One of the investors we watch closely here at The Acquirer’s Multiple is Bill Ackman. In 2015 Ackman did a great interview with The Graham & Doddsville Newsletter in which he discusses how to find great businesses to invest in, why he prefers to be concentrated, and the importance of converting GAAP earnings into owner earnings, or economic earnings when you’re assessing a potential investment.
Here’s an excerpt from that interview:
(G&D): If we were to go back to the period before launching Gotham, how did you get your start in investing?
Bill Ackman (BA): I started investing in business school. A friend recommended that I read Ben Graham’s The Intelligent Investor and it resonated with me. I decided to go to Harvard Business School and learn how to become an investor.
I got to HBS and unfortunately there were no classes really focused on investing. The first year is a set program – it didn’t have much in the way of choice. I thought the best way to learn is by doing, so I started investing on my own. I found that it fit with what I like to do. The first stock I bought went up. I think if it had gone down I would have become a real estate developer or something. Then, six months later, I roped in a classmate, David Berkowitz, who was in my section – it was a little lonely going back to the dorm room on my own to do this kind of thing. The two of us started looking at investments together toward the end of my first year and the beginning of my second year. At a certain point in time, I said, “What if we did this as a real business?” I figured the worst case, if we failed, is we’d have a lot of very good experiences. And if we’re successful, great.
G&D: How would you describe the evolution of your investing philosophy from Gotham to Pershing Square?
BA: Gotham was not set up to be an activist hedge fund – it just sort of happened. I don’t remember the moment we decided to intervene in a company. There were a couple of different cases where it seemed obvious what should happen. The basic evolution was this: Version 1.0 was classic value investing, which entailed investing in statistically cheap securities. Version 2.0 was recognizing the difference between businesses of different quality. I think over time we developed more of an appreciation for the value of a quality business. Version 3.0 was understanding the impact of activism. More recently, Version 4.0 is understanding that if you can find a great business, and if you can switch out a mediocre management team for a great one, you can create a lot of value. That was an evolution over 22 years.
G&D: You manage a concentrated portfolio and there are some inherent risks to that. Broadly speaking, how do you think about constructing the portfolio today and how has that changed over time?
BA: I’m a big believer in concentration. But it’s not just analysis that protects you, it’s the nature of the things you invest in. If you invest in super high quality, durable, simple, predictable, free cash flow generating businesses, that should protect you as well. If you pay a fair to cheap price for businesses of that quality, I think it’s hard to lose a lot of money. The key is you have to be a good analyst in order to determine whether it truly is a great business. You have to really understand what the moats are. You have to understand the risk of technological entrants – the two guys in a California garage working on the next new thing. Buffett would always write about the newspaper business being one of the great businesses, but print has been disintermediated as a result of changes in technology. So we’re concentrated, but we try to invest in businesses where it’s very hard to lose money, particularly at the price we pay.
We size things based on how much we think we can make versus how much we think we can lose. We’ll probably be willing to lose 5-6% of our capital in any one investment. With Fannie (FNMA) and Freddie (FMCC), you have highly leveraged companies where the government is effectively taking 100% of the profits forever. There’s legal risk and political risk, and an enormous of amount of uncertainty. We could realistically lose our entire investment. That’s a 2-2.5% position at today’s market price.
In our other investments, it is very hard to lose money. We like to own businesses with dominant competitive positions, such as railroads, industrial gases, and specialty pharmaceuticals. Some of our investments also benefit from undermanaged operations or reported earnings that understate true economic earnings. When we pay a fair price for those situations, we can make it a significant position.
The biggest investment we ever made was Allergan (AGN), which, at cost, was approximately 27% of our capital. There we were partnering with a strategic acquirer and it had an immediate catalyst to unlock value. It was a very high quality business. We felt it was hard for us to lose a lot of money, so the position could be quite large. Could we lose 20% of our capital? Sure, it was possible, but very unlikely. So in some sense, we think about losing 20% on 27% as risking 5- 6% of our capital.
G&D: You mentioned companies failing to achieve their true earnings potential as possible opportunities. How do you evaluate management teams and what metrics do you consider?
BA: We look at management the same way we judge people we want to hire for Pershing Square. We’re looking for character, intelligence, and energy, but we’re also looking for relevant experience. If you look at Seifi Ghasemi at Air Products (APD), he knows the industrial gas business very well. He spent nearly 20 years with The BOC Group and spent the last 13 years at specialty chemical company Rockwood Holdings (ROC). So he had both disciplines – the qualitative characteristics and the experience. He had been a public company CEO for a meaningful period of time. It was very easy to support him as CEO of the company. We helped recruit Hunter Harrison to Canadian Pacific Railway (CP). He had turned around two other railroads including a Canadian competitor. If you meet him, you’ll understand his leadership qualities. It’s easy if you’re backing someone who’s already done it before. It’s more difficult when you are taking someone who has not been successful before and betting on their success.
G&D: Buffett uses the concept of owner earnings. Are there any particular metrics you find helpful?
