Bill Ackman on What Makes a Great Investment

By John Heins March 12, 2013 Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives. In addition to commenting on his high-profile current investments, Pershing Square apital!s "ill Ac#man in a recent interview with $alue Investor Insight describes the general company traits he loo#s for in both active and passive investments, why a high public profile is an important element of his strategy, whether his thesis on %. . Penney has evolved, what lessons he!s learned from a few prominent mista#es, and why his short conviction on &erbalife is as high as ever. Starting at a basic level, how would you characterize your investing strategy? We rely on concentrated research to identify great businesses that are trading at highly discounted valuations because investors have overreacted to negative macro or company specific events! "hat#s the time arbitrage part of the strategy, ta$ing advantage %hen the mar$et reacts to short term factors that have little impact on long term intrinsic values! &ur greatest competitive advantage, though, comes from using our sta$e in a company to intervene in the decision ma$ing, strategy, management or structure of the business! We don#t li$e %aiting for the mar$et to be a catalyst! Why is Warren Buffett %illing to pay 20' above the highest price at %hich H!J! Hein( stoc$ has ever traded, even after it#s had 20 )uarters of great results* "he ans%er is that control is very valuable! +ot ,ust for the bragging rights, but because you can change strategy, you can redo the cost structure, you can change the ta- structure, you can sell off underperforming assets or hidden assets! "he control premium is really telling you that the current management team and board are not optimi(ing the value of the business! .or a financial buyer, %hich is essentially %hat Buffett is in this case, you#re buying it be cause it#s a great business and because you believe you can ma$e the price paid end up loo$ing cheap! "hat#s very similar to %hat %e try to do/ Buy high )uality businesses at a price that is not reflective of the intrinsic value of the business as it is, and certainly not reflective of %hat the intrinsic value %ould be if it %ere run better! "hat allo%s us to capture a double discount! "hat#s a benefit %e can have over private e)uity! "hey can buy a company and run it better to e-tract incremental value, but they#re typically paying the highest price in a
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competitive auction, so they don#t get that first discount! We don#t get full control, but because %e have a trac$ record of ma$ing money for other investors, %e can often e-ert enough control to ma$e an impact! With 1anadian 3acific 5ail%ay 6137, %e %on a pro-y contest and %ith our 18' sta$e %ere able to appoint 9 of the 18 directors and recruited one of the best rail road e-ecutives of all time, Hunter Harrison, to be 1:&! "hat has created a lot of value! ow do you de!ine a great business? We li$e simple, predictable, free cash flo% generative, resilient and sustainable businesses %ith strong profit gro%th opportunities and;or scarcity value! "he type of business Warren Buffett %ould 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, e-cept on the short side %ith MB42! When you#re putting 9', 12' or 1<' of your money in something, it#s not a day trade! =ou have to focus first and foremost on high )uality businesses that can#t blo% up and should gro% in value over time! "ike #rocter $ Gamble %#G&? 3>? is a perfect e-ample! 4t#s a global leader in many of the most attractive consumer goods categories, %hich have structurally high profit margins, strong customer loyalty, and e-cellent gro%th opportunities in emerging mar$ets, %here 3>? has nearly 80' of its sales! 4ts brands, including 3ampers, "ide, ?illette and &lay, are among the strongest in the %orld! @espite all that, in the second )uarter of last year %e %ere able to buy into the stoc$ at a modest multiple on depressed earnings! "he company had for three years underperformed its peers on many levels, innovation had been %ea$, and an already high overhead cost structure had become even more bloated! With the stoc$ at AB0, %e thought there %as an e-tremely lo% probability %e#d lose money, and that %ith more effective leadership 3>? could return to historically attractive levels of revenue and earnings gro%th and the stoc$ %ould respond accordingly! Co, a great business, at a cheap price, %ith an understanding of %hat can be done to ma$e it more valuable! "hat#s a classic 3ershing C)uare investment! Beam 6B:2M7 %ould be another e-ample of )uality! "he spirits business is highly attractive, %here brand leaders have significant pricing po%er, strong barriers to entry, high margins, and attractive gro%th both domestically and internationally! Beam is no% the %orld#s only pure play, publicly traded global spirits company that is not family controlled or influenced, ma$ing it a very scarce asset! We thin$ in an industry that is very li$ely to see significant consolidation over the ne-t several years, they have many interesting strategic alternatives available!
