Friday File: Pershing Square Thoughts

by Travis Johnson, Stock Gumshoe | March 18, 2016 3:12 pm

What went wrong with Ackman? What did I miss?

I don’t know that I’ve ever seen an investor take the kind of beating Bill Ackman is taking at Pershing Square — and, of course, he brought it on himself with his very public pronouncements on his portfolio companies.

One year does not determine whether you’re a “good” or a “bad” investor, but I do hold some Pershing Square Holdings shares so I’ve been watching Ackman’s moves this past year, and though I’ve seen my holdings drop in value (some was sold along the way in stop losses) I thought it might be worthwhile to look back on what Ackman did that might have been a mistake this year, or what I might have missed as an important turning point. I think there are a few things:

First, why does anyone invest money with Ackman’s Pershing Square? It’s because he’s been an excellent investor over the past decade+, with some strong returns that were achieved in often high-profile investments — and that’s despite the fact that a couple of his high profile investments, like JC Penney and Target in years past, did not work out for him or his investors. I invested money with him because of his track record of finding value investments and using activist techniques (direct contact with and pressure on the board and company) to make those investments work, whether that is through divestments or management shakeup or acquisition or change in strategy or whatever else. In some ways he really developed his own sub-specialty as a “large cap activist” who overwhelms his targets with research and analysis.

So why didn’t that work this past year? Well, partly you might argue that it’s because “value” stocks didn’t have a great year in 2015 — and that he was coming off of a fantastic year so expectations should have been lowered… but though there’s some logic to the “what goes up must come down” argument, his portfolio wasn’t really weighted to traditional value stocks, so that shouldn’t matter, and because Pershing Square runs an ultra-concentrated fund, each individual investment often matters a lot more than does the trend or the broad market.

These are the things that I think made it fall apart for Ackman and Pershing Square, and things that perhaps should have caught my attention as red flags and made me reconsider my investment over the past year:

1. Style drift. Ackman is not an expert in drugs or pharmaceuticals, most of his past successes have been in much more stable and understandable businesses — industrial, retail and the like… and his most extraordinary “wins” have come because of his background and expertise in real estate. He has not had success in pharmaceuticals or similarly regulated sectors in the past, as far as I know, but he saw the opportunity for Allergan to be taken over because their strong brands were undervalued. That might have been a reasonable call, and it worked out exceptionally well (that fueled much of the great returns of 2014), but it also meant that he got a taste for drug companies right near the peak of M&A in that sector.

That led him to invest in Valeant because he had partnered with them on the Allergan deal to some degree and caught a look at the huge return Michael Pearson had engineered for that specialty pharmaceuticals company… but this was also very much not an “activist” position, Pershing bought in to Pearson’s strategy as a huge passive investment, without pushing for any changes or looking for influence. That style drift, in part, led to Ackman turning a few past successful investments into a theory that he thought made it worthwhile to buy more expensive companies that look like those past successes. That second part of “style drift” was elucidated most clearly when he gave his “Invest in ‘Platform’ Companies that grow through Acquisition” presentation at Ira Sohn in May[1] of last year.

That led him to…

2. Over-concentration. Valeant started out as a reasonable position (arguably) in Pershing’s portfolio, which is always concentrated in not much more than a dozen stocks and often has individual stocks that make up more than 10% of the total value… but because Pershing got enamored of Valeant’s “model” that Ackman appeared to believe was sustainable, despite no real expertise in the sector, he kept adding to it as the stock fell. Partly, perhaps, due to …

3. Hubris. I suspect that Ackman failed to consider his or his analysts’ mistakes or misreadings of the regulatory environment… and refused to believe that they could be out-thought by a sharp-worded short-seller like Andrew Left, whose Citron Research report on Valeant started the worst of the downturn. And, as a side-effect of hubris…

4. Believing your track record means your big theories can’t fail dramatically. Ackman also, not long after taking the closed-end Pershing Square Holdings public in Amsterdam, added leverage by borrowing to expand the portfolio after having a spectacular year in 2014. If you post a 40% return year, feel invincible, borrow a billion dollars, and then add a huge position in an industry where you have no track record and have previously avoided investment because of regulatory and management concerns, perhaps investors should be wary.

And I suppose I was, a little bit… but not enough to sell at first — my inclination, as it always is with an outside manager (as when I put money into a mutual fund) is to be abundantly patient and give them time for the strategy to work. Everyone has bad years and bad quarters, and if you have confidence in a manager’s track record then selling after a bad quarter is exactly the wrong thing to do — you’re not giving their portfolio a chance to return to some expected “average” return.

But now, I think there were several points at which I should have reconsidered because they made it clear that the Ackman I was investing with was doing something materially different than he had done in the past: He was borrowing money to juice returns, he was drifting away from his core competencies, he was betting big on a new “theory” that I think is based on personality and acquisition (and seems to be pulled, really, from the roll-up experiences of Jarden and Valeant, two exceptional and unique companies), and I should have sold at one of those places along the line.

