In his recent letter to investors regarding his purchase of 3.1 million shares in Netflix, Bill Ackman provided some lessons in asymmetric hedging. Here’s an excerpt from the letter:
In order to fund our purchase of Netflix, beginning on Friday and over the last few days, we unwound the substantial majority of our interest rate hedge generating proceeds of $1.25 billion. We retained interest rate swaptions that are currently out-of-the-money, and also purchased some additional longer-dated, out-of-the-money swaptions.
The result of all of the above is that the notional size of our interest rate hedge has been reduced by 80%, the term of a substantial portion of the hedge we retain has been extended, and our dollar investment in hedges has been reduced by more than 90%.
Had we not sold the hedge, we could have likely realized more gains based on the increase in rates, largely today, since our sale. That said, we believed the opportunity to invest in Netflix at current prices offered a more compelling risk/reward and likely greater, long-term profits for the funds.
We invest in hedges not to protect the funds from a short-term mark-to-market loss, but rather because they can become a large source of potential liquidity at precisely the time stocks become cheap. We invest in asymmetric hedges as they offer the opportunity for large gains without exposing the portfolio to meaningful losses in the event the potential risk does not transpire.
We invested in out-of-the-money interest rate swaptions in December 2020 and early 2021 because we believed that it was likely that the combination of aggressive fiscal policy, monetary policy, and the reopening of the economy due to vaccines would cause non-transitory inflation, which would require the Federal Reserve to raise rates.
We believed that an unexpected rise in rates could cause a market correction. We viewed this outcome to be a likely one, yet the options we purchased implied that this scenario was very unlikely. Highly differentiated perspectives on future outcomes can yield attractive payoffs for investors, particularly when structured in an asymmetric format.
Fortunately, all of our portfolio companies are extremely high-quality businesses that can withstand inflation as they have the ability to price their highly desirable products, services, and assets to preserve their profitability in an inflationary environment.
We do not believe that the recent move in rates has had any meaningful impact on our companies’ intrinsic values. As such, we believe that our portfolio companies trade at an even more material discount to their intrinsic values, particularly in light of recent, market-driven, price declines. While we do not know what the stock market will do tomorrow, next month or even over the next year or two, we believe that our companies will continue to compound their intrinsic values at high rates for the long term.
You can read the entire letter here:
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