“In the field of monetary and credit policy, precautionary action to prevent inflationary excesses is bound to have some onerous effects--if it did not it would be ineffective and futile. Those who have the task of making such policy don’t expect you to applaud. The Federal Reserve, as one writer put it, after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up."[1]
            
                                                                                                      -     William McChesney Martin 

Early in his career, a relatively well-known behaviorist was watching students coming to class (many were late as usual) by taking the stairs at two – or even three – at a time without ever looking down. Mulling over a seminar he recently gave on “expecting the unexpected”, he decided to give in to his inner Sherlock Holmes[2] and asked maintenance to add a ½” thick plank on to the top stair. After roughly three out of four students tripped and fell (these were days before OSHA and uncontrolled civil litigation!), he told the class how remarkably large a half inch can be when people aren’t looking at where they are going and complacent in their inner thinking. His message: small things can lead to big events, especially when you aren’t aware of your surroundings.     
 
A Valuation Dilemma
 
I bring this up because I was recently talking with my colleague John Dorfman at Dorfman Value Investments about an interesting problem facing those of us who use a discounted cash flow method for calculating intrinsic value. In my recent review of several portfolio holdings, each had several of the same attributes: free cash flow growing at a reasonable rate, earnings increasing at high single digit rates, and management purchasing back shares. A last attribute came as a surprise. Each company saw its valuation drop over the past 6-month period. At first glance, I checked to see where I had misplaced a digit or entered an incorrect figure. Like the students left rubbing their knees and scratching their heads, my immediate reaction was that there was a problem based on my calculations or process.
 
The problem lay of course in the same way our speeding scholars missed that top step. Looking back at each calculation, it was clear the increase in the 10-year Treasury note yield was decreasing intrinsic value greater than the free cash flow growth was increasing intrinsic value. Much like our brilliant future scholars racing up the stairs, it’s amazing how much a difference a half point (or more) in the Federal Reserve discount rate can make in your valuations. This dilemma can frequently be seen near the end of bull markets and robust economies. As the Federal Reserve takes away Mr. Martin’s aforementioned punch bowl, increases in the federal funds rate can create enormous drag on your intrinsic valuation calculations.
 
How This Works: Calculating Intrinsic Value
 
Last year I outlined the main criteria I use in calculating a discount rate to use in my valuation tool set. There are 7 main criteria that create a discount rate range of 5 – 14%. These are the company specific attributes that impact my estimated total discount rate (or weighted average cost of capital). After these criteria are scored, I then add in the current yield of the 10-year Treasury note. This reflects the market conditions driven by the Federal Reserve. The total of these two give me the total discount rate I will apply to future cash flow used to generate the company’s intrinsic value.
 
Company Attributes
 
Company Size: Range 1-3 (1 = smallest 3 = largest)
Financial Leverage: Range 1-3 (1 = none 3 = heavily leveraged)
Cyclicality: Range 0.5-1 (0.5 = none 1 = highly cyclical)
Management/Corporate Governance: Range 1-3 (1 = outstanding 3 = poor)
Economic Moat: Range 1-3 (1 = wide moat 3 = no moat)
Complexity: Range 0.5-1 (0.5 easy to Understand 1 = rocket science)
 
Market Attributes
 
10 Year Treasury Rate: (Insert Number)
 
I should point out that my discounted free cash flow (DCF) model and rising rates will have a greater impact on two groups of companies. The first are those at the higher end of the quality spectrum. For a company with outstanding attributes that score 5 - 6% on the company specific factors, increases in the 10-year Treasury rate can have a far greater impact than a company with a poor score. The second group are companies with high levels of debt on the balance sheet. As rates go up, this will disproportionately affect companies with higher debt servicing requirements. Since I focus only on the former, I will leave issues related to the latter for another discussion.   
 
Let’s take a look at a current portfolio holding and a rising rate environment’s impact on its discount rate calculations and valuation.
 
