original mungerville Posted February 23, 2015 Share Posted February 23, 2015 By the way, I am posting these high-level numbers hoping you guys will add detail to it, state where you agree / disagree, etc. How you look at from a valuation perspective, etc. Link to comment Share on other sites More sharing options...
giofranchi Posted February 24, 2015 Author Share Posted February 24, 2015 "The most extreme mistakes in Berkshire’s history have been mistakes of omission. We saw it, but didn’t act on it. They’re huge mistakes — we’ve lost billions. And we keep doing it. We’re getting better at it. We never get over it. There are two types of mistakes: 1) doing nothing; what Warren calls "sucking my thumb" and 2) buying with an eyedropper things we should be buying a lot of." -Charlie Munger Original mungerville, Let me ask you a question: we are entering the 7th year of a bull market in stocks, with a macro background we all know very well and basically agree about. Question: do you feel more comfortable owning leveraged companies or businesses which don’t make use of debt? Sincerely, I don’t understand: first you seem to be very cautious going foreword, you hold lots of cash and protections, but then you say an investment in VRX is “obvious” and you quote Munger about errors of omission… Well, I might be the only one to think $30 billion of debt is a lot… but assuming $5 billion of owner earnings in 2016, it takes 6 years of owner earnings to repay that debt… Unless, of course, you go on increasing owner earnings 25-30% annually… What seems amazing to me is that in point n.8 you use two times the word “conservative” to arrive at the prediction of owner earnings growth in between 25% and 30% annually from 2016 to 2022… What are then aggressive projections??! I don’t know of any other company in which I am confident to say owner earnings might grow 25%-30% from here until 2022… Therefore, this is what I think: VRX is a wonderful business, and you as a shareholder will do incredibly well… But don’t tell me VRX is an “obvious” investment… Because VRX is doing something no one else is able to do… And to justify $30 billion of debt it must go on doing something no one else is able to do… Certainly not my definition of an “obvious” investment! No, I don’t think I see it, but don’t act on it… The problem here for me is I cannot see clearly enough. Gio Link to comment Share on other sites More sharing options...
giofranchi Posted February 24, 2015 Author Share Posted February 24, 2015 With $30 billion of debt, what might happen if Pearson is wrong about the next major acquisition? Pearson is just great, fantastic!… But even he is not a Marvel superhero… He can make mistakes. Where is protection from the downside, when $30 billion of debt are justifiable only as long as Pearson keeps performing like a Marvel superhero? Gio Link to comment Share on other sites More sharing options...
giofranchi Posted February 24, 2015 Author Share Posted February 24, 2015 Liberty, original mungerville, I ask this, because I really like VRX and greatly admire Pearson, and I truly would like to be “convinced” that even with all that debt there is still some room for error… I would feel much better about investing in VRX, if I believed that a large acquisition which doesn’t turn out to be as profitable as expected could get managed without too much distress… But in such a case wouldn’t all that debt become too burdensome? If you are not worried about it, why? Thank you! Gio Link to comment Share on other sites More sharing options...
Cageyone Posted February 24, 2015 Share Posted February 24, 2015 Here is my dilemma. As a retiree with mandatory monthly withdrawals from my tax sheltered account (100 per cent in equities) I'm trying to keep about a year's future withdrawals in cash to minimize the risk of being forced to sell in a down market. So on two occasions since the AGN non event I've reduced by 20 percent my VRX holding, both times at near 52 week highs, only to see the VRX SP streak higher each time! I don't like VRX's high debt and questionable acquisitions (eg Provege) but clearly Mr Market does! Link to comment Share on other sites More sharing options...
