Notes from Pershing Square Annual Report

Investing in individual companies requires upfront effort but also much recurring maintenance effort. Classified as a maintenance effort is continue to learn from some of the best around. I cam across a notification here of Bill  Ackman’s Pershing Square Annual Report 2014. Bill Ackman have been known in the news due to his fight with Herbal Life, JC Penney and Allergan. What is perhaps seldom mentioned is that he is rather value tiled in his investment approach.

Like most value tilted managers, they write a rather splendid report to update shareholders but also serve as a way to communicate and curate their investors.If you disagree with how they do things, you are free to leave. At the end of the day perhaps, having strong investors will keep you sane from consistently questioning you.

This report is particularly interesting in that, I am often asked how do I carry out investing, and I explained it a few times to folks. When I read what was written, it turns out to contain many of the processes what I strive towards. The best thing is that he explains in such a clear manner, something that I often struggle to.

Particularly it sought to answer some of the questions, but not in detail:

1. How do you choose to be concentrated yet do not suffer from permanent loss of capital
2. The preference for businesses with competitive edge
3. The focus on cash flow based businesses (note the number of times they repeat this in the report)
4. Their aversion to debt or margin
5. Being very stringent on counterparty risk and specifically choosing only businesses that fits the criteria
6. Fluctuating share prices and what they will ‘do’
7. How macro-factor ‘affects’ them and what do they do about it, also why the growth can go nowhere but they will likely still end up good
8. Why stock price decline to them is a good thing

In summary, I find it to be one article that compress many value tilted mantras into one that explains to their investors their quest to find long term fixed deposits. Readers might not understand in detail how some of these factors will make sense in the overall picture and perhaps those question are good learning points to clear up through further reading or explaining.

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The Pershing Square Business Model

In order to achieve long-term success, Pershing Square must make good investments and operate with a robust business model. With much media attention focused on hedge fund failures, I thought it would be worthwhile reviewing the characteristics of our business model and explaining why we will withstand industry-specific and overall environmental threats to the investment and hedge fund businesses. The principal factors which contribute to the robustness of our business model are as follows:

• Our portfolio management approach is inherently low risk (where risk is defined as the probability of a permanent loss of capital), particularly when compared with other hedge fund business models. An important distinguishing factor about Pershing Square compared to most other hedge funds is that we do not generally use margin leverage in our investment strategy. The lawyers prefer that I put in the word “generally” to give us the flexibility to use margin to manage short-term capital flows, but, to-date, we have not used but an immaterial amount of margin, and only for a brief period of time, and we have no intention of changing this approach.
• We generally invest in higher quality businesses with dominant and defensive market positions that generate predictable free cash flow streams and that have modestly or negatively leveraged (cash in excess of debt) balance sheets. We buy these businesses at deep discounts to our estimate of intrinsic value giving us a margin of safety against a permanent impairment of capital. I say “generally” again here because we do make exceptions in certain limited circumstances; that is, we may buy a more leveraged or lower quality business if we believe the price paid sufficiently discounts the risk.
• We often seek investments where we can effectuate positive change to catalyze the realization of value. This serves to accelerate the recognition of value, helps us avoid “dead money” situations, and protects us somewhat from managerial actions which can destroy value.
• We are diversified to an adequate but not excessive extent. This has further benefits for risk and operational management which I will discuss below.
• There is an inherent balance to our long/short investment approach. Historically, when equity or credit markets weaken, our shorts become more valuable, and occasionally materially more valuable, offsetting somewhat the mark-to-market declines in our long portfolio. If we choose to unwind these short positions during market downturns, we can generate capital to invest in a now less expensive market. These short investments generally stand on their own in that they do not typically require a stock market or credit market decline to be successful. That said, they have served as a useful hedging tool during periods of dramatic market declines.

How they prospect businesses on the long side

As a general rule, we purchase simple, predictable, free-cash-flow generative businesses that have sustainable competitive advantages due to brand power, unique assets, long-term contractual arrangements, or other factors. These companies are [generally] modestly or negatively leveraged (i.e., have more cash than debt) and do not need access to the capital markets to survive and thrive. These businesses generate more capital than they need for reinvestment. They deploy this excess capital by buying back their own shares and by paying dividends to shareholders.