A Working Example: Masimo
 
I wanted to use a holding here at Dorfman Value Investments to discuss the frustration of seeing a great company increase its free cash flow, maintain high returns on capital and equity, and keep a hawk’s eye on costs only to see its valuation drop. Masimo (MASI) is a mid-sized medical device company with no debt, little market cyclicality, outstanding corporate governance, and a deep competitive moat. Its company specific scores on the discount rate calculation spreadsheet is 7.00%.
 
With the 10 Year Treasury yielding 2.97% on June 12, 2018, the total discount rate would be 9.97% for Masimo. The 10 Year rate makes up roughly 30% of Masimo’s total discount rate. It may not seem like much, but the impact after a 1, 2, or 3% increase in the 10 Year rate can do truly horrible things to your calculated valuation.
 
At the current discount rate of 9.97%, I have Masimo valued at $105/share. Raise the 10 Year rate from 2.97% to 3.97% (increasing the total discount rate from 9.97% to 10.97%) and the valuation drops to $91/share. Raise it to 4.97% and my valuation drops to $80/share. With each full point increase in the 10 Year Treasury rate, Masimo’s valuation drops by roughly 10-12%. It’s important to remember that this is for a company with zero debt. For companies with extremely high debt loads valuation decreases can be greater and far steeper in nature.  
 
To make up for this lost dollar valuation, Masimo would need to increase my estimated 8% growth in free cash flow over the next 10 years to nearly 11% annually – an increase of nearly 27%. These are numbers I find highly unlikely to occur. The drop in valuation can’t be made up by tweaking the growth numbers. In reality, I am left holding a company in the portfolio worth less today than it was 6 months ago. Realized loss or not, this is a painful exercise for any investment manager.

Conclusions
 
Rising federal fund rates as exhibited by the 10 Year Treasury yield can have an enormous impact on corporate valuations. Even with improving fundamentals such as increased revenue, earnings, or free cash can be offset by the smallest increase in interest rates. These same rates act as a gravitational pull on market valuations – and ultimately – on market returns. While many argue whether the Fed’s decision to end quantitative easing and increase rates is too late or too early, investors should worry less about the punch bowl and more about market value and corporate valuations. Much like those graduate students running up the stairs, it doesn’t take much of an increase to force investors and markets to stumble.  
 
[1] This quote comes from a speech given on October 19, 1955, by William McChesney Martin, who served as Chairman of the Federal Reserve from 1951 through 1970, to the New York Group of the Investment Bankers Association of America. For those who are investing in a growing economy where the Fed is tightening rates and ending quantitative easing, there really isn’t a better read to influence your thinking. 

[2] This is from the classic case of Holmes asking Dr. Watson how many stairs there were on the way up to their flat. His retort was the classic “you see, but you do not observe”. 

DISCLOSURE: Masimo is held in several individual accounts managed by the author. 

​“To be nobody-but-yourself — in a world which is doing its best, night and day, to make you everybody else — means to fight the hardest battle which any human being can fight.”         
                                                                                                             -   e.e. cummings
 
Recently someone sent me a copy of my 2016 presentation at the Gurufocus conference and had some questions about my comments on Valeant. I believe the phrase used was that “I wouldn’t touch it with a ten-foot barge pole”. As I pointed out at the time, Valeant’s model of purchasing rights to drugs – some patented, some not – and dramatically rising prices wasn’t a long-term market strategy. Partnered with taking on $30B in debt for drug products that weren’t worth nearly that, and you had a ticking time bomb. I stated at the time there were some great quality businesses hidden in the story. The company seems to agree, with management announcing it was changing its name to one of these gems - Bausch Health.
 
I bring it up as I own another asset-light in-licensing biopharma in several of my clients’ portfolios – Biosyent (TSI: RX or OTC: BIOYF).  I purchased shares in the company in late 2017 and expect to be a long-term owner in the company. Similar to Valeant, Biosyent seeks out products that have underperformed (through lack of marketing dollars, lack of product fit, etc.) and in-license them to fully support an integrated sales and promotional strategy.
 
There are obvious differences between Biosyent’s business strategy and that employed by the former Valeant. The most significant differences are outlined in Biosyent’s three
criteria when looking for in-licensing or acquisition opportunities.
 