Happy Posted February 24, 2015 Share Posted February 24, 2015 I would feel much better about investing in VRX, if I believed that a large acquisition which doesn’t turn out to be as profitable as expected could get managed without too much distress… But in such a case wouldn’t all that debt become too burdensome? If you are not worried about it, why? With 20% targeted IRR before the big tax benefits they leave a large margin of safety for things to go wrong. As they always seem to overdeliver on synergies they don't seem to be too hard to estimate in advance for them. So if they really messed up in their assumptions they might still earn a 0-5% IRR (but have a significant amount of capital tied up). In that case it would just take longer for them to delever to a point where they feel comfortable taking on the next big one. If the economy also tanks right after they messed up hard, that certainly wouldn't make things easier but both together seem like a low-probability event that you could probably establish for almost any company. If just one of the two happens it will take longer to delever, but they generate enough cash with their current business to grow out of it over time (will certainly hurt returns but shouldn't be a total disaster either). I just think their high return requirements + big tax benefits leave such a big margin of safety that they will be able to handle things when it turned out they made a mistake. The big assumption behind all of this obviously is that Pearson knows what he is doing and that their business model is superior to what the rest is doing, but I believe that to be the case. Link to comment Share on other sites More sharing options...
giofranchi Posted February 24, 2015 Author Share Posted February 24, 2015 With 20% targeted IRR before the big tax benefits they leave a large margin of safety for things to go wrong. As they always seem to overdeliver on synergies they don't seem to be too hard to estimate in advance for them. So if they really messed up in their assumptions they might still earn a 0-5% IRR (but have a significant amount of capital tied up). In that case it would just take longer for them to delever to a point where they feel comfortable taking on the next big one. If the economy also tanks right after they messed up hard, that certainly wouldn't make things easier but both together seem like a low-probability event that you could probably establish for almost any company. If just one of the two happens it will take longer to delever, but they generate enough cash with their current business to grow out of it over time (will certainly hurt returns but shouldn't be a total disaster either). I just think their high return requirements + big tax benefits leave such a big margin of safety that they will be able to handle things when it turned out they made a mistake. The big assumption behind all of this obviously is that Pearson knows what he is doing and that their business model is superior to what the rest is doing, but I believe that to be the case. Thank you Tom1234! :) Those who are not worried about debt reason along the same lines of thought? Gio Link to comment Share on other sites More sharing options...
giofranchi Posted February 24, 2015 Author Share Posted February 24, 2015 Is it possible to never lose money in the investment world? This is the doubt I have… So if they really messed up in their assumptions they might still earn a 0-5% IRR Really messed up… and make a positive return nonetheless?! Wow! It just seems strange to me… Even difficult to accept as the worst case scenario… I mean, even Buffett made some mistakes in investing that have cost Berkshire serious money throughout the years, both in insurance, and in operating businesses, and in the stock market… Is it possible the worst case scenario for VRX is a large investment on which the IRR is 0-5%? I don’t know… I am asking, because I am trying to get a clearer picture. Gio Link to comment Share on other sites More sharing options...
giofranchi Posted February 24, 2015 Author Share Posted February 24, 2015 During the last 3 years VRX has made 22 acquisitions… And not a single mistake? At the same pace from here until 2022 VRX will have purchased 59 more businesses… And not a single mistake? No business that turns out to be a money loser? Even consumer products are durable just as long as consumers’ preferences don’t change, or better products are devised and brought to the market… Is it possible Pearson might truly understand and rightly predict the future for all the products VRX acquires? If this actually happens, I think Pearson will leave Buffett’s investing track record in the dust… Gio Link to comment Share on other sites More sharing options...
Happy Posted February 24, 2015 Share Posted February 24, 2015 I'm interested in other opinions as well. But it seems like the industry has a lot of fat that you can cut, still generally has high margins where it is a long way towards losing money on a product and Valeant is looking for durable products with reasonably predictable cash flows and many smaller products rather than 1-2 blockbusters so they are well diversified. When someone like Pearson has proven that he generally overdelivers and is disciplined enough to walk away if the price doesn't make sense anymore, it's hard for me to imagine that he will misjudge things so badly that he really loses money over the period where he expected to already earn the initial investment back. Buffett made mistakes, but it seems a lot harder for me to move from industry to industry and figure out the companies and where the industry is going than to basically be an activist in the one industry you know inside out and buy high-margin businesses at a reasonable price, cut out the fat with the formula you have shown works and have huge tax benefits on top. 0-5% IRR can't be the absolute worst case as there is always a small chance that something truly terrible happens, but if you worry about that and the economy tanking right after you can't invest your money anywhere because nothing is 100% safe :) Link to comment Share on other sites More sharing options...
