How willing are you to change your mind when your ideas turn out to be wrong, or at least not as good as you thought? That’s the issue at the heart of chapter nine in “Big Mistakes: The Best Investors and Their Worst Investments.” Michael Batnick’s 2018 book aims to help other investors avoid the mistakes made by investing legends.
He wrote:
“The world is always changing, but our views usually don't evolve alongside it. Even when we're presented with evidence that disconfirms our previous views, straying far from our original feelings is too painful for most to bear. This is so deeply ingrained in the fabric of our DNA that there is a name for this natural mental malfunction; it's called cognitive dissonance.”
Bill Ackman (Trades, Portfolio) got started in the hedge fund business at the age of 26. Along with David Berkowitz, a fellow graduate of Harvard Business School, he formed Gotham Capital in 1993. They raised $3 million in capital, and did well using what Batnick called “classic, old-school value investing.” Buying companies for less than their estimated value helped them turn their $3 million stake into $569 million in just seven years.
Unfortunately, they also got outside their circle of competence. Batnick quoted The New York Times: “An examination of Gotham's activities in recent years shows a series of ill”timed bets, a surprising lack of diversification and a dangerous concentration in illiquid investments that could not easily be sold when investors wanted their money back.”
So many clients wanted their money back that Ackman and Berkowitz had to shutter Gotham Capital at the end of 2002.
Still, Ackman wasn’t ready to give up. In 2004, he started another fund, Pershing Square Capital Management, using $10 million of his own money and $50 million from another investor. In 2005 the fund opened to the public and assets under management shot up to $220 million.
With Pershing, the guru gave up buying businesses at a discount. Instead, he committed himself to activist investing:
“Bill Ackman (Trades, Portfolio) rose from the ashes of Gotham Partners like a phoenix and came out one of the most aggressive activist investors of his era. An activist investor is one who acquires a large enough shares [sic] in a company to enact changes. They'll try to persuade management to be more shareholder friendly, which is code for increase the stock price. If they're not successful, they can push for a seat on the board and enact changes from the inside.”
Batnick added that it is one thing to buy shares in a company, and quite another to try to impose your will and ideas, to tell management how to run their business. If it’s so difficult, why do it? There’s a simple answer: The rewards can be very high. For example, one of Ackman’s first targets was Wendy’s (WEN, Financial), where he convinced the board to spin off Tim Hortons. As a result of the spinoff, Wendy’s stock went up 55% in 13 months.
Other companies with which Ackman tangled were McDonald’s (MCD, Financial), MBIA (MBI, Financial), Target (TGT, Financial), Sears (SHLD, Financial), Valeant (BHC, Financial) and J.C. Penny (JCP, Financial). But, his biggest battle of all was with Herbalife (HLF, Financial), a multilevel marketing company that sells nutritional and weight loss products through independent sales agents.
His campaign kicked off on Dec. 20, 2012, when he made a major presentation, accusing Herbalife of being a pyramid scheme. He called the company’s profits “blood money,” because he believed the company was making its profits by misleading low-income people who became agents, not by selling to people who genuinely found value in its products. In Ackman’s eyes, Herbalife was victimizing independent distributors because few of them could sell all the stock they had to buy to get started.
All of Ackman’s allegations were made very publicly, starting with his presentation and carrying on to extensive interviews with the media. Batnick observed, “In those moments, Bill Ackman (Trades, Portfolio) put himself in an almost impossible position. How could he ever admit defeat after telling everybody who would listen that this was a pyramid scheme that would go to zero? If he missed the mark on this, who would ever give him money again?”
In the days immediately following his presentation, it looked like Ackman’s strategy was working; after three days the stock was off by 35%. That was great news because he had taken a big short position of $1 billion. But it also meant his hedge fund competitors were seeing a stock on sale — Dan Loeb of Third Point bought a stake of more than 8% in Herbalife. In response, the market took a renewed interest and bid the stock price up 20%.
Soon after, Carl Icahn (Trades, Portfolio) took a 13% stake in the company. Batnick reported, “Herbalife hit a low of $24.24 in a few days after Ackman's first presentation and hasn't been below there since. It has gained 5% in a day 50 different times since 2012, and at $71.70, shares are currently 70% higher than where they were when he first shorted the stock.” That’s not the sort of news a short-seller like Ackman wanted to hear.
Ackman closed his position in November 2017, after the stock had risen 51% year to date. An article on TheStreet website estimated he lost as much as $740 million of his $1 billion short position. Icahn, on the other hand, had gained about a billion dollars and increased his stake in the company.
For Batnick, the point to this story is that Ackman backed himself into a corner and couldn’t get out — because he could not acknowledge that he had made a mistake, that his short strategy had failed. It’s lesson worth remembering by the rest of us.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:Ă‚
Big Mistakes: The Sage of OmahaÂ
Big Mistakes: Michael SteinhardtÂ
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