The following thoughts are from Salman, who is working closely with me in monitoring our managers and their investment process.

Until last week, Valeant was a Canadian market darling. Fueled by cheap debt and a low tax rate, the Montreal-based pharmaceutical company was on an aggressive acquisition strategy to spur growth. And boy did it grow. At its peak in August 2015, the stock (VRX) was up more than 1,200% over the previous five years. Valeant even became the largest stock in the S&P/TSX Composite Index (at 6%), albeit briefly. But as of today, VRX is down more than 60% from August and is now the 10th biggest company in the index.

We haven’t owned Valeant in any of our funds. Our managers weren’t comfortable with the stock. As it rose in stature, however, this position became more unusual. With Valeant becoming such a big part of the Canadian market, it was uncomfortable for fund managers who didn’t originally own it. They were forced to re-evaluate, and in many cases, capitulate. For funds that are supposed to look similar to the S&P/TSX, it became too big of a risk not to own Valeant.

One of the most extreme examples that we saw of this pressure to conform was a dividend fund holding Valeant – even though it doesn’t pay a dividend.

This certainly isn’t the first time managers have faced this kind of situation. In its heyday, Nortel comprised over 30% of the index. You had to own it, at least until September 2000 that is. And we all remember RIM (Research in Motion).

We learned some important lessons for assessing managers through these situations, and the Valeant circus only serves to reinforce them:

• Beware of FOMO (fear of missing out): We all know that herd mentality is real. We’ve bought clothes or gone to parties because others did. Managers are humans and can fall into the same traps. Before aligning ourselves with any manager, we need to see an ability to ignore that noise.
  
• Risk is not benchmark-relative: We define risk as the likelihood of investors not meeting their long-term return targets. A process that forces managers to measure risk relative to an index doesn’t reduce the risk to the client, just the manager.
  
• Incentives drive behaviour: This lesson impacts us in many ways. In this particular case, it reminds us that great research capabilities can only help so much if managers are paid based on how closely their fund tracks a benchmark over short periods rather than beating the benchmark over a longer time frame.

We spend a lot of time monitoring our managers and talking to them about why they own each stock. We want to see their buying and selling decisions grounded on a company’s prospects rather than what an index is made up of. That’s where undexing comes from.

Of course, our managers aren’t immune to mistakes. They have bought stocks that didn’t pay off like they thought. But we believe making decisions on the fundamentals of a stock, not its status in an index, is the winning strategy for investors over the long run.