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Funds that bought in to Valeant – and lost

The remarkable collapse of the shares of Valeant Pharmaceuticals International Inc. didn't just harm investors who chose to buy directly into the stock. Because of its brief honour of being the most valuable company in the S&P/TSX 60, Valeant shares found their way into dozens of Canadian mutual and exchange-traded funds, in many cases taking up an ample proportion of the portfolio.

In some cases, there was little choice, as funds designed to mimic the performance of the index had to own Valeant's stock. Plenty of other fund managers, however, proactively chose to own Valeant shares. And even as some began to sell as the shares slid from the August, 2015, peak, other funds, which previously avoided the expensive growth story, came to buy in, seeing it as a value play.

Nearly all got burned, now that Valeant trades for about $12.50, down from its all-time high of nearly $350. (And nearly all funds in this story have Morningstar Canada ratings of two stars or fewer, on at least one of their share classes, on the five-star scale.)

To examine some of the buying and selling choices Canadian funds made, I requested holdings data from Morningstar. By tracking the funds' positions, reported either monthly or quarterly, Morningstar can provide a picture of which funds bought or sold as Valeant ran up to its peak, after the high was hit, or when the freefall truly began in 2016.

With this perfect hindsight, we can recognize a number of Dynamic funds for some timely selling. Four of the funds in the family sold 40 per cent or more of their Valeant shares from January, 2015, to July, 2015, as the stock rose toward its all-time high.

All of those funds, including the Dynamic Value Fund of Canada, are value-oriented, which may explain the unfortunate thing that happened next to them, and others. As Valeant fell, funds that seek underpriced or temporarily out-of-favour stocks began to buy Valeant, not sell.

From August to December, 2015, as Valeant fell from that $347.84 intra-day high on Aug. 5 to around $140, the four Dynamic funds added to their Valeant holdings by more than 150 per cent, buying hundreds of thousands of shares. By December, 2015, Valeant took up anywhere from 2.7 per cent to 4.1 per cent of the funds' portfolios. (In the Dynamic Value Fund of Canada's report of performance for the year ended June 30, 2016, it said the fund's negative performance for the year was partly the result of "stock selection in health care, resulting mostly from the Fund's investment in Valeant Pharmaceuticals.")

They were not alone among value-oriented funds. As the clock turned to 2016, other funds saw reasons to jump in for the first time. Two of the most aggressive buyers were the Chou RRSP Fund and the Chou Associates Fund, run by Chou Associates Management Inc. and founder Francis Chou, described by an investing website in March 2016 as "arguably the only staunch Graham-and-Dodd value investor in Canada today."

The two funds started a position by buying about one million shares, combined, in March, 2016, when Valeant went from around $90 to about $30. The two funds bought nearly 500,000 more in June of that year, when the shares dipped below $25.

A spokeswoman for the fund company said Mr. Chou would have no comment beyond the fund's 2016 annual report, published on March 17 of this year. There, he explained that while some of the company's bad press was deserved, its mid-March 2016 debt offering was "an important step for Valeant because it removes the threat of technical default in the short term, and it gives management time to fix the company and return it to sustainable profitability without looking behind their backs all the time."

In the report, Mr. Chou said he now believes the company could generate $1.5-billion (U.S.) to $2-billion of annual free cash flow (cash flow after capital expenditures). "Based on the information we now have, the average price we paid of less than seven times free cash flow is on the high side, but at less than two times free cash flow it is a totally different story. If these numbers hold, we believe that the intrinsic value is much higher than the current price of Valeant."

Three Mackenzie Cundill funds opened positions by buying more than 500,000 shares in February and March, 2016. Mackenzie Investments spokeswoman Trish Tervit says the funds have since changed managers – a company news release in March, 2016, noted the two co-leads of the investment team were leaving the industry or retiring – and Valeant "is no longer a holding." She also added the firm's Canadian Security Fund Series F and Canadian Balanced Fund Series F – both of which held Valeant shares – beat 96 per cent and 98 per cent of peers, respectively, in the year ended March, 2017.

While I've so far focused on value funds that got in too early, I should reserve some special attention for the growth funds that aggressively bought near the top.

A couple of examples: The Morningstar data shows the Desjardins Canadian Equity Growth Fund and the National Bank Canadian Equity Growth Fund each bought nearly150,000 Valeant shares in the first part of 2015, bringing the stock to more than 5 per cent of the funds' portfolios at Valeant's peak. Then they bought more than 150,000 shares apiece in the remainder of 2015 as the stock began to decline. Each sold some shares in 2016, but not nearly all of their positions.

National Bank spokesman Jean-François Cadieux, noting the company's funds are managed by outside companies, said Valeant made up 1.8 per cent of the Canadian Equity Growth Fund in October, 2015, versus 3.65 per cent of the S&P/TSX composite. "Overall exposure was lower than the benchmark, which represents in our view a more accurate measure than trading volumes," he said.

In March, 2016, the Desjardins fund sold roughly one-third of its Valeant shares. That, combined with the falling value of the stock, meant that Valeant fell below 1 per cent of the fund's portfolio – and that underweighting "contributed significantly to [positive] performance," said one of the fund's sub-managers at the time, Picton Mahoney Asset Management.

That's the bottom line for all the Canadian funds in the last couple of years – too much exposure to Valeant contributed to underperformance, and minimizing the Valeant holdings added to gains. The problem, as we see, was that few funds that held Valeant managed to time the fall.

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