Carlos Velásquez · Medium · 10 min read · Photo By: Nick Owuor — unsplash.com
By now the $27 million trade Bill Ackman, the CEO of Pershing Square Capital Management, placed earlier this year is well documented within the investment community. The flexibility of mind to short the bond market in February and net $2.6 billion, then pivot and go long the stock market in March to subsequently bag an additional $1 billion, was legendary.
Given the ROI and how quickly it materialized, Ackman’s initial trade is considered by some to be the best trade of all time.
Others refer to it as pure “genius”.
Ackman initiated this trade by making three relatively small bets that in aggregate ended up risking just 0.375% of his hedge fund’s portfolio.
The thought process that led to this asymmetric trade, however, is not one of an investment genius formulating the perfect trade entry.
Rather, it is one that incorporated a simple heuristic that can be used by anyone — particularly during a crisis — to rationalize asymmetric moonshot bets:
“If nothing happened we would have lost very little money. But if what we expected to happen, happened, the hedge would be very, very valuable.” ~ Bill Ackman (on — The Knowledge Project #82 podcast, at 53:07)
A Shooting Star That Had Been Losing Its Glimmer
Below are Ackman’s most notable winning and losing investments as the CEO of Pershing Square Capital Management. His biggest losses have occurred during the past decade.
+ Profit $1.1 billion Municipal Bond Insurance Assoc. Inc. (2004-2009)
— — — — — — — January 2011 — — — — — —— —
+ Profit $1.6 billion General Growth Properties Inc. (2009-2013)
— Loss of $1.8 billion Target (2007-2011)
+ Profit $2.6 billion Canadian Pacific Railways (2011-2016)
+ Profit $2.4 billion Chipotle Mexican Grill (2016-present)
— Loss of $4 billion Valeant Pharmaceuticals (2015-2017)
— Loss of $1 billion Herbalife (2012-2018)
— — — — — — ——March 2020 — — — — — — ——
+Profit $2.6 billion Short Bond Market (2020)
+Profit $1 billion Long Stocks (2020)
*Excluded from the list above, due to insufficient financial data, are Ackman’s losing bets in Barnes & Nobles (2006-2011) and J.C. Penny (2011-2013); and his profitable bet in Wendy’s International Inc. (2005–2006).
Since starting Pershing Square Capital Management in 2004, Ackman has initiated investments that have resulted in enormous profits — and occasional enormous losses. During the decade leading up to March 2020, his hedge fund’s losses have been largely responsible for its underperformance relative to the S&P 500.
In fact, even with “the greatest trade of all time” factored into his returns, and the profitable pivot to go long the stock market for a $1 billion gain in March, Ackman’s hedge fund (as of August 25, 2020) was down 22% relative to the S&P 500 since the end of 2010.
S&P 500 Had Moonwalked Over Ackman Since 2010
One million dollars invested in Ackman’s hedge fund on January 1, 2011, would have been worth $2.61 million, net of fees, as of August 2020. The same amount invested in an S&P 500 Index fund would have returned $3.34 million. (In all fairness, the returns associated with the S&P 500 Index this past decade were among the best ever.)
At the beginning of 2020, Ackman’s hedge fund had underperformed relative to the S&P 500 during each of the previous nine years except for 2014, 2018, and 2019. Had Ackman not entered into the $27 million moonshot bet in March, his 2020 returns through August 25th would be similar to the S&P 500’s 7.9%. Without said moonshot, the hypothetical $1 million investment made into Ackman’s hedge fund on January 1, 2011, would be closer to $1.96 million.
The 0.34% portfolio risk Ackman took via his Big Short — risking $3,400 of a hypothetical $1 million investment — would be responsible for approximately $469,000 of its gains.
Legends: Made One Moonshot At A Time
“(it took) an hour discussion among the team before we decided to implement the hedge; one of our most successful investments if you look at the risk versus the reward. The amount of time spent was minimal.” ~ Bill Ackman (on — The Knowledge Project #82 podcast, at 21:29)
Bill Ackman initially considered selling his hedge fund’s stock holdings when news emerged that the Coronavirus was spreading. Ultimately Ackman decided to sell only a small portion of his stock position and, instead, hedge his portfolio using Credit Default Swaps. These CDSs enabled Ackman to effectively buy bond insurance, on the cheap, by shorting three bond indices.
The bet turned immensely profitable when bond spreads widened.
On December 31, 2019, Pershing Square Holdings’ portfolio was valued at $7.2 billion. Ackman figured he would unwind the CDS hedge in no more than 90 days at a maximum cost of $125 million, meaning Ackman was prepared to risk up to *1.7% of his fund’s assets on a moonshot bet. (*If credit spreads had tightened, which was highly unlikely given the context, the risk could have increased to as high as 9%.)
