This blog is set up to cover the principles of Value or Deep Value investing, and a lot of what I put in comes from my guru or Warren Buffett or Charlie Munger, however there are a lot of other investors who I like and Bill Ackman has become one I idolized. I won’t sugar coat it, as soon as he launched his SPAC I was there to buy in because I trust in Bill Ackman and his methodologies. He has stumbled sure, but overall his record is pretty dang impressive and then I found out about his principles and wanted to make a post covering them. I realize I digress a bit when I talk about his feud with Herbalife which actually led to a feud with fellow guru Carl Icahn for a time, but I go into details with it to paint a picture of who Bill Ackman is for those who are unfamiliar. It’s important to understand him in order to understand his philosophy I believe. So I hope you enjoy, we’ll start with his principles and my initial notes on them:
1. The business has to be simple and predictable – Bill found trouble when he got away from simple and predictable, even though he could understand it didn’t matter.
2. That you know that it has a dominant market position – This company has already done something that protects it from competition and controls a “majority” (more dominance by comparison) of a market. Revenues and placement pays a huge role.
3. Limited exposure to extrinsic risk that we can’t control- See this often in commodities where the supply for the commodity can be unpredictable at best or manipulated at worst. This is something that no investor can control and most often cannot predict. This makes them very risky inherently.
4. Free Cash Flow generative – Major factor to identifying a big MOAT business.
5. Large Barriers to entry – We can consider different types of moats toll bridge like utilities or railroads or maybe proprietary secrets or the pain involved in switching.
6. Good governance- We need good people running the company in a manner that is beneficial to the stockholder.
7. High Return on Capital – ROIC seems to be the new hotness in the world of value investing. We don’t just want a good return on equity, because equity can be so many sources. ROIC is the barebones (bottom line even) return line.
8. A strong balance sheet that does not require outside capital – A leveraged company is an unpredictable company. Leverage sometimes does strange things to a man to manipulate the Pride and Prejudice line.
Let’s get down to business here, I am a huge fan of Bill Ackman not just because he is a mega successful investor and who doesn’t idolize that? He is a bit of a contrarian at heart which I can identify with personally as I don’t love jumping into the new popular thing, but often sit there and pick it apart exposing some deep problems with it. A great example of Ackman being Ackman was in his shorting Herbalife because he had a legitimate moral problem with their business model. Whether you agree with him or not, it was readily apparent that his bet had very little to do with profit from the companies demise as much as becoming a vocal shareholder.
Shorting a stock publicly is not considered to generally be a good way to win friends and influence people, unless your aim is to tell them that you think they are profiting from the work of those who will never see those profits. Bill said to heck with propriety and publicly shorted Herbalife in 2012 and attempting to bring CONGRESSIONAL SCRUTITNY against the organization calling it and I quote from a CNBC article “the best-managed pyramid scheme in the history of the world.” That in case you were wondering are some pretty strong words to speak publicly about a company when words like ‘slander’ and ‘libel’ depending on the medium used are thrown about with regularity.
Now some did not like his tactics in lobbying members of Congress to get the Federal Trade Commission to achieve what he had been unable to with his publicly stated position and that is fine, you don’t have to like it.** I think he was unfairly characterized as a someone trying to profit from Congressional pressure, but instead genuinely saw a problem and tried to correct it with the tools available to him. It didn’t work, but does that make it wrong for him to have made the attempt? I can’t decide that for you, but I can say that the contrarian with a conscience in me takes a perverse sense of pleasure in how much trouble he caused for a company who I agree seemed more concerned with chasing the almighty dollar than how their employees (sales reps) were treated.***
I agree with Bill in the fact that multi-level marketing companies often benefit those at the top with little to anything left over for those doing the actual leg work. Herbalife’s case isn’t helped by a $123 million fine from the government for bribing Chinese officials to allow the company license to operate in China.* Now while this may not be illegal in China, it still is illegal in the United States which makes one question whether their whole operation is as upright and legitimate as they maintain in their attempts to have Congress make life difficult for short sellers (the “Bill Ackman Bill” as it is known). However I will leave off, because despite my thoughts on Herbalife they are not the point of this post, suffice to say that I am a fan of Ackman and wanted to go over his Principles of investing, so let’s jump in.
Bill has publicly stated in interviews, speaking engagements and even in the letter to shareholders about his new Special Purpose Acquisition Company (SPAC) Pershing Square Tontine Holdings (PSTH.U) that the prerequisites to investing in or acquiring a company include a company that is simple and predictable. This seems like a straightforward statement, but let’s look at our own investing habits, how many of you can tell me exactly what TESLA does that makes it worthy or trading at nearly a 1000x earnings multiple without mentioning their name on a level that your average middle schooler could understand?
I was taught very early in my career to write at a level a middle schooler could understand because you never knew who would be reading what you wrote. This does not mean to demean anyone, but especially as you gain experience in an industry you will begin to up your writing style with that experience to the point that without possessing a degree in the subject no one would have any idea what you are talking about (nor care). Always write simply and plainly, there is no reason to make a document complex that I have ever seen unless you are trying to purposefully hide something. So why would be look for companies where I have to clear out a level of the library to understand what they do? There are, and I will quote the World Federation of Exchanges, “45,740 companies traded on exchanges around the world” don’t we think we can find 20 opportunities from 45,000 that are simple and predictable? I hope so, otherwise I’m in trouble.
