Why the Story Failed at Valeant and Theranos
Everyone loves a good story. The problem as we have seen time and again is that these stories can kill your portfolio and your returns. Look no further than Valeant Pharmaceuticals on the public side, now suffering through a 60 percent haircut; the private equivalent would be blood-testing company Theranos. In both case, the narrative is failing.
Story-telling is an issue that comes back to haunt us. We can't help it; we seem to be hard wired to love a great yarn. Whether it's Ulysses or "Star Wars" or a “disruptive, revolutionary, scalable new technology” (or some other set of buzzwords), we're suckers for a well-told tale, special effects optional.
Pick just about any hot stock or sexy startup and beyond the hard numbers there is often a great narrative about why this company is going to be the next fill in the blank (Apple, Netflix, Google, etc.). All you need to do is to squint a little, ignore the lack of earnings, minor accounting concerns or some newfangled metric no one else follows.
The story is fantastic; sometimes, too fantastic.
Why are we fools for legends before they fall? For most of human history, there were no iPhones (unthinkable) or texting (OMG!). There weren’t even pens and paper to jot down a few notes. Hence, a good, intriguing narrative was important; it was a memorable way to share important information that could be passed from person to person, generation to generation. These stories often imparted important and occasionally life-sustaining information. No wonder we all love a good yarn.
The problem with these stories is that they introduce both emotions and bias into the account. More often than not, that leads to trouble in the world of investing.
Consider that in March of this year, Berkshire Hathaway’s Charlie Munger identified significant issues with Valeant. Likening it to ITT, a failed conglomerate created through a blitz of acquisitons, Munger said “It wasn’t moral the first time. And the second time, it’s not better. And people are enthusiastic about it. I’m holding my nose.”
That was eight months ago. As we have noted before, markets are not perfect, but they are kinda, sorta, eventually efficient. Meaning, that what Munger understood in the first quarter of this year, the rest of the market eventually came to recognize at the end of the third. The cost of that was a mere $60 billion in lost market value.
In Valeant’s case, the alternative story has come into focus at the same time new scrutiny is being given to the company's reliance on pro forma financial reporting, or as Pulitzer Prize-winning reporter Gretchen Morgenson called them, “fantasy numbers.”
With Theranos, something even more basic was astray.
The wonderful heart-warming story of Elizabeth Holmes, founder of the blood-testing startup, is almost as fantastic as Valeant’s accounting. Her fear of needles led her to drop out of Stanford at 19 to commercialize a blood test that relied on a finger prick instead of drawing blood from a vein. She became the youngest person ever to be given the Horatio Alger Award and was appointed to the board of fellows of Harvard Medical School. Time magazine named her to its list of the world's 100 most-influential people. Her closely held company was recently valued at $9 billion, making her a multibillionaire.
That’s a wonderful story. At least it was until it turned out that the blood test didn't perform as expected. We don't yet know if this is merely a temporary glitch or something worse. Regardless, it looks as if the narrative led some investors to follow their hearts rather than their heads.
An alternative narrative is now forming, and one wonders why no one looked more closely at a 19-year-old with no medical background doing what no other health-care or biotech company had managed. Maybe the Theranos story will turn out well, but extraordinary claims require extraordinary proof. So far, that proof has been lacking.
The parlance used by some in the venture-capital community to describe the rare startup with a $1 billion valuation is “unicorn.” What many seem to have forgotten isn't that unicorns are rare, but that they are fairy-tale creatures that don't exist.
My apologies for once again beating the drum on ignoring the narrative and focusing on the data, but it seems that every six months or so this subject returns with a vengeance. If you feel like catching up with my past tirades on the failures of narratives, see this, this, this, this, this, this, this, this, this, and this.
It isn't just stocks. A story can be used to justify almost anything, be it a portfolio position or an ideology. Just ignore the facts and data, and hold on tight for the ride.
Just to cite few: Quantitative easing is going to debase the currency and lead to hyperinflation; gold is headed to $5,000 an ounce; tax cuts pay for themselves; sunspots cause global warming. These are all examples of narratives that have an emotional appeal but have no data to back them up or are at odds with the facts.
There are more stories to come, with more shocks for those too willing to believe. We can't help ourselves. All we can do is try to be aware why a story pulls us in and gets in the way of seeing the world as it really is.
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