Investment case studies: principles in action
In a previous post, we looked at the investment principles of Pershing Square and its CEO Bill Ackman. This post will continue with that fashion, focusing on Pershing’s investment theses that we’ve found interesting and educational (although we’ll stay away from controversies that the media have documented well, like Valeant and Herbalife). From Zoetis to Starbucks, readers will notice common threads across Pershing’s long positions: (1) durable economic moats; (2) runways for growth; and (3) temporary setbacks that create investment opportunities. We’ll summarise here the lessons learnt, briefly as follows.
Please note that this is not an endorsement of their stock selection. It’s simply an opportunity to learn and reflect on their investment theses for several companies, whether right or wrong, in a brief format. Do your own research.
Zoetis (NYSE: ZTS)
Pershing Square announced their investment in Zoetis in November 2014. Zoetis, previously a subsidiary of Pfizer, is a world leader in the animal healthcare products segment. In their 2014 letter, Ackman outlines three primary reasons for their investment in Zoetis.
Growth and focus
Firstly, growth in global demand for pet ownership, protein consumption and animal health are expected to drive Zoetis’ growth. They estimate, at the time of writing, that the global animal health market had grown at ~4% per annum since the Global Financial Crisis. Zoetis’ organic growth, by contrast, had outpaced the industry average during this period. Secondly, they believed that the separation and IPO of Zoetis would allow the company to focus and realise their latent value. Pfizer after all is focused on human health.
Durability
Thirdly, Zoetis enjoyed a portfolio of highly durable products. Unlike other business models in pharmaceuticals and health, Zoetis doesn’t rely on patent exclusivity for revenue and profits. While more than 80% of products do not have patents, generic competition in Zoetis’ markets remain low.
Pershing gives two primary reasons for Zoetis’ structural advantage: (1) The gross margins and market size for individual animal health products are low. This makes it difficult for generic manufacturers to compete at scale; (2) Direct-to-consumer sales from pet veterinarians, and the absence of third-party players, contributes to demand for branded products.
Mondelez (NASDAQ: MDLZ)
Mondelez emerged from the separation of Kraft Foods in 2012. The company comprises of stable and high-quality brands like Oreo, Cadbury, Trident, LU Biscuit and Nabisco.
High business quality
In their June 2015 letter, Pershing described Mondelez as a “high quality, simple, predictable, free-cash-flow-generative business”. Snack foods with established brands enjoy an economic moat that can help to earn higher margins and returns on capital. Branded snacks also enjoy better long-term growth prospects relative to other packaged food segments. Mondelez in particular derived almost 40% of sales from developing markets, with further room for growth as a lower-priced luxury player. By contrast, “US-focused, center-of-plate” packaged food companies face greater challenges to volume and pricing due to competition with fresh food, private labels and Amazon’s foray into US grocery.
Untapped efficiencies
However, despite Mondelez’s brand and product strengths, its profit margins was the lowest amongst its peer group (at the time of writing). Pershing attributes this to the inadequate integration and optimisation of separate brands and product lines during its days with Kraft. In their opinion, poor margins was a temporary problem that created an opportunity for their investment. They also outlined how 3G Capital’s experience with Heinz and Kraft has led to improved standards for operating efficiency, design and management; and their role with Mondelez should translate to an uplift in margins over time. In his May 2016 letter, Ackman describes Mondelez’ focus on improving productivity and margins. Mondelez took steps to “improve its supply chain, reduce portfolio complexity, and rationalize overhead while increasing advertising and promotion”.
Value opportunity
In their 2017 letter, Pershing describes how Mondelez traded at a discount to the S&P500 market multiple. This was despite having better qualities and prospects than the average S&P500 company. Furthermore, Mondelez’s peers, like Nestle and PepsiCo in global foods, or Hershey in sweets, traded at a 25% premium to the company. Pershing believed the company’s share price would improve once uncertainties surrounding the US grocery market, Mondelez’ growth potential and new CEO transition narrowed. However, Pershing exited their position in the third quarter of 2018. While they believed in the business’ quality, defensiveness and opportunity for margin expansion; organic growth was lower than they’d expected, reducing its price-earnings multiple, both for Mondelez and the packaged food segment altogether.