giofranchi Posted February 24, 2015 Author Share Posted February 24, 2015 0-5% IRR can't be the absolute worst case as there is always a small chance that something truly terrible happens, but if you worry about that and the economy tanking right after you can't invest your money anywhere because nothing is 100% safe :) If debt were lower and more easily manageable, I wouldn’t worry at all! I wouldn’t worry even if Pearson might finally commit a major blunder… It is debt that makes me nervous… Because I think debt dangerously shrinks any room left for error… Anyway, thank you! Gio Link to comment Share on other sites More sharing options...
Liberty Posted February 24, 2015 Share Posted February 24, 2015 Of course Valeant has made mistakes, they even talk about that. The important thing is: How big are those mistakes, how are they fixing them, how are they learning from them? They've clearly admitted, for example, that cuts in the salesforce of Medicis was a mistake, and they learned from it for B&L and that acquisition was no doubt much smoother because of it. Same way that I'm sure Buffett learned from Dexter Shoes and General Re's derivatives and such. As for the ability to carry debt, that's a business determination that each investor must make for themselves. The way I look at it, some businesses can carry leverage, and some can't. Those that can tend to have certain characteristics that I see in Valeant, like stable, predictable, growing cashflows that are not susceptible to big single risks. That's why Malone likes subscription models with millions of tiny customers. Big pharma with blockbuster drugs and large R&D budgets are a lot more unpredictable, because when a blockbuster goes off patent or is challenged for whatever reason, you lose all of a sudden a huge chunk of revenue, and big R&D spending is also an unpredictable element because you can spend a lot until later stages of a project and it can lead to nothing. You also have a much smaller margin of safety if you spend most of your gross margin on SGA, taxes, and R&D. Valeant has thousands of small drugs, spread geographically across the world and across therapeutic areas. These assets were selected for strong growth and durability, and because they aren't at the whims of government reimbursement rules and such. In other words, risk is spread, cashflows are more stable and predictable. So you have to ask yourself what would need to happen for these cashflows to be materially affected? People around the world stop buying the creams recommended by their dermatologists and the contact lenses prescribed by their eye doctor? People stop getting traveler' diarrhea? I also think that the debt must be looked at from a business perspective, not just "oh, it would take the X years to pay it back". It's not like they're an unprofitable business that is funding operations with a credit card and at some point they'll run out of rope, and the best thing they can do it pay it back. What Valeant are doing is exchanging debt for assets, and these assets are more valuable than the debt, in good part because of Valeant's model. They are more disciplined than competitors on price - the vast majority of things they buy are private businesses and they are the lone bidder - yet assets are worth more in their hands than they are in competitors' hands because of the lean model, the "low-margin mindset in a high-margin industry", the low tax rate, the large worldwide salesforce which can leverage new assets coming in, etc. There's a margin of safety right there, like being an activist investor, or creating your own catalyst in a way. Look at almost anything they bought. They paid a reasonable price, and bam, the next day they own something that's already worth more because taxes went down double digits. Then 6 months or a year later the restructuring is done and the SGA has been cut down significantly, R&D has been rationalized, manufacturing consolidated, wasteful practices are gone, etc, and it's worth even more than on the day it was acquired. In fact, we've mostly seen organic growth pick up post-acquisition, so on that front too the businesses are worth more (the main exception is Biovail, but that one was done for different reasons, it brought billions in benefits indirectly from the inversion). What Valeant is basically doing is exchanging a 10 dollar bill for a 20 dollar bill (the businesses it gets are worth more in their hands than the debt they're taking on in exchange). Anyone who can exchange mid single-digit debt for businesses giving them high double-digit returns would be stupid not to do it. But of course, there's no guarantees, which is where business-like judgement is required. Link to comment Share on other sites More sharing options...
