This week has seen epic implosions in the stock market: Beleaguered drugmaker Valeant Pharmaceuticals Intl Inc (VRX) plunged 50% on Tuesday, followed by Peabody Energy Corporation’s (BTU) 43% doozy of a selloff.
So what are some of the lessons here for investors? Could disasters such as VRX and BTU have been avoided? If so, these five key factors will serve as your best bet in navigating the minefield that is the current market:
1) Watch Out for Bankruptcy
In the event of a bankruptcy, the holders of stock are the last to get the proceeds from a liquidation. The problem? There is usually nothing left! As a result, a bankruptcy often means that the stock goes to zero. This is a major reason for the severe reactions to VRX and BTU. Both companies have essentially indicated there may be defaults.
The case of BTU appears to be the most dire. The company has made a “going concern” disclosure, which is legal-speak for bankruptcy.
Yet, there were ample warning signs. Last month, Peabody reported that it had drawn down its revolving credit line — a sign of big-time liquidity problems. Alpha Natural Resources (ANRZQ), too, drew down its credit line. A month later it filed for bankruptcy.
2) Don’t Fight Massive Secular Change
Negative secular changes can wreak havoc on an industry. But in the case of coal, there have actually been several of them. The industry has had to deal with the slowdown in the world economy, heavily impacted by China. Next, the plunge in natural gas has also put tremendous pressure on the demand for coal.
But perhaps the biggest threat has been the potential for regulatory action. Interestingly enough, the coal industry may be “the new Big Tobacco” (as stated in a recent piece in the Wall Street Journal). The main reason is that it has been tied to climate change because of the rich sources of carbon dioxide.
VRX is also facing potential secular changes. To this end, there has been much political backlash to the core business model, which relies on acquiring companies and then aggressively hiking drug prices. But given the soaring costs of healthcare, the backlash has been inevitable, both from the federal and state government and insurers.
What’s more, there have been hearings in Congress as well as an investigation from the Justice Department. As a result, VRX has indicated it will change its business, which will likely mean reduce revenues and profits.
3) Beware the “Black Box”
A “Black Box” is a company that is extremely tough to understand because of the complex accounting and corporate structure.
Granted, this is not the case with Peabody, which has a fairly straightforward business. But Valeant is another matter. The company has relied on third-party specialty pharmacies, which have vague details. But there have also been complexities brought on by aggressive mergers and acquisition activity.
And let’s not forget the matter of the 10-K VRX has yet to file. So if you invest in the company, you are essentially doing it blind.
4) Don’t Trust the Analysts
Wall Street analysts may not be a good source of analysis, but let’s try not to act surprised all at once.
Let’s face it, analysts work for financial institutions, which generate lucrative fees from corporate clients (such as from M&A, equity offerings and so on). This is why Wall Street analysts rarely put sell recommendations on stocks.
Valeant is a prime example of this. Even with all the problems, there are still plenty of Wall Street analysts that are bullish on VRX. Consider that the average price target is $94 per share. And how many sell recommendations are there? One.
The irony is that the only one who had spot-on analysis on VRX was a short-seller, Andrew Left. Back in October, he compared the company to Enron and backed this up with some convincing research.
5) Don’t Follow the “Masters of The Universe”
Even the world’s best investors suffer wipeouts. And VRX is a classic example.
The company has essentially been a hot deal for a variety of hedge fund investors, including ValueAct Capital Management LP and Paulson & Co. But the biggest loser is Pershing Square Capital Management LP, led by William Ackman.
Ackman’s fund has lost close to $3 billion on the VRX investment.
Despite this, Ackman still remains upbeat on Valeant’s prospects. According to a letter to his shareholders: “We continue to believe that the value of the underlying business franchises that comprise Valeant are worth multiples of the current market price.”
Although, it seems this will not be very comforting.
Keep in mind that Ackman has a checkered investment history that includes Borders and JCPenny (JCP).
Tom Taulli runs the InvestorPlace blog IPO Playbook. He is also the author of High-Profit IPO Strategies, All About Commodities and All About Short Selling. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.