In a healthy capitalist system, if the thing you are doing is not adding value in the real economy, you should not be able to make money at it for very long.
Unfortunately, that's not always how it works. But the implosion of Valeant Pharmaceuticals International — a company whose primary business is not developing drugs but finding ways to charge more for existing ones, and whose stock price is down 89% from its 52-week high — is a good sign that non-value-creating strategies will fail in the long run.
There are two separate crises facing Valeant. One is an accounting scandal: did the company use improper techniques to inflate its revenues? This is an interesting question, but as Bloomberg's Matt Levine notes, it's probably not the most important one.
Valeant's other crisis goes to the core substance of its business. Like a larger version of Martin Shkreli, it has a strategy of acquiring existing drugs and jacking up their prices. In many cases, these drugs are not under patent, meaning a competitor could legally offer the same product and charge less, but for a variety of regulatory and market reasons that did not happen quickly.
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This strategy is all about exploiting mistakes by other players in the market: The Valeant bet was that competitors will fail to enter markets in which it is charging egregious prices, and that consumers and medical insurers (including the government) will not pay close attention to the prices they are paying.
The problem with a business strategy predicated on mistakes by others is that the mistakes may eventually stop.
As anger over price gouging by the drug industry rose, insurers cracked down on pharmacies and pharmacy benefit managers that pushed overpriced Valeant drugs. One key purpose of Valeant's in-house pharmacy may have been to confuse insurers about who was filling prescriptions, but that jig is up. Meanwhile, politicians from Hillary Clinton on down have said they will find ways to stop Valeant from charging so much.
Lots of businesses can become political punching bags for their pricing. But when oil companies or software companies or bona fide pharmaceutical companies come under political attack, they point to the useful things they do that generate real economic value, and warn that political interference will make those things stop. They are protected because the policy questions surrounding their businesses are genuinely difficult and involve trade-offs.
In the case of Valeant, there is no trade-off to evaluate.
Angry insurers and politicians can squish the Valeant business model like a bug without worrying that this will slow the pipeline of new drug development, because Valeant barely engages in new drug development. When there is no plausible public policy case for your business model, you are especially vulnerable to policy risk.
What is happening to Valeant is similar to what happened to owners of taxi medallions: When Uber forced consumers and policy makers to finally think about why cities impose artificial limits on the quantity of taxicabs, they came back with the seemingly obvious answer that there is no good reason for such limits, and the price of a taxi medallion (once a blockbuster investment) has started trending toward zero.
The lesson for investors should be to ask this question: Does this business do something useful in the real world? Or if the people around us figured out what we were really doing to make money, would we be screwed?
If it's the latter, invest in something else.
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