Chipotle Mexican Grill (NYSE: CMG)
In September 2016, Pershing Square announced their stake in Chipotle Mexican Grill. Pershing states their investment reasoning quite plainly: They liked the company’s “superb brand pioneering” and “outstanding product offering, unique culture, and powerful economic model”.
Temporary setback
Whiel Pershing had studied the company for many years, they entered only after Chipotle’s stock price dived nearly 40%, following news of food safety problems. While it’d take time for Chipotle to restore its reputation, Ackman believed that Chipotle’s troubles were temporary. Pershing Square outlined several drivers that were strongly in Chipotle’s long-term favour.
Strong brand
Firstly, Chipotle had a strong brand (outside their food-safety turmoil). In Pershing and many customers’ view, Chipotle was not your “traditional fast-food experience”. Much of their “authentic brand”, “loyal following” and early growth had come from customer word-of-mouth, social media and local events. Prior to the food safety issues, Chipotle’s unit volumes were among the highest in industry. This was in spite of their restricted store hours (11 hours versus the standard 24-hour fast-food competitor).
Chain-link
Secondly, Chipotle, in their opinion, competed well relative to its peer group on six important product metrics: “food quality, taste, in-store-experience, customization ability, speed and value”. While some competitors score well in one or two attributes, very few could replicate Chipotle success at their price points or scale. Richard Rumelt referred to this type of advantage as a chain-link in Good Strategy / Bad Strategy. This has helped Chipotle to earn an attractive return and maintain a healthy net cash position.
Long runway
Thirdly, Pershing Square believed there was a long runway for continued growth. Ackman describes how digital orders, loyalty programs, catering and new menus might contribute to same-store sales growth over time. In their June 2017 letter, Ackman outlines the opportunity also to expand restaurant penetration in the United States, and to explore opportunities for growth globally.
Value opportunity
Finally, Chipotle was available at a discount to their estimate of intrinsic value. Food safety issues and the reputation impact would hurt near-term margins and earnings. But in the long-term, they believed that the recovery in customer sentiment, growth in units and same-store sales and improvements in operating efficiency and capital structure could lead to value creation. Their December 2016 letter makes for great reading on this front.
In 2017, Ackman observed how Chipotle’s share price had see-sawed between $499 in May and $263 in July 2017, following another food safety issue and underwhelming quarter. Ackman outlined how Chipotle’s valuation (and that of similar companies) are sensitive to investor estimates of future margins, unit volumes and growth. So, despite Chipotle’s healthy balance sheet, attractive net cash position and zero use of debt (at the time of writing), its stock price remained volatile.
Pershing illustrated Chipotle’s potential valuation with an example in his October 2018 letter. They estimated that if Chipotle were to grow same-store sales by around 10%, restaurant margins would increase from around 18% to 22%. Assuming a 29% tax rate, and overhead and depreciation expenses at last-twelve-months levels, then earnings per share, by their estimates, could more than double. And all this is before expected growth in new stores that earn comparably high returns on capital.
Starbucks Corporation (NASDAQ: SBUX)
Pershing Square disclosed their holding and thesis on Starbucks on October 2018. The Starbucks story is probably one of the better-known narratives. Today, it’s the leading coffee brand in the United States, with room for expansion globally. Ackman outlines several characteristics that made Starbucks an attractive investment opportunity.
Stable growth
Firstly, specialty coffee is a stable and growing market. Coffee enjoys a loyal and habitual customer base and is, unlike other drink categories, better placed to navigate trends towards “health and wellness and sustainability”.
Defensible runway
Secondly, Starbucks’ structural advantage enables them to compete and grow on several fronts: (1) its quality, experience and menu innovation allows it to compete with low-cost and quick-service providers; (2) its “convenience, technological and cost -advantages” allows it to outplay boutiques; and (3) it generates strong returns on investment (more than 65% pre-tax), with ample runway for reinvestment (store count growth in China in particular).
