I recently bought Michael Batnick’s book Big Mistakes: The Best Investors and Their Worst Investments. What Mr. Batnick does is use tales of investment greats such as Warren Buffett to teach lessons about behavioral finance.
However, the great value proposition of this book is the mistakes made by the most successful investors and what we as investors can learn from it.
Imagine you have a stock portfolio tucked away. Investing is a risky business, but you want to give it a go anyway. You split your money between ten stocks, but one crashes to zero and you lost 10% of your capital.
What if you split your investments between 100 companies? Doing so will require a little bit more time, but you would have only lost one percent. This is diversification.
One of the most successful investment funds of all time, the Sequoia Fund prefers long-term and large-scale concentrated investments. The preference for potent and concentrated positions is the very opposite of diversification, but it worked magnificently for Sequoia. A $10,000 investment into Sequoia in July 1970 would be worth $4 million today.
In 2010, the fund made a huge mistake: Valeant Pharmaceuticals (NYSE: BHC).
On April 28, 2010, Sequoia began purchasing shares in Valeant at $16. By the year’s end, the company’s price ballooned by 70%. The next year was just as fortuitous: Valeant gained 76% in the first quarter. Things seemed rosy. The stock became the fund’s largest holding; however, financial disaster was just around the corner.
Sequoia described Valeant as a company which cuts corners on research and development but invests heavily in its sales force. This might sound like savvy cost-cutting, but the reality is far more conceited. Valeant skimped on R&D because its business model revolved around purchasing existing drugs and jacking up their prices.
Take Valeant’s 2013 purchase of Medicis, a company who invented a treatment for people exposed to lead poisoning. Before the acquisition, the drug cost healthcare providers $950. Overnight, the price rocketed to $27,000.
Because of incidents like these, Valeant started receiving bad press. And when presidential candidate Hillary Clinton pledged to prevent price gouging in the pharmaceutical industry, Valeant’s shares slid 31%. One month later, Citron Research published a report accusing Valeant of accounting fraud. Shares tumbled another 19%.
The debacle was a disaster for Sequoia. Soon after, they sold their entire position and took a 90% loss. The company’s assets crashed from $9 billion to under $5 billion in the space of a few months. The lesson to take from this incident is that concentrated holdings can generate wealth quickly and decimate it just as fast.