Bill Ackman (Trades, Portfolio) has been in the news a lot as a result of his recent blockbuster short against the market. The Pershing Square boss made a whopping $2.6 billion profit from a $27 million credit default swap position - a return of 10,000%. Credit default swaps are a form of insurance, and Ackman entered the position right before the market collapsed in early March.
This is an example of a huge and highly sophisticated trade that most ordinary investors will never have anything to do with. But Ackman engages in regular long-side investing as well as this kind of esoteric trading, and over the years has offered a lot of advice for those willing to listen. Comments he made in a Reuters interview a few years ago on the importance of free cash flow were particularly interesting.
Free cash flow is the most important thing
For Pershing Square’s long portfolio, Ackman likes to look for high-quality businesses in a way that is very Buffett-esque, and indeed he acknowledges Buffett’s influence on his thinking:
“Simple, predictable, free cash flow-generative, dominant businesses - a business that Warren Buffett (Trades, Portfolio) would describe as having a moat around it. If you believe that the value of anything financial is the present value of the cash you can take out of it over its life, you need to know how much that will be. If we can’t predict the cash flows, we don’t know what it’s worth. We figure out how good the business is and then we ask “where is it trading?” And if there’s a wide gap between price and value - you can buy it for 50 cents and it’s worth $1.20 - then we take a hard look at why that is”.
Any investor, no matter how conservative, needs to make certain assumptions about the future. You need to have some level of confidence that the business you are buying will continue to generate cash while you hold it. And so it helps to have a simple and predictable business, rather than something where the prospects are less clear.
Ackman’s fastest investment decision
When asked about the length of his usual investment process, Ackman said that one of the best decisions he ever made only took four hours. This was when Pershing Square acquired a 42% stake in Wachovia Corp., a financial services company that went under during the 2008 financial crisis. Citigroup (C, Financial) had agreed to acquire the banking subsidiary of Wachovia, leaving the holding company intact. This holding company still had a sizable amount of cash and securities on its balance sheet, as well as a strong wealth management business. Wachovia’s stock had halted while the Citigroup announcement was being made.
Over the course of four hours, Ackman and his team went through Wachovia’s 10-K and determined that the holding company was worth between $11 and $14 per share. After the announcement, the stock opened at $1.84, giving them a chance to build up their 42% position. This is an example of the type of analysis that can be done by any investor willing to put in the work.
Disclosure: The author owns no stocks mentioned.
Read more here:
- The Value Investor’s Handbook: Shiller Price-Earnings Ratio
- The Value Investor's Handbook: Investing Blunders to Avoid
- Jim Chanos: Where Do Shortsellers Get Their Edge?
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