Liberty Posted February 24, 2015 Share Posted February 24, 2015 0-5% IRR can't be the absolute worst case as there is always a small chance that something truly terrible happens, but if you worry about that and the economy tanking right after you can't invest your money anywhere because nothing is 100% safe :) If debt were lower and more easily manageable, I wouldn’t worry at all! I wouldn’t worry even if Pearson might finally commit a major blunder… It is debt that makes me nervous… Because I think debt dangerously shrinks any room left for error… Anyway, thank you! Gio Gio, could you please tell me what type of scenario you are envisioning that could make the debt problematic? Like, they buy a big, profitable, growing company, and after the acquisition it turns out it's losing tons of money and shrinking? Or there's a global recession big enough that people all around the world stop buying products in all countries and all categories at the same time for long enough that we come to the debt maturities without the ability to refinance? What's the outline of a scenario that you're afraid of. I'm curious. Link to comment Share on other sites More sharing options...
giofranchi Posted February 24, 2015 Author Share Posted February 24, 2015 Thank you, Liberty! Your view on VRX’s debt is very helpful. :) Cheers, Gio Link to comment Share on other sites More sharing options...
giofranchi Posted February 24, 2015 Author Share Posted February 24, 2015 Gio, could you please tell me what type of scenario you are envisioning that could make the debt problematic? Well, Salix went from $30 in 2010 to $170 in September 2014. Then in November 2014 it gets accused of stuffing its inventory, making its sales growth appear artificial. And the stock goes down 50%. The CEO and CFO resign, lawsuits ensue, etc. Then rumors of a sale begin, and the stock recovers. Pearson now accepts to buy at $158 per share, quite near its all-time high. I am sure Pearson knows what he is doing now, but it doesn’t seem a deal without risks to me… What if he is wrong on a deal that doubles VRX’s debt level? I understand he is giving away something which costs him 6% to get an asset that might earn 20%... But the 6% is sure, the 20%, though very probable, might not be that sure… Listen, in my experience business is difficult… I don’t know what might go wrong… But I usually have a very hard time thinking that nothing could ever go wrong! And the idea of having put myself in the situation of paying 6% over $30 billion no matter what happens to my business makes me somewhat nervous… Though for something as good as VRX, I am trying hard to control this feeling of discomfort! ;) Gio Link to comment Share on other sites More sharing options...
original mungerville Posted February 24, 2015 Share Posted February 24, 2015 "The most extreme mistakes in Berkshire’s history have been mistakes of omission. We saw it, but didn’t act on it. They’re huge mistakes — we’ve lost billions. And we keep doing it. We’re getting better at it. We never get over it. There are two types of mistakes: 1) doing nothing; what Warren calls "sucking my thumb" and 2) buying with an eyedropper things we should be buying a lot of." -Charlie Munger Original mungerville, Let me ask you a question: we are entering the 7th year of a bull market in stocks, with a macro background we all know very well and basically agree about. Question: do you feel more comfortable owning leveraged companies or businesses which don’t make use of debt? Sincerely, I don’t understand: first you seem to be very cautious going foreword, you hold lots of cash and protections, but then you say an investment in VRX is “obvious” and you quote Munger about errors of omission… Well, I might be the only one to think $30 billion of debt is a lot… but assuming $5 billion of owner earnings in 2016, it takes 6 years of owner earnings to repay that debt… Unless, of course, you go on increasing owner earnings 25-30% annually… What seems amazing to me is that in point n.8 you use two times the word “conservative” to arrive at the prediction of owner earnings growth in between 