It’s been about a year since Valeant Pharmaceuticals fell apart into a pile of smoldering rubble. As that link details, its biggest investor and biggest fan, Bill Ackman, was at that point down several billion dollars on the investment, and things did not get any better. His fund sold out of its Valeant position last month, at a loss of at least $3 billion. If you cast your memory back to October of 2015, when things first started to go wrong, you can find Ackman quotes about the incredible skills of the company’s managment team, the tremendous upside to the investment, the worthlessness of the accusations about their business practices – enough schadenfreude to power a medium-sized city, actually.
And he’s recently sent out a letter to the remaining shareholders of his hedge fund, apologizing for losing so much of their money. Personally, I wouldn’t find that all that comforting, considering all the table-pounding that those expressing doubts got at the time, but better late than never and all that. This is a terrific example, and will be a terrific example for years to come, of overconfidence and the sunk-cost fallacy. This is not a new phenomenon – there’s a good example of it in how Montesquieu talks about Pompey’s dealings with Julius Caesar
I believe that Pompey was ruined more than anything else by his shame at thinking that he had lacked foresight in elevating Caesar as he did. He yielded as slowly as possible to this idea. He did not prepare his defense so that he would not have to admit he had placed himself in jeopardy. He maintained before the senate that Caesar did not dare make war, and because he said it so often, he always repeated it.
I think that investing in pharma and biotech companies makes a person peculiarly vulnerable to this sort of mistake. So many plays in this stock market sector turn on particular stories, clinical trial results or FDA approvals of specific drugs, and these fit right into the narratives that we humans (and we investors) like to tell ourselves. Investors in small drug stocks often get so, well, invested in these stories that they follow their beloved companies right over the cliff, denying at every step of the way that there could possibly be a problem. It’s very hard to be objective about such decisions, but drug stock stories are perfectly placed to capture the sorts of investors who have no interest from the start in being objective, anyway. It’s the brave little company and the poor patients they’re trying to help, fighting against the forces of evil. If the stock goes down, it’s not because there could be honest doubts about whether the new drug is going to work. No, it’s nasty short sellers. Or the evil “money managers”. Or the horrible FDA. Somebody. There has to be a villain.
Valeant’s case was driven by another narrative, to be sure: the one about how the industry is in its situation because of lack of business acumen, and never mind all that bleating about how hard drug research is. Someone like Bill Ackman is too sharp to be taken in by the more simple story of “Here’s why this drug is going to work”, and he’s not going to fall into the low-grade conspiracy thinking just mentioned. He was, though, perfectly positioned to be taken in by the more complex story of “Here’s how this business strategy is going to work”, and against the normal backdrop of the drug industry, a hard-nosed, cost-cutting, earnings-focused plan like the one Valeant was selling really stood out. None of this messy luck-in-the-clinic stuff; Valeant had it all down to a process that couldn’t lose. The rest of the drug industry was too slow and old-fashioned to realize it! That was the sort of exciting narrative a billionaire hedge fund manager could go for.
It’s one of the single biggest human cognitive biases that we turn things into stories, and we expect those stories to make sense. They should have beginnings, middles, and ends, and there should be winners and losers – but this isn’t the way the world has to work, it’s the way our minds apparently have to work to make sense of things. Investments are a good place to see this in action, but many of us can think back to research projects we’ve worked on and see the same effects. Drug discovery projects have their own narrative – at most companies, that’s how they start, with a summary proposal slide making the case for why Target X or Approach Y is a good idea. The hard part is being able to see these stories from the outside, and to realize that at times, that’s all they are (or all they might turn into, as new data come in). We all have Pompey’s fault – we don’t want to look like we didn’t see the trouble coming, so we deny that the trouble is coming at all.
Oh, and the CEO that took over at Valeant last year to turn things around? He’s just been paid $62 million for that. $980K is base salary, and $42 million is from stock awards, along with a $9 million bonus. You say that things haven’t actually turned around? Well, just imagine what the pay package will be if they do. If I were a Valeant shareholder (Heaven forfend) I would probably find all this somewhat annoying, but anyone who’s holding the stock now is a very different person than I am.