BA: I think the job of the security analyst is to take the reported GAAP earnings of a business and translate them into what Buffett calls owner earnings. I call them economic earnings. The next step is to assess and understand the durability of those earnings. Fundamentally, what you’re looking for is how much cash the business can generate on a recurring basis over a very long period of time. That’s what we do. GAAP accounting is an imprecise, imperfect language that works for very simple businesses. For a widget company that grows 10% a year, GAAP earnings are really good at approximating economic earnings. For Valeant Pharmaceuticals (VRX), for example, a company that’s been very acquisitive, GAAP accounting is not a very good way to think about that business.
G&D: How do you typically source ideas? Is there one method in particular that’s had a lot of success?
BA: Interestingly, Allergan (AGN) and Air Products (APD) were brought to us. That’s a good way to get ideas. We have a reputation for being a good, proactive investor. Canadian Pacific (CP) came from an unhappy CP shareholder. Air Products came from a happy CP shareholder who made a lot of money with us and said, “Hey, this is the other dog in my portfolio, maybe you can help.” Allergan came to us through Valeant because they were looking for someone who could help increase the probability of their success. We’re looking for big things. Today we have $19 billion in capital. We want to put 10% or more in an investment so we prefer companies with market caps above $25 or even $50 billion. We are looking for high business quality and opportunities to make the business much more valuable. Some of our sourcing comes from reading the newspaper and just looking for companies that meet that very simple model. Where is there a super high quality business you can buy for a discount where there’s an opportunity for optimization?
G&D: Many respected investors have publicly praised your investment creativity. It seems to be one of the defining qualities of Pershing Square. How do you cultivate that creativity? Is there a way for someone to develop that ability?
BA: Someone once pointed out that almost everything we’ve done has been unprecedented. We shorted a company and announced to the entire world that it is a pyramid scheme. With General Growth Properties (GGP), we bought 25% of the equity of a company on the brink of bankruptcy, convinced them to file for bankruptcy, and helped them restructure. We started a company from scratch with Howard Hughes (HHC). That was a collection of assets we spun out of GGP and replaced the management team. We’ve had two successful investments in SPACs during a period in which these vehicles were out of favor in the investment community. Our Allergan activist campaign was somewhat unprecedented as well. I don’t think it’s as much creativity as it is a willingness to consider opportunities that are unconventional and outside the box. What’s required is that you have to have a basic understanding of what’s right, what’s legal, and what’s possible, and not limit the universe to things that no one else has done before.
We are absolutely going to consider things that haven’t been done before. We don’t need a precedent. We’re just interested in things that create value and we’re going to look at them objectively. To execute the strategy, you have to be willing to do things without caring what other people think. You need thick skin. In this strategy, not everyone’s beloved, particularly on the activist short side. You’re not going to make many friends in that business except for the first person who took your advice and got out.
G&D: Given that we’re in this “golden age of activism,” there are lots of investors and capital focused on activism. Have you found it more difficult to find ideas to add to your portfolio as a result?
BA: No. First of all, it depends on what you count. In terms of dedicated activist funds, there is something like $150 billion. That’s a still a small number in the context of the size of the market. We are one of the largest at $19 billion. We are also one of the most concentrated activists. A combination of concentration and scale means we’re doing very big investments and these are very big companies. Every company we’ve invested in, we were the first activist who bought a stake.
Generally this is fertile ground. I would say there’s more activism happening in small and mid-cap companies, so I don’t think it has affected us. I do think companies are trying to fix themselves before an activist shows up, and that’s a threat. As businesses become better managed and boards of directors replace weak CEOs, there’s less for us to do.
G&D: What about allocation of time within investments – what portion of your time is spent generating ideas versus analyzing companies versus engaging in activism?
BA: It depends. This year I spent a lot of my time on Allergan (AGN), the IPO of Pershing Square Holdings (PSH), and a little bit of time on Zoetis (ZTS). But we’ve got a very capable team focused on a few major things. It’s much more of a team approach and strategy than a typical investment firm. Usually you have a back office and an investment team. At Pershing, we are totally integrated in everything we do – public presentations, legal analysis, compliance, and so on.
G&D: Before we close, do you have any advice for students who are interested in potentially starting their own fund or going into investment management after they graduate?
BA: You should only work with someone that you like, trust, and admire. You should be smart about who you choose to work for. In terms of starting something right out of business school, it’s something that I did a long time ago. I was fortunate to be able to have a 2.0 – Gotham in some ways was a training ground for Pershing Square. I think I was much more successful at Pershing Square because of the experience I had at Gotham. You can have that kind of experience working for someone else. It wasn’t really my nature to go work for someone else which is why I didn’t do it, but you can learn a lot that way. I wouldn’t worry very much about how much money you make. I’d worry much less about compensation than I would about what you can learn.
I also think that in order to be a great investor, it’s very helpful to understand business and how to run a business. I think it’s a really interesting time because it’s so easy to start a business today, relatively speaking. Start up costs are much lower due to the ease of access to the Amazon Cloud and other development resources. I think I would be starting a company today as opposed to managing money. You can always manage money. In fact, if you do well in whatever you do, you’re going to have to manage your money anyway. It’s good to learn the skills. I think we have enough people in the investment business. We want some more start-ups
You can read the entire interview here.
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