Value opportunity
Starbucks’ share price stagnated between 2016 and 2018 despite growth in earnings per share during the same period. Ackman cites investor concerns surrounding the same-store sales growth, lowering in growth targets, “senior leadership transition and management turnover”. This gave Pershing the opportunity to enter “at a ~25% discount to the company’s historical average valuation multiple of ~26 times forward earnings”.
They believed the company was well placed to manage these concerns. Ackman noted that continued innovations in experience and menu should help them to maintain same-store sales growth over the long-term. Similarly, he describes how the new CEO Kevin Johnson had impressed them with bold and early initiatives to “simplify the business”.
During this period, Starbucks sold its packaged goods segment to Nestle and Tazo tea brand to Unilever; “closed underperforming Teavana retail stores”; and optimised their location mix. These actions, Ackman believes, would improve managerial focus, reduce overheads and allow Nestle to grow Starbucks-branded packaged goods (in which they earn royalties).
Hilton Worldwide (NYSE: HLT)
Pershing outlined their thesis for Hilton Worldwide in their June 2017 letter. They describe the company as an “asset light, high-margin, fee-based” business that franchises and manages hotel properties under several established brands. Examples include Hilton, Hampton, Double Tree and Hilton Garden Inn. They highlight several characteristics that in their view made Hilton an attractive opportunity: (1) high-quality business; (2) opportunity for “capital-light” growth; (3) “best-in-class” management team; (4) sound boardroom oversight; and (5) a catalyst to “unlock” shareholder value (i.e. spinoffs and buybacks).
Economic moat
Hilton’s economic moat, in Pershing’s view, comes from their “extensive and growing network of brands and properties”, creates a “self-reinforcing value proposition to both guests and hotel owners”. For guests, it’s the loyalty program and promise of “a consistent and reliable experience”, regardless of destination. And for hotel owners, it’s the benefit of access to over “60 million loyalty program members, scaled marketing programs, reservation and IT systems, and supply chain purchasing power”.
Contrarian outlook
While Hilton had produced 15% in unit growth and 70% in free cash flow per growth since their IPO in late 2013, its share price had increased by about 10%. In Pershing’s view, investor concerns and narratives surrounding “a potential downturn in the lodging cycle” and the rise of Airbnb had dampened the outlook of the traditional hotel industry.
Downturns are indeed possible, as the industry observed in 1991, 2001-2002 and 2008-09 (and again in 2020-21). But at the time, Pershing believed that Hilton’s capital-light unit growth could offset potential declines in revenue per available room.
Additionally, Pershing argued that Airbnb was less of a competitive threat than the general narrative had made it out to be. Ackman describes how the bulk of Hilton’s revenue comes from “short-stay business travellers” that desire Hilton’s consistent experience and loyalty program. By contrast, the average Airbnb customer are “leisure travellers” with longer stay-dates that desire or do not mind more “unique and local accommodations”.
With all this in mind, Pershing placed their stake and exited after 11-months, following a 32% total return for reallocation elsewhere. There were two catalysts here for Hilton’s stock price: (1) spinning off their owned hotel and timeshare businesses; and (2) commencing their stock buyback program.
Margin of safety
Pershing would reopen its position in Hilton on October 2018 when the company’s share price fell. Again, investors were cautious about “a potential downturn in the lodging cycle”. However, Pershing believed that Hilton’s intrinsic value per share had actually improved during this period as the result of free cash flow growth and share buybacks. In their view, the company’s share price (20 times their estimate of 2019 free cash flow), economic moat and capital-light runway for growth afforded them a margin of safety.
COVID-19
Their thesis in light of COVID-19 is interesting as well. While COVID-19 had hit Hilton hard, Pershing’s outlook for the hotel industry was more optimistic than prevailing media narratives at the time. Yes, corporate demand for video conferencing has sky-rocketed in the wake of COVID-19. But Pershing believed that corporate demand for travel and lodging is likely to resume over time. To paraphrase their reasoning: when one business utilises in-person meetings for pitches and relationship building with customers, suppliers and so on – competitive forces are likely to spur other businesses to do the same.