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What about something like Burger 'ing %B'W&? Is that a great business? "his is a B0 year old brand that for much of its recent history has been managed horribly, but it still e-ists, %hich is a good indicator of a good business! 4t#s the %orld#s second largest fast food hamburger restaurant chain, %ith over 12,<00 restaurants in 90 countries, and has made enormous progress on several strategic initiatives since it %as bought in 2010 by 3?, the same group Warren Buffett is partnering %ith on Hein(! "hey#re refranchising substantially all company operated units, have overhauled the menu and mar$eting strategy, and have accelerated a lo%er cost store renovation program! 2ll of that is paying off in significant and ongoing gro%th in free cash flo%! "hat type of turnaround is usually only possible %hen the core business is a good one! Is it ty(ical !or you to delegate activism, as you seem to have done in this case? We#re generally averse to ma$ing investments in controlled companies, but %e consider 3?#s controlling o%nership of Burger Ding to be a positive! We 100' believe in it, the strategy and the management team! Comeone else can be the catalyst from time to time! )escribe how you construct your (ort!olio with both active and (assive investments? We thin$ having 9 to 12 core positions at a time provides an ade)uate degree of diversification, %hile allo%ing us to concentrate in a handful of ideas that %e $no% very %ell and believe have highly favorable ris$;re%ard characteristics! 4f our capital base %ere permanent, %e#d probably only do active investments! But it isn#t, so the fact that 4 don#t ever %ant to be forced to sell an active investment in the course of an engagement means %e also need to hold passive positions! Historically, around <<' of our portfolio has been in active investments, 1<' or so has been in cash, and the balance has been passive! What has tended to (er!orm better, active or (assive? "he <<' of our capital in activist investments has produced more than E0' of our returns! &ne primary reason %e#re %or$ing hard to increase the amount of permanent capital %e have is to devote as much of the portfolio as possible to active positions! @oing that should enable us to earn higher returns over time! Why maintain the *+, or so average holding in cash? "hat#s ,ust %hat it#s been on average, the level can be much higher or lo%er! We don#t believe in leverage, so cash serves as li)uidity for potential future opportunities, the si(e and availability of %hich can vary! We earn a high enough return on capital that %e can
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afford the dilution of cash! Maintaining a high (ublic (ro!ile a((ears to be im(ortant to the e-ecution o! your strategy. Why is that? "he press is a necessary element of the strategy! Foo$ at something li$e 3rocter > ?amble! We haven#t run a pro-y contest! We haven#t made a public presentation! 2ll %e did is buy some stoc$! "hat became publicly $no%n and immediately the press %as all over the company and %hat they %ere or %eren#t doing right! "hat saved us a lot of time and energy! &n solid, high profile boards of companies that are underperforming, sometimes the directors ,ust need a little bit of a push! &ne of the best pushes is a reputational push, %hich a press spotlight can administer! "hat spotlight can be particularly important in our shorts! We don#t short on valuation, but in situations %here %e believe a company is violating the la%, or has misleading or inaccurate accounting, or has a potential regulatory problem! 4n these cases the attention really matters! 4f you#re a regulator %ith any sort of oversight of Herbalife 6HF.7, ho% can you ignore it %hen a reputable investor %ho has spent 19 months researching it says it is a certainty that the company is a pyramid scheme* 4magine if 4#m right and they#ve done nothing on a company that#s in the paper everyday! In taking such (ublic (ositions, do you risk being so committed that you/re less a(t to recognize evolving !laws in your thesis? &ne of the $eys to this business is having conviction based on your %or$ that you#re right and the rest of the %orld is %rong! 4f you don#t have that confidence, you#ll never buy anything because there#s al%ays something that can go %rong! :veryone thought the idea of buying stoc$ in ?eneral ?ro%th 3roperties right before it %ent ban$rupt in the middle of the financial crisis %as the stupidest idea they#ve ever heard of, and plenty of people said so! "he stoc$ %as at 3< cents a share, do%n from AB3, and %e bought 2<' of the company! =ou can#t get much more contrarian than that! "here#s obviously a balance to maintain bet%een confidence and humility! =ou have to be humble enough to recogni(e %hen you#re %rong! 4#m %illing to loo$ silly! With ?eneral ?ro%th, %e could have loo$ed very silly! But even if things hadn#t %or$ed out, 4 still thin$ it %ould have been a good investment! 4t %as probabilistic, %here %e thought the upside %as high enough and li$ely enough that %e %ere %illing to ta$e the ris$ of the stoc$ going to A0!

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To read the remainder of this interview, sign up now for a no-obligation free trial subscription to $alue Investor Insight. The trial subscription will allow you to see the entire new issue of $II, which also includes e'cerpts from Seth (larman!s latest "aupost )roup annual letter and in-depth interviews with Tom Per#ins of Per#ins Investment *anagement and Stephen )oddard of The +ondon o. To start your ,ree Trial, clic# her

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