As a result of the above characteristics, the intrinsic value of the businesses that we own is relatively immune to equity and credit market volatility. They [generally] do not have large debts that need to be refinanced. They [generally] do not need to raise equity capital to continue to exist or even to grow. Because these companies are buyers of their own shares, we are actually the beneficiaries of short-term declines in their share prices because more shares can be repurchased in the market with the same amount of capital. Our proportionate interest in these companies will grow at a higher rate if their stocks decline than if their share prices were to have risen over the same period. Because these businesses have superior economic characteristics and limited or negative financial leverage, I would expect our long investments, on average, to decline less than the market as a whole in a dramatic market decline. The stock prices of our investments, however, are still likely to decline during periods of equity market declines unless specific value-creating events occur that will cause a realization of value. Pershing’s investment strategy requires us to identify investments for which we can determine their outcome with a very high degree of probability. As a result, we typically invest in businesses with low business volatility and a high degree of cash flow predictability. 

As an investor who has successfully effectuated corporate change and as typically one of the largest holders of the companies in which we invest, we are well positioned to push for value-creating actions in the event such opportunities are created in volatile markets.

For obvious reasons, we much prefer that a stock price declines while we are acquiring our interest for it enables us to buy a full position at a lower price. While we don’t automatically buy more if the share prices of our holdings decline, it is the rare circumstance where an existing holding’s stock price declines meaningfully and we are not excited to take advantage of the opportunity. This is true because the businesses in which we generally choose to invest are those whose values are not materially affected by extrinsic factors we cannot control. While nearly every one of our investments is exposed to the economy to some degree, we attempt to identify companies for which increases or decreases in interest rates, commodity prices, short-term volatility in the economy, and similar factors are not particularly material to our investment thesis.

Long Exposure and Market Correlation

Our greater long equity exposure means that we are likely to have greater daily correlation with short-term moves in the market than if we had less exposure. Over longer periods, we expect our portfolio to continue its high degree of divergence from overall stock market performance because of the high degree of concentration in our holdings and the event-driven nature of most of our investments.

While a more positive macro environment will increase the value of our holdings, we expect to generate high long-term rates of return from our existing holdings even without a substantial improvement in the economy. I have come to think of our investment approach as akin to a form of long-term arbitrage, where we invest and then work with our portfolio companies to cause the spread between our purchase price and intrinsic value to narrow. In some cases, in addition to unlocking existing value, we can assist a company in increasing its long-term intrinsic value by bringing in new management, adopting a change in strategy, modifying its structure and approach to allocating capital, by selling or spinning off non-core assets, through cost control and with other approaches.

Our ability to cause the price-value spread to narrow is, in most cases, unrelated to macro events, and has improved significantly over the last [eleven] years. It is largely a function of Pershing Square’s growing influence in the capital markets, our experience with previous investments, and specific circumstances with each of our holdings.

Valuation

We believe the value of a business is equal to the present value of the cash the business generates for its owner over its lifespan. By analogy to debt instruments, a business is like a bond where the owner will receive a stream of coupons over its life, but where the coupons are variable and not precisely known, and the business’ life or term is similarly uncertain. To value a business, one needs to predict approximately how much cash the business will generate that can be distributed to its owners over its life on a per-share basis. I emphasize ‘per share’ because dilution from option issuance or from ill-advised acquisitions – or, conversely, accretion from stock buybacks – can have a very material impact on the long-term, per-share value created for owners.

Because of the inherent uncertainty in valuing bonds with unknown coupons and terms, we have generally chosen to invest in businesses where the coupons (the economic earnings) are more predictable, and the long-term prospects are more certain. This has led us to purchase interests in simple, predictable, free-cash-flow-generative businesses. We also require a purchase price which represents a large discount to our estimate of intrinsic value. This, perhaps more than anything, helps mitigate the risk of our being wrong about our future estimate of a business’ performance.

Management and governance can have a big impact on the per-share prospects of even the best businesses, and an even greater impact on lower-quality businesses. This has led us to purchase higher-quality businesses when we can find them at prices that make sense. The importance of good governance and management to a successful investment outcome is made particularly clear when the cash flows to the owners of a business are back-end loaded. The majority of the cash generated by most publicly traded businesses is not distributed to their owners in the short term. Cash returned to owners in the form of dividends and stock buybacks usually represent a minority of the cash generated by the business, with the balance of a business’ cash often reinvested in new projects or acquisitions.

