To the Shareholders of Pershing Square Holdings, Ltd.:
2019 was an extraordinary year for PSH. We generated our best NAV returns in Pershing Square Capital Management, L.P.’s 16-year history with a total NAV return including dividends of 58.1%, and a total stock price return of 51.2%.5 2019 was also an excellent year for our portfolio companies as their operating and business progress largely kept pace with their stock price returns. We made two new investments, Agilent (A, Financial) and Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), and exited three positions. We incurred no markto-market or realized losses on any of our holdings in 2019, a fi rst for Pershing Square.
We continued to make progress after the turn of the year. In advance of recent market declines, in January we sold our stake in Starbucks as it approached our estimate of intrinsic value. In February, we sold a third of our stake in Chipotle in order to reduce what had become an outsized position. At the time of sale, Chipotle represented more than 20% of the portfolio due to the company’s substantial business progress and strong share price appreciation.
Earlier this year, we were sufficiently concerned about the health and economic implications of the coronavirus that we considered, for the fi rst time ever, liquidating the portfolio in its entirety because we believed it was likely that markets would decline materially. After a careful review of the portfolio, we concluded that a hedging strategy was more consistent with our long-term ownership philosophy, and would likely lead to a better long-term outcome than selling off all of our assets. To mitigate coronavirus risk, in late February, we entered into a series of large hedging transactions in the credit default swap market that have off set the substantial stock price declines of our investment holdings in the recent market downdraft.
After the initial market decline, we unwound our credit hedges and redeployed a substantial majority of capital by adding to existing investments including Restaurant Brands (QSR, Financial), Lowe’s (LOW, Financial), Hilton (HLT, Financial), and Berkshire Hathaway, and by investing $500 million ($432 million from PSH) in a secondary share offering by Howard Hughes (HHC, Financial). We also re-established a position in Starbucks (SBUX, Financial). PSH has approximately 18% of the portfolio in free cash, and we are continuing to look for only the most extraordinary opportunities.
We believe that our success in 2019 was driven by a series of organizational and investment-related changes we implemented in late 2017. In sum, we focused our investment strategy on the core principles that have driven our high rates of return since the inception of Pershing Square, and restructured the organization to an investment-centric operation without the attendant requirements to continually raise capital. Today, 85% of our total assets – approximately $7.2 billion out of $8.5 billion – is represented by Pershing Square Holdings.6 Our competition is principally comprised of passive investors, and active investors with impermanent capital. Our greater capital stability is an important structural competitive advantage for our long-term investment strategy that should enable us to generate high risk-adjusted returns over the long term.
While we continue to manage two private funds for long-term investors of the fi rm, we are no longer actively raising capital for these vehicles. As a result, we are now able to operate with greater focus and substantially improved productivity. In addition, we moved last May from hedge-fund central in midtown Manhattan to our new offi ce at 787 Eleventh Avenue, on the far west side in a neighborhood known as Hell’s Kitchen. Without marketing or investor relations responsibilities, the investment team’s resources are now entirely dedicated to investment analysis, selection, monitoring, and portfolio management.
During the year, PSH engaged in a series of corporate transactions including the initiation of a quarterly ten-cent dividend, the launch of a series of buyback programs totaling $300 million, and the issuance of a 20-year bond (callable beginning in year 10 and at par by year 15). Since the inception of PSH’s buyback program on May 2, 2017, PSH has acquired $650 million of its shares representing 17.7% of initial shares outstanding.7 We continue to believe that PSH is undervalued at current market prices and NAV discount levels, and we have substantial available free cash. We have therefore continued to opportunistically buy back shares.
During 2019 and after year end, affi liates of the Investment Manager continued to acquire additional shares of PSH. Unlike many other closed ended funds where the investment manager has only a de minimis investment, in PSH, the manager is by far the largest investor. We now own more than 22% of the fully diluted shares outstanding, representing $1.28 billion of PSH’s equity.8 Our large ownership stake in PSH materially improves the manager’s alignment of interests with other shareholders, particularly when compared with other investment funds.