25% and 30% annually from 2016 to 2022… What are then aggressive projections??! I don’t know of any other company in which I am confident to say owner earnings might grow 25%-30% from here until 2022… Therefore, this is what I think: VRX is a wonderful business, and you as a shareholder will do incredibly well… But don’t tell me VRX is an “obvious” investment… Because VRX is doing something no one else is able to do… And to justify $30 billion of debt it must go on doing something no one else is able to do… Certainly not my definition of an “obvious” investment! No, I don’t think I see it, but don’t act on it… The problem here for me is I cannot see clearly enough. Gio Hi Gio, I understand your general concerns: - In terms of the macro, I am more than covered with various hedges. - I did not say buying in here is "obvious", I think I said that when the price was 50-65% of today's price and debt was $15 billion less - which is when I bought. - My rambling recently with my outline of the numbers is me trying to figure out if I should sell (this is what I was thinking on Sunday because I could not see where the value was going to come from), hold (this is where I was on Monday), and then I figured why not make a case for how this might even make sense to buy (which is why I posted the above thread). And this is exactly the conversation I want to have because I don't like $30 billion in debt (like you) but I am trying to make sure that I am not missing an opportunity here. - Let's turn this thing into a bad story (invert). As noted above, I have the macro covered, so the big risk for me is if they make a bad acquisition, and that can certainly happen. Paul Tudor Jones has a rule where he will not trade unless he sees 5 in upside for every 1 in downside. If we use that as a basis, the key question as you stated is: what is the downside if they make a bad acquisition? Let us say Salix is a flop and figure out where the stock would end up. I think even with a flop, returns on Salix should cover debt interest (lets say a 5% return is a complete flop, don't forget that Pearson can cut away whatever is not working and Valeant's tax rate is only 5% which is hard not to benefit from) however Valeant ratings would be downgraded. Earnings would be 4 billion instead of $5 billion in 2016. The equity multiple on those earnings, after a big flop, would be no higher than 10x. So market cap around $40 billion, possibly lower. Enterprise value might be no higher than 12x (especially if the junk bond yield market overall starts to widen, but I am covered with my macro hedges there), with $30 billion in debt (and only $4 billion in earnings), this would mean equity valuation could be even lower ($4B X 12 = $48 billion; $48 billion minus $30 billion = $18 billion market cap. So maybe the market cap could drop from from current $66 billion to say $20 to $40 billion. Let's call that a 50% downside from here. Based on 5:1, the upside would have to be 250% upside which I can actually see but that would be in 2022 which is a long long way away. A time which should include a major recession with asset levels very high and central banks out of ammo, the return of massive deflationary forces and/or a new monetary system in my view. So pretty scary environment between now and then in my opinion (mainly taken from Ray Dalio). At 50 to 65% of today's price, before the Salix acquisition, it was obvious to me. And apparently obvious to Lou Simpson, Value Act, and Sequoia was still holding their enormous 20% of the entire fund stake. I don't think this is obvious at all at this price - which is why I wanted to have a conversation. When I am sure, I don't really need to converse with you guys!! ... I certainly don't make a secondary post asking you guys to reply!!! Link to comment Share on other sites More sharing options...
Liberty Posted February 24, 2015 Share Posted February 24, 2015 Low-key interview with Pearson on Bloomberg. Nothing new... http://www.bloomberg.com/news/videos/2015-02-23/how-valeant-stands-to-benefit-from-salix-acquisition Link to comment Share on other sites More sharing options...