Nike (NYSE: NKE)
Pershing Square’s short-term investment in Nike is also an interesting one to learn from. In their December 2017 letter, they describe Nike as another “high quality business” that can grow revenues, improve margins and compound earnings over the long-term.
Nike of course is the market leader and most iconic brand for athletic shoes and clothing. Ackman believes Nike to enjoy strong barriers to entry, reflected in their “marketing spends”, “brand loyalty”, “patented innovations”, “manufacturing skill” in footwear, and leverage over suppliers and retailers.
I’d add that their endorsements with sports’ biggest superstars allows them to grow through multiple fashion cycles. But we should also highlight that Nike was not always the sporting behemoth it is today (Nike founder Phil Knight’s Shoe Dog makes for fantastic reading). Like Nike’s predecessors, they’re not immune to mistakes, complacency and bureaucracy.
At the time of writing, Pershing believed that Nike had plenty of room for growth alongside new products and refreshes. Newer opportunities include growth in health & wellness, casual wear and emerging markets. Nike’s superior pricing power, and improvements in manufacturing and distribution channels, should contribute to margins as well.
That said, Pershing sold their stake in Nike after four months and a 34% appreciation in price. The uplift reduced their margin of safety and prevented them from placing a substantial stake. Ackman believed they could allocate capital to more promising opportunities elsewhere.
Standard & Poor’s (NYSE: SPGI)
During the same period, Pershing also made a short-term investment in S&P with a similar thesis to Nike. Ackman liked the “annuity-like characteristics” of S&P’s businesses in credit ratings and financial data services. This, along with its strong “pricing power”, growth prospects, and “margin opportunity”, made the company an interesting opportunity to them. Credit ratings in particular enjoy high barriers to entry. It takes decades to develop the trust, reputation, relationships and know-how. And in Pershing’s words, it is a “must-have for new debt issuance”. Today, it’s a market in which two established brands dominate: S&P and Moody’s. But like their stake in Nike, Pershing exited after a sudden price appreciation prevented them from taking a larger position.
United Technologies (NYSE: RTX)
In their May 2018 letter, Pershing Square announced their new position in United Technologies Corporation. The industrial holding company comprises of several high-quality divisions: (1) UTAS (aerospace systems); (2) Pratt & Whitney (aerospace engines); (3) Otis Elevator Company; and (4) Climate, Controls & Security (CC&S). Each of which, Pershing thinks, benefit from “favourable long-term growth trends and recurring long-term cash flows”.
Razor blade models
At the time of writing, UTX was a “market-leading provider of mission-critical aerospace systems and engines”, both in commercial and defence segments. Ackman likens United Technologies’ aerospace business model to razor blade businesses (you might include the printer business model here too). That is, companies that sell equipment at breakeven or near-breakeven prices, and derive their profits from the sale of add-ons, spare parts and services.
High barriers to entry
The aerospace business also benefits from high barriers to entry. It’s not hard to see why when you think about the capital and patent intensity, accumulated R&D manufacturing technologies, long product development cycles and onerous regulation involved. There were several economic tailwinds in UTX’s favour too: (1) long-term global demand for aircraft and air travel (remember this was written in 2018); (2) a decade’s worth of backlog orders for commercial aircraft to navigate business cyclicality; (3) the acquisition of Rockwell Collins, whose expertise in avionic systems will help the company to offer integrated products.
Scale, networks and market share
The thesis for Otis is similar. As a global manufacturer and service provider, Pershing believes that Otis’ scale and established networks allows them to deliver faster and more cost-effective solutions to customers. While Otis enjoys decent margins on their elevator sales, Pershing estimates service contracts to account for more than 70% of the company’s profits. The company also benefits from “strong order books, multiyear backlogs” and long-term service contracts. This helps to shield them from the business cycle. Furthermore, Global trends towards urbanisation should support long-term demand for elevator sales and services.