As a result of the incentive fee, we receive a larger percentage of the profits than other shareholders to compensate us for managing the portfolio. Many critics of incentive fees argue that they give investment managers an incentive to take excessive risk because if a fund is profi table, the manager receives a fee, but if the fund loses money, the manager can walk away without personal losses. In other words, if the manager does not have a substantial ownership stake in the fund, the incentive fee can be considered a free, or nearly free, option which increases the incentive to take risk because options become more valuable with increased volatility.
At PSH, the fact that affiliates of the manager own more than 22% of shares outstanding minimizes the incentive for the manager to take excessive risks, as losses are borne proportionately by the manager with other investors. In other words, the risk of loss and opportunity for gain of our large shareholding overwhelm the option value of the incentive fee. Furthermore, in our case, our PSH ownership is a disproportionately larger percentage of our net worths than for nearly all of our unaffi liated shareholders, so our principal incentive is to protect PSH from permanent losses, and then to maximize long-term profits.
It would be inappropriate to write about the investment implications of the coronavirus without first acknowledging the severe health implications and tragic loss of life that we are all experiencing in our own neighborhoods, nations, and around the globe. It was in fact our initial focus on the health risks of the virus that led to our decision to deploy a hedging strategy to protect PSH’s investment portfolio. Health and wealth are highly correlated, and we therefore must solve this global health crisis in order for global GDP to grow, and for job and wealth creation to occur.
We have previously summarized our thoughts on the coronavirus and our hedging strategy in a series of communications beginning on March 3rd (Link) when we disclosed that we had entered into hedging transactions, on March 9th (Link) when we disclosed the positive eff ect of the hedges on NAV, and on March 25th (Link) and March 26th (Link) when we provided detailed information about the unwinding of our hedges, and the reinvestment of capital in our portfolio and in certain new investments. Rather than repeat our coronavirus analysis in detail again here, I provide a short summary and then elaborate on the portfolio-specifi c implications of the virus.
On March 3, 2020, we disclosed in a press release that we had acquired large notional hedges which had asymmetric payoff characteristics. We did so because of our concern about the likely negative eff ect of the coronavirus on the U.S. and global economy, and on equity and credit markets. Our hedges were in the form of the purchase of credit default swaps (CDS) on the U.S. investment grade and high yield credit indices, and the European investment grade credit index.
After we purchased these hedges, U.S. and global equity and credit markets declined dramatically, and our hedges increased in value from zero to a peak of $2.7 billion (in PSH $2.3 billion).9 At this value, our hedges were worth approximately 40% of our total capital as our equity investments declined substantially over the same period.
The risk of remaining short credit versus the potential rewards became less attractive as the hedges increased in value. Furthermore, the opportunity cost of this capital increased as the proceeds from the hedges could be reinvested in our portfolio companies and other new opportunities at highly discounted valuations.
As various U.S. state, city and local governments began to aggressively confront the health and economic risks of the coronavirus through unprecedented non-essential business closures and shelter-in-place/stay-at-home implementations or “lockdowns,” we believed that our worst case fears would not be realized.
The U.S. federal government and the U.S. Treasury have also intervened in fi nancial markets in an unprecedented fashion, and Congress has passed legislation which will help bridge the economy and our country’s workforce and citizens during what we believe to be a temporary but massive and extremely painful economic shock. We have been encouraged by the Treasury Secretary’s and the Administration’s all-in approach to mitigating the damage to the capital markets, and for keeping fi nancial markets functioning and open, which are critical for our economy and capitalism to work.
For all of the above reasons, as we became increasingly positive on equity and credit markets, beginning on March 12th and entirely on March 23rd, we completed the exit of our hedges which generated total proceeds of $2.6 billion for the Pershing Square funds ($2.1 billion for PSH), compared with premiums paid and commissions totaling $27 million. These gains off set a similar amount of mark-to-market losses in our equity portfolio.