Liberty Posted February 24, 2015 Share Posted February 24, 2015 Gio, could you please tell me what type of scenario you are envisioning that could make the debt problematic? Well, Salix went from $30 in 2010 to $170 in September 2014. Then in November 2014 it gets accused of stuffing its inventory, making its sales growth appear artificial. And the stock goes down 50%. The CEO and CFO resign, lawsuits ensue, etc. Then rumors of a sale begin, and the stock recovers. Pearson now accepts to buy at $158 per share, quite near its all-time high. I am sure Pearson knows what he is doing now, but it doesn’t seem a deal without risks to me… What if he is wrong on a deal that doubles VRX’s debt level? I understand he is giving away something which costs him 6% to get an asset that might earn 20%... But the 6% is sure, the 20%, though very probable, might not be that sure… Listen, in my experience business is difficult… I don’t know what might go wrong… But I usually have a very hard time thinking that nothing could ever go wrong! And the idea of having put myself in the situation of paying 6% over $30 billion no matter what happens to my business makes me somewhat nervous… Though for something as good as VRX, I am trying hard to control this feeling of discomfort! ;) Gio Indeed. As with any company that does M&A, you have to trust the due diligence process to some extent. Fairfax makes big acquisitions too, and has been burned very badly in the past. Why are you comfortable they won't make a big mistake soon? Pearson's track record is pretty good, and you could say that doing lots of small deals does build up experience for the DD team. I also think that as a ex head of McKinsey's pharma stuff, he's spent his whole career looking inside a lot of businesses. Chances are he was already pretty familiar with many of the companies he's looking at acquiring now. Not all CEOs have that background with other companies. I think the thing that makes me more comfortable with Salix is that there's a new management that has been auditing the company for a while, and in their DD process Valeant had access to inventory info from wholesalers (they said that they had "almost perfect information" by SKU and by distributor -- this isn't Salix giving them that info, it's the distributors, so you would have to not trust them either). They've already put 500m of inventory workout in the deal model and I think they mentioned on the call that they also made provisions for potential further problems if they were to arise, so the numbers they're giving us already include a pretty big margin of safety, they aren't a "everything goes perfectly" projection. I would be very surprised if they didn't over-deliver on synergies by at least 100m, and remember that their deal model is done at statutory tax rates, not at Valeant's actual tax rate, so there's another margin of safety there too. Link to comment Share on other sites More sharing options...
giofranchi Posted February 24, 2015 Author Share Posted February 24, 2015 Fairfax makes big acquisitions too, and has been burned very badly in the past. Why are you comfortable they won't make a big mistake soon? I am not comfortable at all! That’s why, though I would have preferred a rights offering rather than selling shares to new shareholders, I like the fact they have chosen not to raise their debt level. If you don’t owe anything to anyone, your business results may go up and down without feeling the pain too much. To owe lots of money might make business sense, like you have so clearly explained, but you better be sure business results go up and stay up… This is what makes me uncomfortable… Gio Link to comment Share on other sites More sharing options...
giofranchi Posted February 24, 2015 Author Share Posted February 24, 2015 Anyway, this is what I am going to do: each month my company gives me some cash, little more than 1% its capital of today, and I will start buying VRX again with that cash. I will gradually build a position that won’t be too large, in case a very low probability bad event happens, but which could have nonetheless a meaningful beneficial impact on my company’s portfolio of investments, if VRX actually manages to increase Cash EPS at 20-25% annual from here until 2022. Cheers, Gio Link to comment Share on other sites More sharing options...
Liberty Posted February 24, 2015 Share Posted February 24, 2015 Fairfax makes big acquisitions too, and has been burned very badly in the past. Why are you comfortable they won't make a big mistake soon? I am not comfortable at all! That’s why, though I would have preferred a rights offering rather than selling shares to new shareholders, I like the fact they have chosen not to raise their debt level. If you don’t owe anything to anyone, your business results may go up and down without feeling the pain too much. To owe lots of money might make business sense, like you have so clearly explained, but you better be sure business results go up and stay up… This is what makes me uncomfortable… Gio But Fairfax is levered, just in a different way. In fact, it's why they had to so aggressively hedge, because otherwise a big shock could have had a big impact on their equity. I'd say skin creams and contact lenses are more predictable than hurricanes and floods, but maybe it's just me ;) Valeant's organic growth has been accelerating for quite a while, but who the heck knows what will happen in insurance or with interest rates (which matter when you have a bond porfolio that is multiples of your equity)... You have to pick the risks that you are comfortable with. Link to comment Share on other sites More sharing options...
Liberty Posted February 24, 2015 Share Posted February 24, 2015 Anyway, this is what I am going to do: each month my company gives me some cash, little more than 1% its capital of today, and I will start buying VRX again with that cash. I will gradually build a position that won’t be too large, in case a very low probability bad event happens, but which could have nonetheless a meaningful beneficial impact on my company’s portfolio of investments, if VRX actually manages to increase Cash EPS at 20-25% annual from here until 2022. Cheers, Gio What do you mean? Are you going to buy a company that has 30bn of debt when we're 7 years into a bull market? ;) Link to comment Share on other sites More sharing options...
