car, the maker of Wonder Bread and other businesses. It broke up in 1990s. One of its descendants, an industrial company, later took back the name.

As Valeant’s stock plummeted over the past two weeks, some big shareholders came to its defense, propelling the debate into a business-media spectacle. Ackman held a four-hour presentation on Friday, comparing the company to Berkshire as he sought to persuade investors that Valeant should be trading higher. His pitch fell flat, and the stock closed lower.

Ackman said during the presentation that he spoke with Munger about his March remarks. The Berkshire vice chairman’s objections focused on leverage, tax rates and acquisitions, and Munger explained that he says what comes to his mind, according to Ackman.

Munger elaborated on Saturday: Valeant relied on “gamesmanship” to run up its value. Its strategy, using acquisitions and price increases, is different from ITT, but it still created a “phony growth record,” he said. Unlike Enron, Valeant’s stock isn’t a house of cards because it has some valuable properties, including its portfolio of treatments, he said.

Old Ties

Valeant said Sunday that it sets prices that reflect the value of its drugs, and that it offers assistance programs to “remove the financial obstacles that may keep patients from obtaining the medications they need.”

A spokesman for Ackman declined to comment further on Munger’s latest remarks, referring to the Friday presentation. Sequoia’s managers, Robert Goldfarb and David Poppe, didn’t respond to messages seeking comment. They also have defended their investment.

Buffett’s ties with the fund stretch back decades. In 1969, he shut down his investment partnership to focus on Berkshire and suggested that clients put their money with William Ruane, a friend from Columbia University.

Ruane co-founded the Sequoia Fund in 1970 along with Richard Cunniff. Over the next decades, the pair used many of the same investing strategies that Buffett and Munger employed, looking for undervalued stocks that would climb over the long- haul. While both Ruane and Cunniff are now deceased, Berkshire is the second-largest holding at the $8.1 billion fund.

The biggest is Valeant. On June 30, the holding accounted for 29 percent of assets, largely because it had gained so much since Ruane Cunniff bought the stock.

Dismissing Comparison

Munger’s critique has been a topic of conversation at the fund manager. At a May investor meeting for Ruane Cunniff, someone asked what Goldfarb and his colleagues thought about the dig from Buffett’s right-hand man, according to a transcript of the event.

Ruane Cunniff dismissed the comparison to ITT, saying that Valeant is more concentrated in a single industry and less likely to dilute shareholders by issuing stock to fund deals. The share plunge in recent weeks has pushed Sequoia’s current managers to publicly defend their pick to investors.

“Valeant is an aggressively managed business that may push boundaries, but operates within the law,” they wrote in a letter last week. The recent value of $110 a share “does not strike us as a rational price for a company with a diverse collection of product lines and strong earnings growth.”

Having so much of the fund in one company troubled two of its independent directors — Vinod Ahooja and Sharon Osberg — who resigned last week, the Wall Street Journal reported Thursday, citing an unidentified source. The fund’s chairman, Roger Lowenstein, confirmed the departures, without giving a reason for why they stepped down.

Praising Goldfarb

Munger said Saturday that he had lots of admiration for Goldfarb, adding that “he’s been very right” on Valeant because the Sequoia Fund invested so early in the drugmaker.

It’s easy to see why investors have been so taken with the stock, Munger said. “It looks kind of Buffett-like,” because Chief Executive Officer Mike Pearson “cut out all the glitz” of running a drug company, he said. However, Valeant’s tumbling share price shows why morals should still be a part of the calculation for making an investment, Munger said.

“They’re deeply intertwined,” he said. “I don’t think that investing should be divorced from reality.”