Pershing Square shareholder letters - Bill Ackman investing principles

Pershing Square - Bill Ackman - Investing principles

Learning from Bill Ackman

Bill Ackman, CEO of Pershing Square Capital Management, describes how he likes to read the annual reports of companies to understand their history, progress and strategy. He also revisits his own letters to shareholders to review the development and direction of Pershing Square itself.

High quality letters and annual reports in my opinion are a rich source of learning for students of business, industry and investing. Great letters to shareholders, like that of Markel Corporation or Constellation Software for example, are filled with concise wisdom. Pershing Square‘s letters, in my opinion, are of that calibre too.

This post, the first of two, will summarise the lessons that I took from Pershing’s 2014 to 2020 quarterly letters – Focusing more so on their investment principles and busines model. The second post will look at their economic reasoning and the investment theses that I found most interesting.

Principles

Ackman reiterates Pershing Square’s principles and strategy in several letters to shareholders (e.g. Dec 2014 letter). If I could summarise their long-side approach in four blunt themes, it’d be: (1) value, (2) quality, (3) activism and (4) concentration.

Value

Pershing Square’s goal is to maximise the long-term compound annual growth rate of its intrinsic value per share. Like other value-oriented funds, they seek to purchase businesses at a large discount to their estimate of intrinsic value. That is, to ensure that every investment has a margin of safety that proportionate to the risk of permanent capital loss.

Since they mark their assets to market in their financial statements, Ackman believes that net asset value or book value per share to be a reasonable proxy for this. But in the short-term, mark-to-market is not always a reliable measure of progress. Either way, growth in intrinsic value of the underlying holdings is the ultimate driver and marker of long-term results.

Quality

Their investment strategy, as noted in their 2018 letter to shareholders, is to invest in “simple, predictable, free-cash-flow-generative businesses… [that] have high returns on capital, very long-term growth trajectories, wide competitive moats, unique and irreplaceable brands and/or other assets”. They like businesses that generate capital in excess of reinvestment needs, which the company can then redeploy into share buyback and/or dividend programs.

The rationale is simple: The risk of permanent loss of capital is lower when the business enjoys a durable competitive advantage and strong balance sheet, and trades at a price well below intrinsic value. These companies tend to depend less on new and dilutive capital raisings and are more “immune to equity and credit market volatility”. Furthermore, if their holdings are net buyers of their own stock, then long-term shareholders can benefit from temporary declines in its share price.

“The long-term health of the businesses we own depends on demand for …, cookies, biscuits, and chocolate (Mondelez), industrial gases (Air Products), …, companion and livestock pharmaceutical products (Zoetis), …, and low-cost residential mortgages (Fannie/Freddie). In each of these cases, we believe that demand will remain recurring and robust over the long-term with relatively limited impact from technological substitution, commodity prices, all but substantial declines in GDP, or other extrinsic factors outside of our control.”
Pershing Square Capital Management, Letters to Shareholders

Short-selling

Pershing’s criteria for short-selling are the inverse of their long-strategy. They prefer businesses that: (1) are highly leveraged; (2) rely on capital access for survival; (3) employ bad business models; (4) use fraudulent accounting and financial shenanigans; and (5) have a low ceiling on valuation (analogous to the margin of safety). Companies that satisfy these criteria are rarer. So, shorting remains a more sporadic feature of Pershing’s overall strategy.

Activism

Pershing Square will also look for opportunities in which they can help to trigger or accelerate the realisation of value. Examples include improvements of capital structure, introduction of new operating efficiencies, spinoffs and sale of assets. Often, they’ll have influence over the company through their large stake, active voice and/or board representation. Their activism allows them, in theory, to prevent management from value destroying activities.

Concentration

In their November 2014 letter, Ackman wrote that Pershing would concentrate the bulk of their capital in eight to twelve investments with a long-term holding period (four years or more). They’ll also reserve about one-third of their capital in cash and passive investments to minimise the risk of forced-selling during an activist campaign.

For Pershing’s investment strategy to flourish, they must understand their investments with a high degree of confidence. Unlike bonds or treasury securities, a business’ coupons (cashflows) and lifespan are often uncertain. So, they prefer companies and industries with lower business volatility and higher cash flow predictability.

They’ll throw companies in the “don’t know” basket if their earnings are difficult to predict and/or sensitive to commodity prices, economic cycles, interest rates and other market or macro- factors. Ackman also says it important to think about value on a per share basis. Issuances, buybacks and acquisitions for example can impact per-share value to owners.

Risk management

Ackman reminds readers that “investing is a probabilistic business”. For every decision they make, they have to consider the likelihood and degree of success and failure. Pershing is not averse to taking more risk if the opportunity presents even greater rewards. Sometimes they’ll invest in businesses of lower quality and/or higher leverage if the margin of safety is sufficiently large. (Note also that they define risk as the probability and severity of permanent loss of capital)

Eggs and baskets

Pershing’s “simple approach” to investing allows them to avoid the complexities of risk management. Firstly, they “put [their] eggs in a few very sturdy baskets”. Secondly, their avoidance of margin leverage allows them to sell shares on their terms and not when markets are in freefall alongside margin calls. Thirdly, concentration allows them to understand and monitor their eggs and baskets carefully.

