When the Seamen’s Union of the Great Lakes was negotiating with U.S. Steel (NYSE:X) in 1947, the corporation was always discussing ways to reduce labor hours. During one set of negotiations corporate leaders suggested cutting the paint brushes used for painting the ships’ bottoms from 2-inch width to 1-inch width. The labor leader (who was my grandfather) told them, “Well why not go to ½ inch and think about how much more money you could save?” It wasn’t until later that management made the link between the costs saved on the brushes and the amount of labor to paint something with one-fourth the original size paint brush.

I bring this up because the saga of Valeant Pharmaceuticals (NYSE:VRX) is something akin to the situation U.S. Steel found itself in during its labor negotiations. In its bid to find a new business model, the cost savings it looked to achieve simply moved risk from the income statement to the balance sheet. This sleight of hand produced a company that generated significant returns for investors for awhile but unfortunately was based on a foundation of very weak nature.

There is value in the company. Its Bausch & Lomb unit is a first-class ophthalmology company with considerable free cash flow. Other pieces of the company - with real products producing income - are also worth something, though perhaps less than some analysts think. However, $30 billion in debt undermines the value of all of these.

In general, biopharma companies take a great deal of risk discovering and developing new drugs. Much of this research and development has been outsourced to large contract research organizations (CROs) that conduct much of the legwork in the R&D process. This doesn't mean that large biopharmas remove the risk from their financial statements. Far from it. Most of these companies spend up to 18% of revenues in this discovery and development process. It’s a very messy business. Just ask any company that has spent money on Alzheimer’s research[1]. What made Valeant so different was it announced it was removing this risk by not engaging in any R&D. In fact, CEO Michael Pearson made clear that R&D was for - as Donald Trump would say - “losers.”

Valeant swapped R&D for debt

But there really is no way to avoid the discovery and development of new drugs. You can either take the job on yourself like the larger biopharma firms, or you can transfer that risk as debt on the balance sheet from acquisitive behavior. It should be noted that this latter approach has almost never worked in the past and rarely works now.

Want the financial benefits of curing disease? You have to take the risk yourself by doing the work yourself. Valeant chose to avoid such risk by acquiring small companies with generic or branded products already in the marketplace. This worked for awhile as it utilized price increases on these existing products to mitigate the danger of enormous amounts of short- and long-term debt. With both government agencies and payers taking a much harder look at such increases, the ability to meet this debt obligation looks far shakier.

Valeant’s gamble on growth
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With this acquisitive strategy you’d better be awfully successful at choosing the best drug candidates. Recent moves by Valeant show it may not be as gifted as it thinks. Its recent acquisition of Sprout for Addyi – a drug for the female libido (think of it as a female Viagra) – has been problematic at best. Insurers are denying or limiting coverage for the daily pill and large pharmaceuticals benefit managers are blocking it. The result: Many prescriptions written by doctors aren't getting filled. Projected sales of $1 billion have turned out to be wildly off. As to its comparison to male libido products, prescriptions for Viagra totaled 598,452 between March 27,1998 (when it was approved) through the end of April 1998, based on data from IMS Health. Addyi prescriptions totaled 227 from Oct. 17, when it became available to the public, through Nov. 6. Reasons for the difference? The drug provides results for only 10% more women than those on placebo and has severe requirements such as a total prohibition on alcohol. Failures of this sort can lead to disaster when your finances require a steady growth of increasing free cash flow to meet extraordinary amounts of debt.

There are three general lessons that we can learn from Valeant as we go forward.

When people say they have a new paradigm, watch your wallet
Throughout the history of health care, people have been pushing new reality-bending solutions to old problems. These include everything from cancer prevention products and weight loss products to zero-risk investment opportunities. In nearly every case there is a twist on a very old problem. Paradigm shifts can be very costly to your personal finances whether it’s that special GNC(NYSE:GNC) no-exercise diet or making money with little/no risk.

Excessive greed is not a corporate strategy

In the long term, excessive greed has a tendency to end badly on Wall Street. There is a certain amount of decency that is required in the business community. Fifteen percent profit margins are one thing, but 150% margins are – as Keb' Mo' would say – a "whole 'notha thang." Valeant’s overreach wasn't just the vast expansion of its balance sheet but the unmitigated greed in the price increases of its product line.

Financial markets are about trust

Ultimately Wall Street works on trust. Organizations have to believe that each will pay the other back, clearing houses will respect agreements, and investors have confidence in their investment holdings’ management. In Valeant’s case, Wall Street and investors have lost complete faith in the intelligence, integrity and competence of corporate management and its strategy. When that happens, there are very few places for that company’s investors to hide.

Conclusions

During their labor relations in 1947, U.S. Steel lost sight of its negotiation demands and its impact on the core business. In more modern parlance it bit its nose to spite its face. Valeant could learn a lot from those negotiations. The “new paradigm” of eliminating R&D only shifted risk from the income statement to the balance sheet. Its business model of increasing prices only added to that risk. When investors began to see that risk had not been mitigated by Valeant’s corporate strategy - but increased dramatically - the inevitable losses took place. To not see the connection has taught the company - and its investors - a valuable lesson about the fool and his money.