On May 4, when Ackman made his presentation to Ira Sohn about how Valeant was one of many “platform” companies he was focusing on as serial acquirers, following in the footsteps of Martin Franklin at Jarden, the price of Pershing Square Holdings was around $27.

On June 3, when Pershing Square was finalizing their billion-dollar bond offering (the first leverage for the funds — not dramatic leverage given the size of assets under management, but still a change of strategy), Pershing Square Holdings was around $28.

In late November, when Pershing was doubling down dramatically on Valeant[2], going not only to an even larger equity position but also betting big by selling put options and buying call options, Pershing Square Holdings was at about $20.

There were also other opportunities throughout the second half of 2015 when Pershing was adding to its Valeant position that I had plenty of opportunity to say “that’s too much concentration in one crazy stock”, and I didn’t — in some cases, I even bought more shares.

I had too much confidence that Ackman would adhere to the same strategy that made me want to invest with him, and let him keep much of my money even though his strategy in 2015 turned out to be wildly more risky than I thought (and, I’d argue in retrospect now, wildly different from his successful strategy in navigating investment winners and losers in the prior decade).

The shares are around $13 now. I sold some of my shares along the way to stem losses, as I did with my holdings in the Sequoia Fund which is also a concentrated owner of Valeant shares, and that was largely because I was uncomfortable with my personal overweight in Valeant through these two managers…. but, in retrospect, I should have sold all of my Pershing Squares as I became more aware of Ackman’s style drift and his use of leverage to magnify his bet on Valeant. Even though Pershing has generally traded at a discount to net asset value, which should be compelling for a good manager who generally owns high quality stocks, the actual decisionmaking of Ackman clearly merits an even bigger discount now. And not just because they’re going to come under pressure to sell some stocks they didn’t want to sell (Pershing is reportedly now selling some Mondelez to give them some cash flexibility — they still have to deal with those Valeant put options and pay the interest on their bond).

They’ve now gone “more activist” with Valeant and put a Pershing Square person on the board, but that is far too little, too late — the confidence of an outside investor has to be that a concentrated hedge fund with a huge overweight position has to know that position inside and out and not just be betting on a track record and a personality, which is what it now seems to me they were doing.

That’s what I was doing, too, in putting too much weight on Ackman’s track record and my perception of his skill… but I’m an investor, I’m allowed to make dumb mistakes with my money sometimes, and I give myself some forgiveness because Ackman’s shift in style was gradual and took place after a fantastic year when some big bets paid off very well and he had arguably earned extra patience. Valeant didn’t shift in style, it’s just, I think, that Pershing misunderstood the company and the risk level.

With the massive budget and analytical might of Pershing Square, the continued doubling down on Valeant even before Pershing seemed to have a rational understanding of the company and the sector was nearly an unforgiveable error of both judgement and analysis. Some of that’s magnified by the fact that Valeant became a poster child for biotech greed, but that wasn’t entirely accidental or unpredictable — Valeant certainly had its critics in the years before Pershing Square bought shares, and it certainly should never be the case that a small operation like Citron Research can call attention to accounting concerns that Pershing Square misses. There simply has to be a fuller understanding of those regulatory and accounting risks before a fund buys a massive and dramatically overweight position in a company. The Sequoia Fund might get a bit more of a pass on that with their huge Valeant holding, but only because they owned the company for far longer — they still failed to compensate for the risks of a huge outsize position, though they did not lever themselves to Valeant in a single year as Pershing Square did.

So, as you can imagine, my rethinking of Pershing Square leads me (belatedly) to “right-size” my position substantially. Some of it was sold over the course of the past year, as was some of my Sequoia position, but now I’ve sold more and Pershing Square in my portfolio is down to a much more manageable size that reflects my new understanding of the risk of the position. I haven’t sold all my Pershing Square shares, but now it’s at a level where I’m not going to worry overly about the future. I should have done that months ago as red flags were seen, but I won’t let the fact that I glossed over those red flags force me to continue taking more risk than I had intended — waiting until now to sell more of my position was an error, but holding on to avoid booking a loss, or to avoid admitting a mistake, would be a larger error. Even if it turns out that this is a bad price for selling and it bounces back in the near future.

I don’t think Bill Ackman’s a fool, and I expect he will probably recover and get back on track if he corrects his errors of the past year — but I’ll watch from a distance for a while now, and give things time to settle before I reconsider and think about either selling out of the balance of my Pershing Square position entirely or, perhaps, re-upping if I think the lessons learned augur a return to excellence for Ackman’s gang. I’ll let you know either way.

Endnotes:
  1. presentation at Ira Sohn in May: https://www.pershingsquareholdings.com/media/2014/09/Ira-Sohn-2015-Presentation.pdf
  2. doubling down dramatically on Valeant: http://www.bloombergview.com/articles/2015-11-24/bill-ackman-found-a-cheap-way-to-buy-more-valeant-stock

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