Here’s a great interview by Advisor Perspectives with Bill Ackman. During the interview Ackman discusses his investment strategy, how to define a great business, how to construct a portfolio, the importance of an active approach to investing, and why maintaining a high public profile is important in the execution of his strategy. He also provides some insights into why Warren Buffett is willing to pay 20% above a company’s highest price to secure an investment.
Here is an excerpt from the interview:
Starting at a basic level, how would you characterize your investing strategy?
We rely on concentrated research to identify great businesses that are trading at highly discounted valuations because investors have overreacted to negative macro or company specific events. That’s the time-arbitrage part of the strategy, taking advantage when the market reacts to short-term factors that have little impact on long-term intrinsic values. Our greatest competitive advantage, though, comes from using our stake in a company to intervene in the decision-making, strategy, management or structure of the business. We don’t like waiting for the market to be a catalyst.
Why is Warren Buffett willing to pay 20% above the highest price at which H.J. Heinz stock has ever traded, even after it’s had 20 quarters of great results? The answer is that control is very valuable. Not just for the bragging rights, but because you can change strategy, you can redo the cost structure, you can change the tax structure, you can sell off underperforming assets or hidden assets. The control premium is really telling you that the current management team and board are not optimizing the value of the business. For a financial buyer, which is essentially what Buffett is in this case, you’re buying it because it’s a great business and because you believe you can make the price paid end up looking cheap.
That’s very similar to what we try to do: Buy high-quality businesses at a price that is not reflective of the intrinsic value of the business as it is, and certainly not reflective of what the intrinsic value would be if it were run better.
That allows us to capture a double discount. That’s a benefit we can have over private equity. They can buy a company and run it better to extract incremental value, but they’re typically paying the highest price in a competitive auction, so they don’t get that first discount. We don’t get full control, but because we have a track record of making money for other investors, we can often exert enough control to make an impact. With Canadian Pacific Railway [CP], we won a proxy contest and with our 14% stake were able to appoint 8 of the 14 directors and recruited one of the best railroad executives of all time, Hunter Harrison, to be CEO. That has created a lot of value.
How do you define a great business?
We like simple, predictable, free-cash-flow generative, resilient and sustainable businesses with strong profit-growth opportunities and/or scarcity value. The type of business Warren Buffett would say has a moat around it.
We’ve done almost nothing in energy or other cyclical businesses. We avoid healthcare because of all the regulatory uncertainty. We’ve done nothing active in financial services, except on the short side with MBIA. When you’re putting 8%, 12% or 15% of your money in something, it’s not a day trade. You have to focus first and foremost on high-quality businesses that can’t blow up and should grow in value over time.
Describe how you construct your portfolio with both active and passive investments?
We think having 8 to 12 core positions at a time provides an adequate degree of diversification, while allowing us to concentrate in a handful of ideas that we know very well and believe have highly favorable risk/reward characteristics. If our capital base were permanent, we’d probably only do active investments. But it isn’t, so the fact that I don’t ever want to be forced to sell an active investment in the course of an engagement means we also need to hold passive positions. Historically, around 55% of our portfolio has been in active investments, 15% or so has been in cash, and the balance has been passive.
What has tended to perform better, active or passive?
The 55% of our capital in activist investments has produced more than 90% of our returns. One primary reason we’re working hard to increase the amount of permanent capital we have is to devote as much of the portfolio as possible to active positions. Doing that should enable us to earn higher returns over time.
Why maintain the 15% or so average holding in cash?
That’s just what it’s been on average, the level can be much higher or lower. We don’t believe in leverage, so cash serves as liquidity for potential future opportunities, the size and availability of which can vary. We earn a high enough return on capital that we can afford the dilution of cash.
Maintaining a high public profile appears to be important to the execution of your strategy. Why is that?
The press is a necessary element of the strategy. Look at something like Procter & Gamble. We haven’t run a proxy contest. We haven’t made a public presentation. All we did is buy some stock. That became publicly known and immediately the press was all over the company and what they were or weren’t doing right. That saved us a lot of time and energy. On solid, high-profile boards of companies that are underperforming, sometimes the directors just need a little bit of a push. One of the best pushes is a reputational push, which a press spotlight can administer.
That spotlight can be particularly important in our shorts. We don’t short on valuation, but in situations where we believe a company is violating the law, or has misleading or inaccurate accounting, or has a potential regulatory problem. In these cases the attention really matters. If you’re a regulator with any sort of oversight of Herbalife [HLF], how can you ignore it when a reputable investor who has spent 18 months researching it says it is a certainty that the company is a pyramid scheme? Imagine if I’m right and they’ve done nothing on a company that’s in the paper everyday.
You can find the entire interview at Advisor Perspectives here.
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