“Being able to sleep at night is one prerequisite for an investment manager. Understanding the value of your portfolio is another. They aren’t mutually exclusive but they aren’t the same thing either. If you follow this formula I think you will generate more than adequate returns”.
 
                                                               Scott Simmons
 
As value investors you hear a lot about circle of competence. Warren Buffett speaks about not going beyond the limits of this circle. Tom Watson - IBM’s founder - said, “I’m no genius, but I’m smart in spots, and I stay around those spots”.  At the Nintai Charitable Trust we certainly don’t count ourselves among the hallowed halls of genius, so we try to stick around our spots as well. But this really only tells half the story of our investment philosophy. We use a separate – but interlocking – circle we call the Circle of Comfort. This is a series of measures we use that allows us to sleep well at night. They mostly have to do with the quality of the business we invest in – balance sheet strength, management team, returns on equity/capital, etc. Let’s assume we didn’t sleep for one night, but rather we pulled a Rip Van Winkle and slept 15 years. My guess is our investment would be in the same business line but would be worth a great deal more than when we went to sleep. 
 
The Dual Circles
 
As shown in the graphic below we see our best opportunities in the overlap of our Circles of Comfort and Competence. This means we look for companies with the financial ability to withstand a tremendous series of shocks along with a business where we can identify and quantify where these might come from (such as regulatory changes to new competitive offerings). There aren’t that many companies that meet our criteria. Our screen (using Gurufocus’ All-In-One Screener) has a tendency to show roughly 140 companies the fit into our Circle of Comfort. From there we further whittle down the list by companies that reside in our Circle of Competence. 

A Working Example
As we mentioned, our “comfort” screen on Gurufocus brings up about 140 companies. You can recreate this screen by entering in the following criteria:

• Cash to Debt: >100
• Debt to Equity: 0
• ROA 10 YR Median: >15%
• ROE 10 YR Median: >15%
• ROC 10 YR Median: >15%

After creating this list we can quickly rule out some due to lack of a competitive moat (Fitbit - FIT), corporate structure (Hugoton Royalty Trust - HGT), or lack of industry expertise such as consumer retail (Luluman Athletica –- LULU). Of this list 9 companies are currently in the Nintai Charitable Trust portfolio. We definitely enjoy swimming in this part of the investment pool.
 
An example of such a holding is Intuitive Surgical (ISRG). Relative to our Circle of Comfort, the company has 10 year averages of 30% ROC, 91% ROE, and 17% ROA. The company has no debt and $1.6B cash/short term instruments on the balance sheet. ISRG converts roughly 30% of revenue into free cash (generating $691M in free cash last year) and maintained 26% net margins over the past 5 years. In the past 3 years the company has reduced outstanding shares from 41.1M to 37.9M. Overall we are quite comfortable the company could handle any series of catastrophic events including product litigation, public policy changes, and/or a deep recession. 
 
In regards to our circle of competence, we are quite comfortable in estimating market growth, adoption rates, and customer satisfaction within the robotic surgery space. With a pool of roughly 75 current ISRG clients we know and communicate with, we can maintain a deep understanding of key issues surrounding their product. Serving on several healthcare Boards also adds to our understanding of the space.
 
Conclusions
There are two models that guide my thinking at the Nintai Charitable Trust. The first is sleeping well at night by assuring I stay within my Circle of Comfort. This means finding compounding machines with rock solid balance sheets. Second is making sure I have deep knowledge of the industry in which the investment does business. This includes market drivers, competition, and public policy/regulatory issues. Through these I remain within my Circle of Competence. These models create a framework that assures I don't wander off into unsafe, unknown and unknowable investment traps. If that allows our Trust directors to sleep well at night and provide adequate returns we couldn't ask for any more. 

In the winter of 1928, Joe Kennedy decided to stop to have his shoes shined before he started his day's work at the office. When the boy finished, he offered Kennedy a stock tip: "Buy Hindenburg." Kennedy soon sold off his stocks, thinking "You know it's time to sell when the shoeshine boys start giving you stock tips. This bull market is over".
 
Over the years we’ve all seen events that indicate the high in the stock markets – blockbuster deals by private equity that have absolutely no chance of ever making a return (at least positive) for their investors[1], commercials that imply a tow truck driver owns an island/country[2], or the wave of “bubble funds” that seem to crop up every time during a market peak[3].
 
I bring these up because I recently saw a commercial[4] that certainly meets the criterion of hinting at a market high. In this case the hands down winner is the recent Super Bowl commercial for a company called SoFi. Its commercial model believes the yawing gap between have and have-nots is filled with those who are “great” and those who are “not great”. Frankly you are far more likely to be with the “not great” than the “great” according to their marketing.
 
