When Hedge Funds Come and Play

One of the ongoing fall soap operas in Wall Street right now concerns Valeant Pharmaceuticals (ticker symbol: VRX), which develops and manufactures a range of specialty generic and branded drugs.

The stock had been one of the darlings of Wall Street after it had risen from around $35 per share in 2010 to over $260 per share in August.  Yesterday, the stock closed at $85 per share, a decline of nearly 70 percent on accusations of ‘aggressive accounting’ and possible fraud.

Thankfully, we don’t own the company, but I haven’t been able to escape reading about it in recent months because some of the top hedge fund players had huge positions in VRX.

One in particular, Bill Ackman’s Pershing Square, has been a vocal promoter of the stock and has been waging a public battle against the short-selling hedge funds that made the accusations in the first place.

The WSJ has featured a number of articles about other hedge fund managers that own VRX and have been crushed in recent weeks.  It’s what Wall Streeters call a ‘crowded trade.’

In a crowded trade, a lot of investors pile in, partly because they see other people doing it, and then, when something goes wrong, everyone has to head for the exits at the same time, forcing the stock lower.

Even VRX’s CEO, Michael Pearson, was caught in the malaise and was forced to sell 1.3 million shares of the stock to meet margin calls in excess of $100 million at his broker.

Goldman Sachs publishes a list of popular stocks in hedge funds that I keep an eye on, but we don’t really trade on this kind of information.  It’s a little too short-term oriented for our taste and even the recent history of VRX gives an example of what’s wrong with selling when a trade becomes crowded.

Over the last five years, even with the 70 percent decline since August, the stock has earned 27.2 percent per year while the S&P 500 was up 17.1 percent.