As a shareholder willing and able to take a pro-active or re-active stance with respect to our holdings, we can help mitigate the risk of poor governance and the inefficient use of excess cash by having an impact on both management and governance. While we can have significant influence, we cannot completely eliminate poor investment or management decisions. As a large influential shareholder, we can also often play a meaningful role in determining when the equity “bond” comes due. For example, if it makes sense for a business to be sold because it has reached the end of its strategic life, or because management cannot be identified to maximize the value of a business, or because the greatest long-term value can be generated through a sale, we can meaningfully increase the probability that a sale can be executed.

The Impact of Macro Factors on Our Investment Selection

Despite the fact that we occasionally have an opinion, we spend little time trying to outguess market prognosticators about the short-term future of the markets or the economy for the purpose of deciding whether or not to invest. Since we believe that short-term market and economic prognostication is largely a fool’s errand, we invest according to a strategy that makes the need to rely on short-term market or economic assessments largely irrelevant.

Our strategy is to seek to identify businesses and occasionally collections of assets which trade in the public markets for which we can predict with a high degree of confidence their future cash flows – not precisely, but within a reasonable band of outcomes. We seek to identify companies which offer a high degree of predictability in their businesses and are relatively immune to extrinsic factors like fluctuations in commodity prices, interest rates, and the economic cycle. Often, we are not capable of predicting a business’ earnings power over an extended period of time. These investments typically end up in the “Don’t Know” pile. Because we cannot predict the economic cycles with precision, we look for businesses which are capitalized to withstand difficult economic times or even the normal ups and downs of any business. If we can find such a business and it trades at a deep discount to our estimate of fair value, we have found a potential investment for the portfolio. Next we look for the factors that have led to the business’ undervaluation, and judge – based on our assessment of the company’s governance structure, management team, ownership, and other factors – whether we can effectuate change in order to unlock value. When the price is right, the business is high quality, the management is excellent, and there are no changes to be made, we are willing to make a passive investment.

Our assessment of the short-term supply and demand for securities plays almost no role in our determining whether to invest capital, long or short. If we believed that it was possible to accurately predict short-term market or individual stock price movements and we had the capability to do so ourselves, we might have a different approach.

Over the past [11] years, we have profited not because of our predictive powers concerning macro events, but rather because of our ability to identify high quality companies with low business volatility that trade at a discount to intrinsic value, where catalysts exist or can be created to narrow the valuation gap. Because we do not believe that we have a competitive advantage in predicting short-term market or economic conditions, we generally choose to invest in businesses that will excel in almost any economic environment. Even so, given that our funds have investments which are generally more long than short; an improving economy will assist the funds’ performance. We expect, however, that investment selection, rather than macro factors or stock market movements, will continue to be the principal determinant of our performance as the substantial majority of our historic (and anticipated) profits have come from the narrowing of valuation discrepancies between the prices we have paid for our investments (or received in shorting a security) and fair value.

Our Approach to Risk Management

Our simple approach to investing also allows us to avoid complicated approaches to risk management. Our investment strategy does not require us to open offices all over the globe. As such, we don’t need traders working around the clock. We can go to sleep at night and sleep. Our weekends are largely our own. Our risk management approach is to: (1) put our eggs in a few very sturdy baskets, (2) store those baskets in very safe places where they cannot be taken away from us and sold at precisely the wrong time due to margin calls, and (3) to know and track those baskets and their contents very carefully. We call this approach the sleep-at-night approach to risk management. If I can’t, we won’t.

I am extremely skeptical of more automated, algorithmic, Value at Risk, and other business school sanctioned approaches to risk management. None of these approaches saved Lehman, Bear Stearns, Fannie, Freddie, AIG, WaMu, Wachovia or any of the other institutions that used these and other ostensibly more sophisticated risk management strategies. Our investment strategy and approach to counterparty risk serves to limit the risks inherent in our individual investment selections, our counterparty risk, and the portfolio as a whole. There are, however, other important risks to our business, principally operational, reputational, and regulatory risk.