What Can Be Learned From Ackman's Foray In Valeant

Editor's note: A previous version of this story inaccurately stated Pershing added to its Valeant stake after selling a portion of its Mondelez stake. SEC filings indicate Pershing owned 9 percent of the company as of March 28, 2016, same as reported at the beginning of the year.

It's impossible to determine Bill Ackman's actual position, break-even level or where he will eventually throw in the towel in Valeant Pharmaceuticals Intl Inc VRX. However, there are several valuable lessons investors and traders can learn from the Pershing Square CEO's saga.

Lesson 1: Be Careful When Adding To A Losing Position

First and foremost, be very careful when adding to a losing position. Certainly, the situation is muddled when applying this to Ackman's tactics in Valeant since he has been a long-term investor. At some point, he had a tidy profit in the issue.

Furthermore, be careful not to confuse the "adding to a losing position" with building one. For example, if you want to invest $1,000 in stock XYZ and are unsure if it has found a bottom, a good idea may be to invest half and be prepared to invest the other half at higher or lower prices.

Lesson 2: Always Know Your Exits

Next, have a specific, predetermined exit strategy (good or bad). It's essential to have this in place beforehand. This may be based on technical analysis, changes in the fundamentals for the company, specific dollar amount, or a disruption in the broad market. Of course, the exit strategy can be altered to lock in some profit if the position moves in one's favor.

Related Link: Warren Buffett And Charlie Munger Agree: Valeant Was A 'Sewer' And 'Enormously Flawed'

While the two aforementioned lessons can be applied to the individual investor, the next few can applied more specifically to money managers.

In Context: Valeant, The 'Early-Stage' Berkshire?

It may not be prudent to compare a person invested in company with one managed by the greatest investor of all time, such as Warren Buffett's Berkshire Hathaway Inc. (NYSE: BRK-A) (NYSE: BRK-B). That sets pretty high expectations that are unlikely to come to fruition.

In May 2015, when Valeant was trading at the $225 area on its way to its all-time high ($263.81, made in August 2015), Ackman told Fortune, "Berkshire Hathaway was the quintessential platform company, and still it had been 'continually undervalued' for its entire history." He added, "You'd think after 25 years people would realize, and Valeant is a very early-stage Berkshire."

Current Challenges

Now that a few lessons from Ackman's action have been discussed, let's examine the challenges he's facing to turn his big winner to big loser back to a big winner.

Having Wall Street (and beyond) know you're stuck long or short in a position isn't the best position in which to find yourself. The reason being that aggressive traders will use any bad news to pound or rally an issue.

For example, Buffett's negative comments over the weekend regarding Valeant resulted in the issue falling from Friday's close of $33.36 to $28.92 before ending Monday's session at $32.66. It should be noted: The issue rebounded to $38.50 on Tuesday, which in and of itself is bullish, as the issue has rebounded sharply from the Monday's swoon.

Ackman will find plenty of sellers the entire way up if and when Valeant recovers. Not only will other investors be praying for a scratch or a small profit, many with large positions at much lower average prices will unload millions of shares on the way up.

Finally, Valeant will not be at $35 in the next year. One of two things will happen: 1) it could double to $70 or higher or 2) it could go to $0.

Related Link: Ackman: Valeant Made Some Mistakes, But It's Not A Sewer

For Ackman's sake and other investors in the issue, if the SEC investigation reveals little or no wrongdoing in the company's tactics, then it could once again trade on its true fundamentals. After all, the company does make money.

Last quarter, it beat Wall Street estimates for EPS ($1.55 vs. estimated $1.37) and revenues ($2.76 billion vs. estimated $2.25). Of course, future estimates and revenues are in disarray as the results of the investigation looms.

On the other hand, if the investigation reveals infractions, there will be a stampede to exit the issue, with Ackman leading the way. Also, changes on Capitol Hill may not be so friendly to Valeant and other related issues in the sector.

From a technical perspective, there are two very important levels to keep an eye on:

• On the downside, a breach of the low of the move ($25.27) may instigate another wave of selling that may take the issue to $20 or lower.
• On the upside a breach, and string of, closes over $38 is the level to watch.

On four different occasions, including the last two days, it has approached this level but backed off. A break above qualifies as a breakout to the upside and would send the short sellers scrambling for cover and momentum traders to pile into the issue.