We have redeployed the substantial majority of our net proceeds from these hedges by adding to our investments in Agilent, Berkshire Hathaway, Hilton, Lowe’s, Howard Hughes, Restaurant Brands, and by repurchasing our stake in Starbucks. We have done so at deeply discounted prices and now own substantially larger stakes in each company. Even after these additional investments, we maintain a cash position of about 18% of the portfolio.
In summary, as a result of the reinvestment of the proceeds from our hedging transactions, we have four percentage points more cash (free cash before the decline was equal to 14% of the portfolio), and we have increased our stakes in Agilent by 16%, Berkshire Hathaway by 39%, Hilton by 34%, Howard Hughes by 158%, Lowe’s by 46%, and Restaurant Brands by 26%. We have also reestablished a 10% of capital position in Starbucks. If our portfolio companies grow in value and their stock prices increase over the long term as we expect, the long-term returns for PSH will be substantially greater than before as a result of the reinvestment of the proceeds from the hedging transactions.
You might ask whether it was prudent for us to have unwound hedges and reinvested capital without knowing whether equity markets had bottomed. We of course do not know whether the recent lows that have been achieved will be breached by further market declines. Our decision to unwind our hedges was driven by the less favorable risk-reward ratio off ered by our credit hedges as spreads widened, and the much more favorable risk-reward ratio presented by the then-trading values of companies in which we bought shares. At the prices paid and based on our estimates of the long-term cash fl ows these businesses will generate, we believe our recent acquisitions will generate very high rates of return over a multi-year holding period. If stock prices decline further, the returns we could have earned by waiting to invest capital would be even higher. We have kept substantial cash on hand to allow us to buy more at lower prices if markets decline further.
In our experience, it is diffi cult for a large investor to buy stocks while markets are recovering as liquidity is generally limited when markets rise rapidly. It would not be a surprise to see a rapid recovery in the stock market when investors have greater confi dence that the risks of the virus are largely behind us. We have therefore chosen to be a substantial buyer as markets have declined. While it is diffi cult to predict when markets will make a full recovery, we believe that the factors for a stock market recovery are coming into view. Namely, nearly the entire country and much of the world are essentially in lockdown, which implies that the number of cases and resulting deaths should peak over the next several months. This combined with the availability of cheaper and faster testing will enable many employees to go back to work allowing the U.S. and other countries to begin an economic recovery.
We are not, however, predicting a V-shaped recovery as it will be sometime before the virus’ impact can be eliminated, and the required social distancing and other virus-safe behavioral requirements will somewhat restrain the global economy. Furthermore, the psychological and fi nancial impact of the economic shock we are currently experiencing will likely cause many consumers to be hesitant about opening their wallets until the passage of time heals memories of this challenging time, and corporate and consumer balance sheets are repaired.
To share a note of optimism, the enormous economic and reputational incentives to discover therapeutic cures, more accurate, faster and cheaper testing, and a vaccine are driving scientists, technologists, corporations, governments and academic and research institutions around the globe to work toward a solution to our global malaise. This increases the likelihood that we may be positively surprised with a faster than expected cure or other mitigants to the virus and its negative health and economic effects.
It is important to be reminded that the value of a business is the present value of the cash it generates over its life. While many investors and market commentators use the heuristic of assigning a price-earnings multiple to analyst estimates of next year’s earnings, this simplistic approach is not valid for the current environment, as the next 12 months of earnings are not representative of the true long-term earnings power of most companies.
The revenues and earnings for the majority of businesses over the next year or so will be extremely poor, and in some cases disastrous, but for companies with strong balance sheets, dominant market positions, and which do not need access to capital, the virus will likely only disrupt the next 12 to 24 months of cash fl ows. In a discounted cash fl ow valuation of a company, the loss or disruption of the fi rst, and possibly second, year of cash fl ows, does not generally destroy more than 5% to 10% of the value of the business. The fact that many stocks have declined by 30% to 60% or more from levels that did not appear to be overvalued suggests that there are many compelling bargains in the equity markets. We discuss some of these opportunities in our portfolio below.