giofranchi Posted February 24, 2015 Author Share Posted February 24, 2015 But Fairfax is levered, just in a different way. In fact, it's why they had to so aggressively hedge, because otherwise a big shock could have had a big impact on their equity. I'd say skin creams and contact lenses are more predictable than hurricanes and floods, but maybe it's just me ;) I don’t agree. Float is a completely different beast. That’s why, as long as you underwrite profitably, Buffett says float is even more valuable than equity. They must be good enough underwriters, of course! And that is the business judgement you have to make. But to compare the predictability of creams and contact lenses with the predictability of hurricanes and floods imo doesn’t make any sense at all… The hedging thing is also a myth imo: a big shock could have a similar impact on MKL’s equity, and yet they don’t hedge… ;) Gio Link to comment Share on other sites More sharing options...
Liberty Posted February 24, 2015 Share Posted February 24, 2015 But Fairfax is levered, just in a different way. In fact, it's why they had to so aggressively hedge, because otherwise a big shock could have had a big impact on their equity. I'd say skin creams and contact lenses are more predictable than hurricanes and floods, but maybe it's just me ;) I don’t agree. Float is a completely different beast. That’s why, as long as you underwrite profitably, Buffett says float is even more valuable than equity. They must be good enough underwriters, of course! And that is the business judgement you have to make. But to compare the predictability of creams and contact lenses with the predictability of hurricanes and floods imo doesn’t make any sense at all… The hedging thing is also a myth imo: a big shock could have a similar impact on MKL’s equity, and yet they don’t hedge… ;) Gio Leverage is leverage, it cuts both ways. Float has a lower cost than debt if you underwrite well over a full insurance cycle, that's true, but the effect on the returns to shareholders is similar. If Fairfax does something stupid with its float, they can more easily wipe our their equity than if they didn't have any float, just like a company with debt can do the same. In a cyclical business or with non-durable assets (a mine, an oil well), paying back the debt and keeping it low is paramount because your cashflows have a limited life. But with durable businesses, you can stay levered permanently and that's just part of the model, like float is for insurance. Malone doesn't intend to ever pay down all his debt on businesses that can support it, and I doubt Valeant does too (if they couldn't make acquisitions, they'd probably keep levered up by buying back stock, like QVC and SIRI). Fairfax has a lot of low-cost float (hasn't always been low cost, might not always be), but they have to invest most of it in bonds and safe things because insurance has a claim on it, and they sometimes have to carry expensive hedges to protect their equity because of the leverage (another option would be to delever to a level similar to MKL, for example). Valeant is paying more for its debt than FFH is paying for its float, but it doesn't have to invest most of it in bonds and safe thing, it can go for much higher-return opportunities. If these opportunities offer better returns on average by at least the cost of debt, than Valeant's debt is actually quite a good deal even compared to insurance float. Insurance float isn't magical, it's just a way to lever up; it has benefits (low cost, durable), and disadvantages (restricted in what you can do because of insurance needs) The hedging thing is also a myth imo: a big shock could have a similar impact on MKL’s equity, and yet they don’t hedge… ;) Look at the ratio of assets to equity at MKL vs FFH (granted, the difference used to be higher not too long ago - but I think over the cycle it's mostly been much wider than now), and look at the kind of things they invest in in their equity portfolio. That's where the differences are. Sanjeev has made a compelling argument a while ago about exactly this, and I mostly defer to his expertise on this one. Link to comment Share on other sites More sharing options...
giofranchi Posted February 24, 2015 Author Share Posted February 24, 2015 You cannot compare creams and contact lenses with hurricanes and floods, because imo it is conceptually wrong. The predictability of creams and contact lenses should be compared to the predictability of FFH’s investments in its portfolio (bonds and stocks), while the predictability of what Valeant has to pay on its debt (a sure thing) should be compared to the predictability of what FFH has to pay on its float (here instead we have the possibility it doesn’t have to pay anything!). Last time I checked MKL’s stock portfolio was a larger percentage of their equity than FFH’s… But now I will check again! ;) Gio Link to comment Share on other sites More sharing options...
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