• Be a unique product with a specific market niche.
• Provide either a therapeutic or technology advantage for patients and healthcare professionals (HCPs). 
• Have strong market support with defendable intellectual property rights.

 
Compare these criteria with Valeant’s purchase of Sprout Pharmaceuticals in 2015. Sprout had recently received a controversial approval from the FDA to market Addyi, its female version of Viagra. The drug had initially been rejected after poor clinical trial data and finally received approval after a series of shaky clinical reviews with documented side effects when combined with alcohol or other drugs. With this, Addyi had already violated Biosyent’s second criterion. After purchasing Sprout for over $1B, the company assured Wall Street it would quickly recoup its purchase price by doubling the initial drug price from $400/dose to $800/dose. It also estimated drug sales would top $1B in its first year of sales. This number was lowered to $300-$400M later in the year then lowered to $100M. Actual sales came in $27M – a miss by over 99%. These numbers demonstrated Valeant violated Biosyent’s first and third criterion. In the end, Valeant was forced to write off roughly $940M of the Sprout acquisition as bad debt.
 
It shouldn’t come as any surprise that a comparison of key measures I look for in an investment were (and still are) vastly different between Valeant and Biosyent in 2016. 

Why This Matters
 
The ability to shy away from those “can’t lose” opportunities where management are “shifting paradigms” can be excruciatingly difficult. When all the heroes at the local cocktail circuits are talking about “creating synergies” standing pat doesn’t make you a great conversationalist. To paraphrase mr. cummings, the hardest journey in life is sometimes just fighting to be you – a value-driven investor. In that attempt, I believe value investors should keep several themes in mind. (Note: not all value investors - such as Mr. Buffett’s cigar-butt method - agree with these. I’m just more comfortable with is approach. Even my own friend and co-worker John Dorfman thinks me mad as a hatter sometimes).
 
 
Addition is Generally Better than Subtraction
As most people in private equity will tell you, investing in a company and providing increased capital to grow the business is far different (and potentially easier) than purchasing a failing one, slashing costs, and trying to right the ship. My nature in general is to avoid situations like the latter simply because my brain isn’t wired like that. Biosyent’s model – by its very nature – makes greater sense to me and I believe offers a better model for employees, patients, and shareholders. Biosyent management is focused on growing the top and bottom line with a laser-like focus on margins and returns on equity and capital. Growth for growth’s (and Wall Street’s) sake is not a generally successful long-term strategy.    
 
Capital Allocation is Critical
Biosyent’s focus on defensible products with clear IP rights, and a well-researched market base makes capital allocation a helluva lot easier than buying a pig in a poke and trying to confer thoroughbred status on the poor creature (how’s that for a mixed metaphor?). The example of Valeant’s acquisition of Sprout is an outstanding example of poor allocation of capital. Biosyent’s management measures its success on its ability to identify a potential target, purchase it at a fair value, and execute a commercial strategy that generates high internal rates of return on their acquisition. You really can’t ask much more from management. 
 
To Thy Own Self Be True
Biosyent has never deceived itself into thinking they are transforming the biopharmaceutical industry. Rather they see themselves as simply arbitraging away a difference between missed opportunities and market needs. They provide outstanding products to patients with diverse needs in smaller niche markets. They have not gone on record as destroying the pharmaceutical model, ridiculing research and development, or gaming the system on pricing. I’ve often used a quote from my first boss who said people get in real trouble when they begin to believe the lies. At the end of the day Biosyent is a biopharmaceutical company providing patients with medicines that improve – and sometimes – save lives. Nothing more, nothing less.
 
Conclusions
 
Ai its core, capitalism is (or should be) about capital seeking the best possible return on its investment. Great management will achieve great returns on that capital over a long period of time. The difference between Valeant and Biosyent couldn’t be more stark. Finding management similar to Biosyent’s is a rare event. Given time they will do the heavy lifting in your portfolio’s returns. By not straying into the public domain and being roundly abused by the latest TV carnival barker, individual investors can win that battle e.e. cummings warned against. In the end, the victory will be all the sweeter knowing your returns are uniquely your own.  
 
Disclosure: Biosyent is held in several individual accounts managed by the author.