The Impact of Coronavirus on our Portfolio Companies
The important question is what impact will the virus have on our portfolio companies? We are fortunate to own businesses that are designed to withstand the test of time. Our strategy of investing in simple, predictable, free-cash-fl ow-generative, conservatively fi nanced companies with limited exposure to extrinsic factors we cannot control should serve us well in the current, highly stressed environment. Importantly, our portfolio companies are generally considered essential businesses, and for the most part will remain open to the extent possible during a state and/or a national shutdown. All of our portfolio companies, however, will be aff ected to varying degrees in the short term by the virus’ impact on the global economy. Below, we share a few observations on the short- and long-term impact of the crisis on each of our companies.
As a provider of testing equipment for labs around the globe, Agilent (A, Financial) is well positioned to benefit from increasing investments in healthcare, safety-related testing, pharmaceuticals, and other industries where highly accurate testing is essential for environmental, safety, product design, quality control, and other reasons. In the short term, Agilent will be aff ected somewhat by the recent closure of university labs, generally lower global business activity, and the impact of lower energy prices on a small portion of the company’s customer base. In sum, we believe the net impact of the virus on Agilent’s longterm intrinsic value to be minimal.
Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) was built by Warren Buffett (Trades, Portfolio) to withstand a global economic shock like this one. With more than $120 billion of free cash available for investment, Berkshire is well positioned to deploy capital opportunistically. Pandemics are generally excluded from insurance policies, and we believe that Berkshire’s insurance operations have limited exposure to the coronavirus. Berkshire is also highly advantaged in being able to invest its insurance company capital in equities when compared with other insurers who are generally limited to fi xed income investments where there is little yield to be found.
Berkshire’s privately owned portfolio of industrial and other businesses will absorb some short-term economic impact from the virus. In light of Berkshire’s extraordinarily strong fi nancial position and the nature of the portfolio companies it owns, we believe that Berkshire will not be materially negatively impacted as a result of the crisis. Rather, we believe that Berkshire will emerge from this crisis as a more valuable enterprise as the market decline will enable it to invest a substantial portion of its cash in investments which will accelerate its long-term growth in intrinsic value.
We believe that restaurants that have easy-to-use digital ordering, delivery, and drive-thru will emerge stronger from this crisis, as their customers will become more accustomed to ordering home delivery on the company’s mobile apps, and using the drive-thru or digital order ahead for takeout orders (including Chipotlanes). While we expect that Chipotle (CMG, Financial)– the Restaurant Brands (QSR, Financial) concepts of Burger King, Popeye’s and Tim Horton’s – as well as Starbucks (SBUX, Financial) will lose a substantial amount of sales during shutdowns, they will likely gain digital and delivery market share during this period, and will thereby emerge stronger from the crisis.
Chipotle’s burrito and bowl off erings are ideally suited for delivery, and offer families a healthy alternative to cooking at home. We expect Chipotle’s superb digital delivery offering should benefit as its customers order home delivery of the company’s low-priced, healthy, high quality food. For Restaurant Brands’ concepts, drive-thru, pickup and delivery represent about two-thirds of sales suggesting that they are well positioned to provide low-cost food in the current environment. Starbucks’ superb digital offering, delivery, and no-touch pick up are well adapted to service its consumers’ global coff ee habit, particularly when compared with competitors who have not built digital and delivery off erings.
Lowe’s (LOW, Financial) should also emerge stronger following the crisis as it has the capital structure and cash fl ows to withstand any shortterm negative impact on its business. As consumers spend more time in their homes, they have historically shown a greater propensity to do repair and other home-related upgrades for which Lowe’s will be a beneficiary. As a provider of cleaning supplies, masks, goggles, protective equipment and clothing, and appliances, Lowe’s is also an important supplier of crisisrelated items. We expect Lowe’s to emerge a stronger, more dominant and more profi table company after the crisis.
