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Valeant after 97% plummet catches eye of value-investing funds

Valeant Pharmaceuticals’s head office in Laval, Quebec, Canada.

Ryan Remiorz/AP

Two years ago, Valeant Pharmaceuticals International Inc. shares plunged off a cliff. Now, some investors are starting to pick them up and dust them off.

Smart-beta pioneer Dimensional Fund Advisors LP more than tripled its stake in the beleaguered pharmaceutical company during the third quarter. The bulk of that buying was done for the firm's value portfolios.

Built upon the research of Nobel laureate Eugene Fama and Kenneth French, both of whom serve as directors and consultants, Dimensional became a favourite of many investment advisers by employing factor-based investing. Rather than simply tracking indexes that are based on market capitalization, Dimensional builds its funds using methods that are typically used by active investors to pick individual stocks. By deviating from an index in a rules-based way, the firm attempts to get the best of both the active and passive investing worlds. Its core philosophy is that stock price movements are unpredictable, but certain groups of stocks outperform others. Those that outperform tend to be smaller and cheaper companies -- the antithesis of the old high-flying Valeant.

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Dimensional's involvement is a now-uncommon vote of confidence in Valeant, which was once a favourite among hedge funds who could appreciate its brand of financial engineering. That was before probes into its business practices, accounting and alleged price gouging caused the stock price to collapse, forcing Chief Executive Officer Michael Pearson out the door and Bill Ackman's Pershing Square Capital Management to sell its stake at a loss of almost $4-billion.

Ultimately, Valeant would see 97 per cent cleaved off its market cap during what would turn out to be an 18-month descent to a single-digit stock price.

Dimensional bought almost a million net shares during a four-quarter stretch beginning in the second half of 2016. The big move was made in this year's third quarter, when the firm purchased 3.4 million shares. Adam Martin, a spokesman for Austin, Texas-based Dimensional, declined to comment.

A stock with a high book value in relation to market cap could potentially be added to the company's value portfolios, according to the prospectus for the DFA International Value Portfolio. Valeant is certainly cheap in comparison to its peers at this point. Among 25 peers in the Bloomberg Intelligence global specialty pharmaceutical valuation peer group, Valeant's market cap to book value ranks as the fifth-lowest, and it's on pace to record the highest annual free cash flow in company history. Leverage ratios, while still lofty, have decreased throughout 2017.

"Value investors have begun accumulating our stock recently, and we agree with their position the stock is undervalued," said Lainie Keller, a spokeswoman for Valeant.

Analysts remain cautious. The average 12-month target price among analysts surveyed by Bloomberg is $16.69 a share, a few cents below its current price. That reticence is in part because of the debt wall looming just over the horizon -- some $25-billion coming due between 2020 and 2025. Free cash flow would have to almost triple from last year's total by 2020 to make servicing those debt levels feasible.

Despite that challenge, the company delivered on financial targets and has continued to "proactively manage its debt load," according to a research note from Deutsche Bank analyst Gregg Gilbert. And Joe Papa, who succeeded Pearson as CEO, said on a Nov. 7 conference call that while the turnaround is only in its middle phases, "Valeant today is a stronger company than it was a year ago."

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Dimensional's purchase isn't necessarily a validation of the company's progress in fixing its problems, but after two years of dips that portended false bottoms, there's some solace to be taken when a fund that trades on rules declares the stock to be on the upswing.

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