So what does SoFi do? At it’s most basic it has taken the unicorn model (pumping an organization full of venture capital and private equity and delaying a public offering) writ large – providing loans for people who don’t need money (the great) and not providing loans for those who have a need (the not great). One of my favorite writers Felix Salmon has a great discussion about the commercial here. He cogently lays out the absurdity of the company’s message, its ridiculous valuation, and the improbability of spending a large percentage of its revenue on insulting marketing campaigns.
 
My take on SoFi is from a different angle. Much like Ambassador Kennedy’s feelings on getting a stock tip from the shoe shine boy, I think SoFi’s commercial is a warning signal for a potential market top. Combined with other news such as this and this, I recommend keeping your eye out for three clear markers of a market peak.   
 

1. Absurd/Extreme Financial Product Claims: Running a commercial that insults the vast majority of Americans is unlikely to provide a company with a lot of positive PR. More importantly, claiming that nearly everyone you meet on the street is “not great” is one of those absurd claims that seem to pop up when markets get frothy. Much like the tow truck driver owning an island, this is a commercial absurd in its claims and not worthy of investors’ time.
2. Poor Capital Allocation: In general, the markets should be the means of allocating capital where it can best achieve adequate returns for investors. The operative words here are “in general”. During periods such as 1999-2000 or 2006-2007 the markets can dramatically fail in this core function. Sometimes capital can follow trends and - much like the pack of proverbial lemmings - fall right off the sanity cliff. A great metric to keep your eyes on is private equity acquisitions. When you see a string of the largest PE deals ever made, it’s time to take a close look at your holdings.
3. Cheap Debt Floods the Market: Many winners in a frothy market are funded by cheap debt. Whether it’s a large private equity firm doing a $10B deal for a green nanotechnology technology firm or Valeant running up $30B in acquisitions, cheap debt is a great growth tool until it isn’t available anymore. With the Fed raising rates late last year it won’t take much more before we see cheap debt go the way of the dodo.

 
Why This Matters
 
It's a rather unfortunate - if not predictable - cycle where markets peak and irrational behavior suddenly takes hold. When you begin to see marketing such as the SoFi ‘s Super Bowl commercial, then you know there is far too much capital sloshing around the markets. It is remarkably easy to fall into Wall Street’s thinking about these types of investments. It is even more important to reject it in your investing strategy and capital allocation. At times like these I advise investors to bear in mind three thoughts.
 
You Are Not A Lemming….So Don't Act Like One
When Valeant Pharmaceuticals was reaching its peak valuation of roughly $250/share in the summer of 2015, it seemed nearly every successful hedge fund (and even a few mutual funds) had extraordinarily large positions in the company. Accordingly, you began to see individual investors bid up the shares wanting to be the next Bill Ackman. When a company bases its strategy on raising cheap debt, acquiring new holdings, slashing internal staff, and jacking up prices, it generally isn’t a real long-term winner. Ask Al Dunlap how that worked out for him. Just because every hedge fund is piling in doesn’t mean you should do so as well. Stick to your circle of competence, focus with value, and let compounding be your friend.
 
Keep a Keen Eye on Your Valuations
As the markets – and corporate valuations – get stretched, don't hesitate to take profits. Last year, the Nintai Charitable Trust saw nearly 60% turnover as we sold winners held since the early 2000s. If a fellow investor is willing to pay a 40% premium to your valuation, don’t hesitate to let them have it. Anchoring on a stock simply because it’s been very profitable is a fine way to see those gains dissipate.
 
This is the Worst Time to Get Intellectually Lazy
At market tops, it’s frequently believed that focusing on valuation is a sucker’s game. A great economist once said, “After one year of market gains most investors think they are lucky. After 5 years of market gains most investors think they are geniuses”. We’ve reached the stage where many investors believe they have greater than normal investment skills. They do not. As you see markets near their all-time highs its even more important to double check your assumptions and rerun your valuations.
 
Conclusions
It seems like just yesterday we were all writing about the perils of a bear market. The past month has seen the markets recover much of their losses with the S&P 500 roughly at the same levels as one year ago. At the Nintai Charitable Trust we find our purchases made in the last six months (Paychex, Linear Technology, SEI Investments) are up substantially and offer little to no discount to our estimated intrinsic value. It seems appropriate the shoeshine boy’s advice to Ambassador Kennedy was to buy Hindenburg. Much like the Zeppelin with the same name, markets (and stocks) that get grossly overinflated have a tendency to go up in flames with little to no warning. I suggest investors lock in profits from holdings that look grossly overvalued. Otherwise your long-term returns might be - in SoFi’s words - not so great.
 

[1] Such examples include commitments made during the height of the 2007 bubble including KKR/GS Capital’s acquisition of Harman and Cerberus’ acquisition of ACS busted deals.

[2] The full commercial can still be found here. It’s a nostalgic look back at a time of true market madness.

[3] Just ask the shareholders of the Merrill Lynch Internet Strategies Fund or the Chicken Little Growth Fund (I’m not making these up).

[4] The commercial can be seen here.