In recent years, one of the worst hedge fund trades was Bill Ackman (Trades, Portfolio)'s Valeant (today called Bausch Health Companies Inc. (BHC, Financial)) debacle.
When the hedge fund manager eventually sold the position, he booked more than $4 billion worth of losses for his hedge fund, Pershing Square.
This is a valuable case study for investors. Ackman made several bad decisions, which are easy to spot today with the benefit of hindsight. But at the time, it was difficult because no one knew how the story would end.
By looking back at the trade, we can improve our own investment processes by identifying Ackman's biggest mistakes.
The biggest mistakes
I will not concentrate on Valeant itself. As an outsider, there were many red flags about the business that one could have identified as reasons to stay away at the time. Identifying these red flags is a different matter altogether.
Rather than focusing on the company, I will consider the psychological mistakes Ackman made at the time.
What's fascinating about this case study is the fact that Ackman is not really a bad investor.
Yes, he made a mistake that ultimately incurred a $4 billion loss, but he was considered one of Wall Street's best fund managers before that.
In the years since Valeant, he's rapidly repaired his reputation. Pershing Square netted a 70.2% return last year, after adding 58.1% in 2019 and outperforming the S&P 500 in 2018.
It is not unreasonable to say Ackman is a good investor who made a bad mistake.
That makes the whole thing even more interesting as very few investors can make such a significant mistake and then come back. They often ride the stock down to zero, vaporizing their wealth and reputation at the same time.
Doubling down
Pershing Square began buying Valeant in the first quarter of 2015. Ackman started by allocating 26% of his portfolio to the stock, acquiring roughly 19.5 million shares.
When the company's problems started to emerge, Ackman deepened his and his investors' involvement.
In the first quarter of 2016, Pershing bulked up its holding in Valeant to 21.6 million shares. The stock had slumped from the original purchase price of $200 to less than $30 at this point. On April 27, 2016, Ackman and Valeant's then-CEO Michael Pearson testified before the U.S. Senate.
Doubling down on a position that's not going your way can be a profitable investment strategy. However, it seems that what Ackman failed to do here was consider the other side of the argument.
Psychological bias
Charlie Munger (Trades, Portfolio) has spoken at length about the psychological bias that affects investment managers when they are over-committed to an opinion.
This bias from consistency and commitment tendency leads investment managers to maintain old conclusions despite disconfirming evidence.
This bias, in turn, prevents one from evaluating the other side of the argument. Consistency and commitment tendency can act to prevent one from inverting the question and asking, "What if I'm wrong?"
At the same time, Ackman may have just been suffering from simple denial. He couldn't believe what was happening and, after years of riding high before Valeant, thought he could solve the problem.
All these seem to be possible explanations for the string of errors the hedge fund manager committed between 2015 and 2017.
Maybe if Ackman hadn't had so much success in the run-up to his Valeant investment, he wouldn't have been so committed. Perhaps if he weren't surrounded by people constantly praising his actions, he would have questioned his thoughts more.
These are all possibilities to consider. The main takeaway is that Ackman's experience with Valeant shows just how important it is for investors to question and break down their ideas. No one is ever immune from psychological biases.
Disclosure: The author owns no stocks mentioned.
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