Fannie Mae (FNMA, Financial) and Freddie Mac (FMCC, Financial) have already proven themselves essential to the U.S. housing fi nance system, which is a critically important bulwark for the U.S. economy. The current disarray in the non-agency residential and rental housing mortgage market, which has recently occurred as a result of the crisis, will remind the Congress and the American people of the critically important function that Fannie and Freddie perform during periods of economic stress. The crisis has also made manifestly clear the need to recapitalize Fannie and Freddie so that the private sector becomes the fi rst loss capital in the housing fi nance system, which should provide even greater urgency for a recapitalization and privatization of the two companies. While we wait for the necessary steps for this to occur, both companies are quickly rebuilding needed capital through retained earnings. For these reasons, we believe that Fannie and Freddie will emerge as even stronger and more essential enterprises after the crisis.
The Howard Hughes Corporation (HHC, Financial) has significant short-term exposure to the crisis. In particular, the decline in oil prices will negatively impact Houston, the location of the Woodlands and Bridgelands, two of HHC’s master-planned communities. HHC’s Summerlin master plan community will also be aff ected by the virus’ impact on the casino and conference business in Las Vegas. The company’s other assets will also be impacted to varying degrees. In order to mitigate these risks, on Friday, March 27th, HHC completed a $600 million equity off ering, the fi rst such equity off ering of any company since the crisis began. HHC was able to complete the off ering as a result of a $500 million investment from Pershing Square ($432 million from PSH) and $100 million from other long-term oriented shareholders.
The independent directors of HHC made a decision to raise capital to ensure the company would maintain a fortress balance sheet, now with more than $1 billion of cash, in light of the potential short- to intermediate-term impact of the crisis on the company’s business. We believe that HHC will continue to create substantial long-term value for its shareholders, and that its portfolio of small cities with large population infl ows will remain highly desirable places to live and work. We therefore viewed the opportunity to increase our investment to approximately 30% of the company to be highly attractive at the current share price.10 While there is more short-term risk to HHC’s business, we believe that this risk is more than compensated for by the opportunity to invest capital at the current valuation.
The hotel industry and Hilton (HLT, Financial) have been highly impacted by the crisis as many hotels have closed or are experiencing very large declines in occupancy. As a result, we expect Hilton’s revenues to decline over the next several or more quarters, and to begin to recover with increases in economic activity as the global economy reopens. After adjusting Hilton’s intrinsic value for the impact on our valuation from reduced revenues and cash fl ows, we continue to believe that Hilton stock is highly attractive at current valuations. We also believe that the crisis will cause independent hotels to seek an affi liation with global brands like Hilton, which will contribute to the company’s long-term growth. Hilton is well positioned to succeed because it has the best management team in the industry, a portfolio of great brands, a dominant market position, a capital-light economic model, and a strong balance sheet.
In all of our portfolio companies, we are fortunate in their being led by superb management teams who have the skills, leadership qualities, and adaptability to manage through these challenging times. We are extraordinarily grateful for their leadership.
We continue to expect that markets (and our performance) will remain volatile, and therefore, new opportunities may present themselves that are superior to investments we currently own. This may lead us to sell certain of our existing holdings including investments we recently purchased. We may also choose to reestablish similar or diff erent forms of hedges or raise or deploy more cash based on developments with the coronavirus and other market factors. In other words, we are more likely to change our investment positioning and/or have higher portfolio turnover in this environment than we typically do.
We are in one of the most challenging periods of time for our country, and for the world. Tens of thousands of people have or will soon become severely sick, and many will die. Millions will lose jobs and struggle to regain employment. This is a global tragedy that could have been prevented with better long-term planning, which should have begun more than a decade ago. I have always said that experience is making mistakes and learning from them. And learn from this we must.
We are all incredibly fortunate to work alongside a superb team of talented, motivated, extremely high-quality human beings at Pershing Square. The recent market turmoil when combined with our transition to working from home would be a challenge to any company. I am proud to say that every team at Pershing Square rose to the challenge enabling us to fl awlessly execute during this challenging period.
Thank you for your long-term commitment to Pershing Square. We are honored and fortunate to manage capital on behalf of investors who have committed to us for the long term.
William A. Ackman