CC&S likewise is a “market leader” for products and services in security (Chubb), fire (Kidde), refrigeration (Transicold) and heating, ventilation and air conditioning (Carrier). Carrier’s residential business for example has several characteristics in its favour: (1) “leading market share”; (2) “pricing power”; (3) opportunities for volume growth (incl. ongoing replacement cycles); and (4) unique advantage with dealers, who tend to “stock only one or two brands according to demand from brand-loyal contractors”.
Temporary setbacks
Around the time of Pershing’s purchase, both Pratt &Whitney and Otis were experience depressed margins. The former due to upfront losses and “stumbles” with the launch of their new geared turbofan; And the latter due to investment for growth and “weakness” across China and parts of Europe. Pershing believed those setbacks to be temporary, and anticipated margin expansion in the years to follow.
Value opportunity
At 16 times current year earnings, Ackman felt that the market had undervalued the quality and growth prospects of UTX. Following their purchase, Pershing Square worked with management to separate UTX’s aerospace, elevator and CC&S divisions. In addition to improved managerial focus and capital structure, they believed the separation would help each constituent to realise its fair value.
Merger exit
As they describe in their 2019 letter, Pershing exited their position in UTX after the company’s announcement to merge with Raytheon (RTX). In Pershing’s view, the merger would destroy shareholder value for two reasons: (1) United Technologies was a “high-quality, high-growth aerospace business”, while Raytheon was a “lower-quality, lower-growth defence contractor”; And (2) management announced the deal at a valuation that was well below Pershing’s estimate of UTX’s intrinsic value.
While Ackman considered “a campaign to block the transaction”, Pershing had lost confidence in UTX’s management following the merger’s announcement – describing the uphill “battle” to resolve UTX’s leadership, strategic and capital allocation decisions. Perhaps a lesson from their experience at Valeant, they felt their time, capital and effort was better utilised elsewhere.
Lowe’s Companies (NYSE: LOW)
Pershing took a position in Lowe’s in 2018 after the company announced their search for a new CEO. While Lowe’s had underperformed in same-store-sales growth and profit margins relative to Home Depot, Ackman believed the company had strong underlying economics and room for improvement.
Scale and runway
Firstly, the US-based home improvement retailer operates within an oligopolistic environment. As Ackman notes in his June 2018, their “market presence” and “scale advantage” allows them to operate as a “convenient and low-cost provider”, whether in-store or online segments. Secondly, they believed the U.S. housing market would continue to drive demand for home improvement over the medium-term.
Insular defence
Thirdly, while Pershing had avoided investments in retail due to rising competition with online retailers, they felt that the home improvement segment was “well insulated” for several reasons: (1) home improvement products are often “difficult and/or expensive to ship” due to complexities in size, weight, installation, regulation and so on; And (2) customers still prefer to see and feel the products in person before a purchase. Ackman notes that e-commerce penetration in home improvement retail remains low. But even if online competition were to rise, Lowe’s online platform should help the company to preserve market share.
Management and value
Fourthly, Ackman believed that Lowe’s new CEO Marvin Ellison and management team could close the performance gap between Lowe’s and Home Depot. Marvin himself was a former executive at Home Depot and has since poached several Home Depot executives for new roles. And at 18 times earnings, Lowe’s stock price, in Ackman’s view, didn’t reflect the change in management, “underlying business quality”, and prospect for improvement and growth. For context, Home Depot was trading at 21 times earnings during the same time.
Further reading
Pershing Square Holdings. Letters and Presentations to Shareholders. Available at < https://www.pershingsquareholdings.com/company-reports/letters-to-shareholders/ >
- Pershing Square shareholder letters – Bill Ackman – Investing principles and business model
- Boston Omaha shareholder letters – Rozek and Peterson on value investing and billboard businesses
- 30 years of Markel shareholder letters – Insurance, investing and the Markel Style
- Common Stocks and Uncommon Profits – Phil Fisher and his fifteen points for investing
- Bruce Greenwald on Value Investing, From Graham to Buffett and Beyond
- Beating the Street – Peter Lynch on his investment approach
- Constellation Software shareholder letters – Mark Leonard and his investing philosophy