Second, he wants to know that they have a dominant market position. That is a very easy thing to say, but sometimes I think we overthink it when we look at an industry or specific company. If I were to ask you who had the dominant market position in sodas you would likely come back with either Coca-Cola or Pepsi (more likely Coca-Cola if you’re in the south where Coke means any type of soft drink you can imagine and you have to specify.) which shows that they hold dominant market position. Beers the answer could come back as Budweiser, Coors, Miller, which all own a significant enough market share to make them a dominant company. Why should we care? Well as an investor I like to have a company that either returns some money to me every year or puts it to work expanding the organization and while that can often come in the form of marketing, I would vastly prefer it to be expanding operational capacity. If your company already has dominant market position, they need to advertise sure, but it should not need nearly the same portion of the Operating Cash Flow that smaller companies have to shell out for exposure.
Third, we’ve got limited exposure to extrinsic risk. Well that specifically targets commodities industries where one small thing can happen to completely change the landscape. If for instance Asia and South America suffered from catastrophic crop failure the world would be at a loss for sugar cane. Or possibly someone who is sitting on a pile of zinc and flood the market with it which wrecks a company that otherwise a wonderful company. That should be an honest thought in your head whenever you even look at a commodity…how can this go wrong? I will tell you I don’t invest in them anymore because honestly, I’m not smart enough to answer that question.
When we look at a free cash flow generative company…that’s what we all want at the end of the day right? We understand as value investors that companies which generate free cash flow without racking up debt (generally) are strong companies which have the capability of succeeding in the long term and keeping the barbarians at bay with the moat. I will not go too much further there.
His fifth principle of having a significant barrier to entry is how any of us should choose companies no matter our style of investing. A momentum investor should be just as concerned about investing in a company that is a coin flip with another company. I always think of Blu-Ray and HD DVD when I think of this, you could have bet on either of them and it was honestly a matter of opinion initially. I would rather invest in Netlfix vs Blockbuster where there is one company with a significant competitive advantage or even better an Apple vs Next or heck these days Apple vs most other companies. Those who use all Apple products will understand better how much the transition from a completely integrated Apple universe to using a PC, a problem I am wading through right now in order to have the setup I wanted to have for my day job. It’s terrible and I am shocked how my feelings for PCs changed after being indoctrinated into Apple. It’s nuts.
Good governance is so important to me personally because I want to believe even though I choose a business “an idiot can run, because one day one will” (thanks Charlie!) I want to be able to sleep well at night because I trust the people who run the companies, I invest in. I want a leadership who cares about the people who work there, the public good, and shareholders. I don’t know about you, but for me it is also in that order. I think that good governance can help a mediocre company survive or thrive and bad governance can wreck a good company. It only takes a little leverage to bring about a bankruptcy even to the benefit of the governing body.
Return on capital, woo, I love this topic. Until a few months ago everything I ever heard was ROE this and ROE that, now it seems everyone is talking about ROIC or return on invested capital. Daddicus! What’s the difference?! I’m glad you asked. Return on equity includes one especially important factor, debt. Debt can provide a veneer of success over a decaying body that is getting uglier by the day. If you would like an example of this, I would suggest GM’s decline and fall through 2009. Debt is ugly, if we can find a company that is making returns without including infusions of debt then we should feel very confident as long as the rest of the valuation metrics measure up. We should aim for companies with 15% ROIC or better sustained over a period of time (for me 10 years is preferable). When we remember the power of compounding, a company that is achieving this level of success and ,let’s not forget good governance, using it appropriately to return value to shareholder by expanding the business or returning it to the shareholder in the form of dividends will provide great value to you in the long term.
A strong balance sheet that does not require outside capital. Please read this for what it is. Find companies that create enough free cash flow from operating cash that it does not need to indebt itself to grow. This can be very difficult, so maybe this is the time to explore the concept of a certain amount of debt that can be acceptable. In a quickly growing company that is not yet to maturity, there may be the need for a certain amount of debt no matter how much we should not like it. I personally believe that as long as we can stay between 0 and 3 years of operating cash flow in debt that there is a level of comfort with that level of debt. There are some times debt is necessary to a great company…Corona anyone…but it should always be looked at hard and with an eye to the future of the company having taken on that debt.
I know this has been long, but I wanted to ensure that I gave appropriate analysis to the genius that is Bill Ackman. I also want to acknowledge another reason that this list is important. Bill himself admits that he strayed from these principles for a while and paid a heavy price for doing so. He has gone back to his principles and is succeeding greatly from doing so in my opinion. I don’t know exactly, but I have heard that Bill Ackman’s IQ is astoundingly high and I wouldn’t doubt it at all. To me that teaches a lesson that even brilliant people are vulnerable when they stray from their principles. I am not nearly the smartest guy in the room, but I can tell you that I strayed from my principles of investing and suffered a loss that was a significant amount of money to me for doing so. I appreciate Bill for telling it how it is and admitting that he strayed from his stated principles with great pain and by coming back is in the wheelhouse of his success.
I understand that this has been longer than many of there posts and I will say is longer than I had even planned, but I felt it was important enough that I didn’t want to condense it to sound bites. I hope you enjoyed the stroll through the principles and found something that spoke to you. Until next time then.
I am long AAPL, MSFT, PSTH.U, TSLA and have not initiated any new positions within the last 72 hours with no intent to purchase, sell or short any stock or commodity mentioned in this writing within the next 72 hours.
(CNBC, published 19 Dec 2012 “Herbalife Disputes Ackman’s Claim of ‘Pyramid Scheme’”)
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17 thoughts on “8 Principles of Bill Ackman’s success”
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