Ackman refers to this as the “sleep-at-night approach to risk management. If [they] can’t, [they] won’t”. Pershing Square doesn’t need traders and offices around the world or clock. “[They] can go to sleep at night and sleep. [Their] weeks are largely [their] own”. Ackman is also cautious of business school approaches to risk management, like Value-at-Risk. He reminds readers that these sophisticated methods did not save AIG, WaMu, Lehman and so on from the Global Financial Crisis.

Of course, concentration is often volatile in the short-term. It may even underperform relative to benchmarks. The belief is that concentration enables one to select investments with greater probability of strong results over the long-term. For Pershing, this is a three-to-five-year measuring period. With concentration, one should expect the very best ideas to drive the bulk of long-term profits.

New York Times test

When it comes to reputational risk, Pershing Square employs a simple rule: the New York Times test. For major actions or investments they make, they ask themselves how they’d feel if the New York Times were to publish a factual and balanced article about it. If they’re comfortable with how their friends, families and the public would react to it, they can proceed. If not, it’s back to the drawing board.

Investor qualities

In his January 2016 letter, Ackman describes how long-term investment opportunities tend to come when the market values companies on near-term factors as opposed to changes in the company’s long-term intrinsic value. For example, he recalls how macro-events had lowered the intrinsic value and stock price of their investment in Canadian Pacific by around 10% and 35% respectively in 2015-16. Ackman says it’s important to remember that it’s the lifetime generation of cash flows that determine intrinsic value. Short-termism and technical factors can lead to severe under- and over-valuations from time to time.

Conviction

To navigate the manias, depressions and volatilities of the market, one must have their own views on what constitutes fair value. This may or may not align with prevailing market sentiments. Pershing will only make a purchase when they’ve developed enough conviction in the opportunity. They do not take “token positions” as other investors like to do. That said, they do like to “leave some room” to increase their position down the track if the price to value ratio improves.

Confidence and humility

Ackman describes the challenge of changing one’s mind after one’s views are made public. It reflects our bias for inconsistency-avoidance (as Charlie Munger noted in The Psychology of Human Misjudgement) and self-narrative preservation (as Annie Duke described in Thinking in Bets).

The tendency to ignore data and evidence that conflicts with our pre-established views is often problematic. One of Pershing Square’s strengths, Ackman says, is in their “willingness to promptly change [their] mind when confronted with new information which is inconsistent with [their] original investment thesis”.

Similarly, Ackman says that confidence and conviction without humility in investing is dangerous. He recalls Pershing’s exit from J.C. Penney at a significant loss, describing how rational investment decision making, devoid of emotional and personal factors, can help to minimise even greater losses.

Pershing Square is not afraid to abandon a position when they find their thesis is wrong or deteriorating. The “option” to abandon often contains value. Ackman says the balance between conviction and humility is an essential part of Pershing Square’s long-term approach to investing.

“I have learned that the key to long-term success in investing is to balance confidence with the humility to recognize when the facts are no longer consistent with one’s original investment thesis. It is critically important not to let psychological factors interfere with economic rationality in investment decision making.”
Bill Ackman, Letter to Shareholders, Pershing Square, December 2014

Structural advantages

Doesn’t Pershing Square sound like any other value-oriented fund? Ackman doesn’t think so. Part of their advantage he believes is in their reputation, opportunity set, barriers to entry, deep understanding (due to concentration), lower turnover and lower frictional costs. I thought this was an interesting lesson in business models and worth noting.

Opportunity set

Ackman believes that Pershing enjoys a structural advantage as an activist investor in large-cap companies for two reasons. Firstly, the opportunity set is significant. Despite their history of growth, profits and what-not, the eventual scale and complexity of large-cap behemoths often results in undisciplined capital allocation and operating efficiencies. This represents untapped value for the savvy activist.

Barriers to entry

Secondly, there are high barriers to entry and limited competition in large-cap activism. Activists in the large-cap arena require a vast sums of capital and reputational equity. It’s no surprise that passive shareholders and institutions comprise a large fraction of large-cap companies today. Large-caps are often too big for private equity considerations. Through structural and operating improvements, Pershing believes large-cap activism offers another lever to value creation.

Creative advantage

Another competitive but intangible strength, in Ackman’s view, is Pershing Square’s creative advantage. Quite a number of their best investments involved activism and transaction structures at scales that were uncommon to markets historically (some of Pershing’s manoeuvres during COVID-19 seemed successful – amidst a torrent of criticism). Ackman admits in his 2014 letter that Pershing’s operating model will attract a lot of public scrutiny, media and detractors. Success in this space “requires a very thick and calloused skin”.

Operational advantage

Finally, their investment approach and concentration allows Pershing to run a lean operation. A high-asset-per-employee ratio also allows Pershing to attract and compensate their top talent. This, along with exciting work and their “friendly, open, hard-working and family oriented culture”, helps to keep staff turnover low – An operating advantage for the firm. At the time of writing (in late 2014), Pershing Square had ten investment professionals and 70 employees in total. While they could operate with even fewer staff, their COO Tim Barefield believes it important to have “back-up talent for every role in the firm”.

“Pershing Square is a nice place to work. While this sounds like an obvious approach to retaining talent, many and perhaps most hedge funds don’t fit this description. We are big believers in taking care of our team”.
Pershing Square Capital Management, Letters to Shareholders

Pershing Square shareholder letters – Bill Ackman – Investing principles and business model