Harriet Lefton

About the Author Harriet Lefton

Harriet originates from the UK where she worked as a journalist specializing in the metal markets. She graduated from the University of Cambridge before becoming a qualified UK lawyer.

Joel Greenblatt’s Magic Formula Says No to Two Pharma Giants: Valeant Pharmaceuticals Intl Inc (VRX), Gilead Sciences, Inc. (GILD)

Why this Wall Street hedge fund legend sold VRX and GILD?


Joel Greenblatt, the founder of the $6.8 billion Gotham Asset Management fund, has signaled a cautious sentiment towards two-mega cap pharma stocks. In the third quarter, Greenblatt slashed the fund’s holding of both Valeant Pharmaceuticals Intl Inc (NYSE:VRX) and Gilead Sciences, Inc. (NASDAQ:GILD). His moves are closely followed by traders all over the world, keen for an insight into how one of the world’s savviest minds is playing the market.

As for Greenblatt, he founded the fund back in 1985 and has subsequently preached to the masses about his trading strategy. Not only is he the author of several well-known books on investing (including The Little Book That Beat the Market) but he also works as a professor at Columbia Business School where he focuses on his forte- value investing. This strategy of buying good companies at bargain prices has certainly worked for Greenblatt. According to Frederik Vanhaverbeke’s 2014 book Excess Returns, Greenblatt recorded a compound annual return of 45% over 19 years.

However, in more recent times Greenblatt has cautioned that his strategy worked better when many stocks were priced more cheaply. With stocks so expensive right now, it is increasingly difficult to generate the kind of alpha of the past. Nonetheless at the end of the day Greenblatt concludes “Companies that are gushing cash, with high returns on capital, with nice niches and trading at low multiples to cash flow, if I buy a bucket of those, I‘m going to do very well.” The most crucial part of trading, says Greenblatt, is to stick to your guns when choosing investments. This means clearing away the hype and emotion to find stocks that perhaps no one else is even talking about- this way investors can avoid calamities like the tech bubble of the 90s.

Bearing this in mind, let’s now dive in and take a closer look at these two intriguing stock moves:

Valeant Pharmaceuticals

Greenblatt pruned the fund’s VRX holding in the third quarter by 43%. He sold 348,044 shares- leaving the fund with a $6,807,000 position of 475,002 shares.

And in the eyes of JP Morgan analyst Chris Schott it would appear that Greenblatt has made the right decision. The analyst has just downgraded his VRX rating from Hold to Sell, prompting shares to sink by over 4%. (To watch Schott’s track record, click here)

This is the first time JP Morgan has downgraded the stock in the last 18 months. What was the catalyst for this bearish move? Patent erosion and VRX’s massive debt burden. Patent erosions could cost about ~$700mm in 2018 sales and another $300+mm in 2019. Even though new CEO Joe Papa has done a great job of cutting back debt (he has already cut around $6 billion since 2016) the fact remains that VRX still has a debt of $27 billion. The interest payments alone on the debt adds up to about $459 million per quarter.

“While Valeant has made progress stabilizing its core operations and addressing near-term debt liabilities, the company still faces significant patent erosion over that that will results in a step down in 2018 [earnings before interest, taxes, depreciation and amortization]… and muted recovery off of these levels,” explains Schott. At the same Schott says the valuation is now looking stretched and 2018 estimates are “too high.” In the last twelve months, Valeant’s stock has soared by over 50%- and the recent rally has left this analyst wary. We can also see from TipRanks that Schott has had a relatively tough time on VRX stock specifically (17% success rate, -40% average return) so perhaps his latest move is intended to curb further losses.

According to TipRanks, Valeant has a bearish Sell analyst consensus rating from the Street. In the last three months this breaks down into 1 buy, 6 hold and 4 sell ratings. The analyst average price target of $16 suggests downside of -25% from the current share price. Interestingly, however, if you look at only ratings from the best-performing analysts then the consensus shifts to a more bearish Moderate Sell. They also have a far lower average price target of just $12 vs the current share price of $21.37.

Gilead Sciences

In the third quarter Greenblatt demonstrated an equally cautious sentiment towards another giant pharma- Gilead Sciences. He slashed the fund’s position by 28% with the sale of 267,099 shares. The fund now has a total holding of this stock of 696,622 shares valued at $56,440,000.

However, the outlook for Gilead does have hope according to some analysts. Maxim Group’s Jason McCarthy has just assigned a buy rating to the stock with a bullish $94 price target- which indicates upside potential of close to 25%. Based on this model, he believes GILD can generate significant free cash flow through the end of this decade.

In particular, McCarthy is inspired by encouraging clinical trial results for Yescarta for late stage B cell lymphoma. GILD has just announced long-term follow-up data for Yescarta from the ZUMA-1 pivotal study in refractory large B cell lymphoma. The data demonstrated that complete remissions (CR) of 40% were maintained for over one year, sometimes longer. Gilead acquired the rights to Yescarta when it took over Kite Pharma for $11.9 billion in August- and now the fruits of this purchase are beginning to pay off. Kite, an innovative biopharma, specializes in reprogramming patients’ own immune cells to attack cancer cells (CAR-T therapy).

“Yescarta for late stage B cell lymphoma is just the beginning for Gilead. Expansion to late stage leukemia, earlier lines of therapy, combination approaches and new CARs and TCRs targeting myeloma and solid tumors (Kite’s pipeline) should follow as Gilead is now a leader in the cell therapy space” says McCarthy. He notes that the launch of Yescarta is already underway in the US, while approval/launch is expected in Europe in 2018. Ultimately, McCarthy also sees scope for the therapy in both China and Japan as well.

Gilead is also looking to boost its offering with another acquisition. The company has just announced that it has signed an agreement to acquire privately-held Cell Design Labs, Inc. Through Cell Design, Gilead plans to gain new technology platforms that will enhance its research and development in cellular therapy and CAR-T therapy for solid tumors. Gilead will pay $175 million upfront, and additional payments of up to $322 million if certain milestones are met.

TipRanks shows that Gilead has a relatively optimistic analyst consensus rating of Moderate Buy. This is made up of 9 buy ratings and 5 hold ratings. These analysts believe shares can spike by nearly 15% from the current share price to hit $88.22.