This moonshot bet, however, paid off within just a couple of weeks at a $27 million total cost (0.375% of the portfolio) resulting in 100x returns.
As he unwound his CDS positions in mid-March Ackman began reinvesting the profits in the stock market, at the trough, and ultimately raked in another $1 billion.
“Our…performance was driven by our late February and early March hedging program in the index CDS markets, the subsequent unwinding of that hedge beginning on March 12th, and the contemporaneous reinvestment of nearly all of the gains from hedging by March 18th, which allowed us to take advantage of the large decline in the share prices…” ~ Pershing Square Holdings, Interim Financial Statements June 30, 2020
Moonshot and “crisis alpha” bets like these are the reason that, despite underperforming the S&P 500 (largely due to the $4 billion loss in Valeant Pharmaceuticals) since the end of 2010, Ackman’s hedge fund has returned 1100% since 2004. The S&P 500, in contrast, has appreciated 335% during this 17-year period.
Accredited investors invest in Ackman’s hedge fund in spite of its inherent volatility due to Ackman’s ability to attain superior returns, in the long run.
The Framework Of Six Earthly Lessons
The most profitable trade of all time unfolded by applying a simple heuristic that took an hour to hash out. The mindset and mental framework that enabled this bet, however, have been fine-tuned during an entire investment career. They are the reasons Bill Ackman is a successful investor.
And a Billionaire.
At least six insightful lessons can be gleaned from Bill Ackman’s career.
- Uncertain times call for asymmetric bets: of Ackman’s most successful bets, one dates back to the build-up of the 2008 Global Financial Crisis (he shorted MBIA which paid off big in early 2009); Ackman’s $60 million bet, turned-$1.6-billion-profit, in General Growth Properties occurred when the company reemerged from bankruptcy after the 2008 crisis; the Chipotle bet happened after a Salmonella outbreak depressed its stock price (CMG has tripled from its $415 March 2020 low, as more customers are ordering takeout); and the two bets made in 2020 — one of them a 100-bagger — that paid off handsomely occurred in the context of a global pandemic. Only Canadian Pacific Railways was a traditional investment in which optimizing operational efficiencies drove returns. Asymmetric bets drive investors’ long-term returns. Crises increase the odds of finding such bets.
- Profit $1.1 billion Municipal Bond Insurance Assoc. Inc. (2004-2009)
- Profit $1.6 billion General Growth Properties Inc. (2009–2013)
- Profit $2.6 billion Canadian Pacific Railways (2011-2016)
- Profit $2.4 billion Chipotle Mexican Grill (2016-present)
- Profit $2.6 billion Short Bond Market (2020)
- Profit $1 billion Long Stocks (2020)
2. Investors need to be right only some of the time: hedge funds do not report their short positions to the SEC. Ackman probably enters into short positions regularly via hedges like the asymmetric bet he made on the index CDS market in February 2020. (A similar, ongoing, short on the Municipal Bond Insurance Association led to Ackman’s fund making a $1.1 billion profit during the Global Financial Crisis.) A handful of investments are responsible for most of Ackman’s portfolio gains since 2004. How much money one makes, when correct, matters more than the frequency in which one is correct. The best investors are often correct less than 50% of the time.
3. Successful investors sometimes apply unconventional strategies: Ackman seeks to find alpha, often unconventionally, which has led to several unconventional losses (e.g., $4 billion loss in Valeant Pharmaceuticals). Most individual investors tend to play it safe and, if they lose money, are content with being conventionally wrong. Some investors even equate implementing unconventional investment strategies to being naive or foolish. Yet in order to have a chance to beat the stock market, developing a mindset that allows one to think and invest unconventionally, especially during crises, is almost a requirement.
4. Searching for alpha requires embracing volatility: accepting volatility in one’s portfolio is the price investors must pay in order to have a chance to beat the stock market in the long run. Since its inception, Ackman’s hedge fund returns have experienced more volatility than the broader market. This volatility has been amplified by the notable losses Ackman has incurred, but also by the enormous profits he has occasionally reaped. One must learn to unemotionally experience market volatility. Investment strategies with the best long-term results tend to also be the most volatile. The longer one’s investment horizon the more accepting of volatility one should be. In fact, one should even strive to use market volatility to one’s advantage.
5. Understand the history of the markets: Ackman recalled that the Government’s inaction exacerbated the 2008 Global Financial Crisis. Once Federal authorities signaled in March 2020 that they understood the severity of the Coronavirus outbreak, Ackman concluded the Fed was going to act quickly (unlike 2008) and take the necessary steps to protect the capital markets — and, as a result, the stock market could rebound. Ackman began taking profit on his CDS positions and simultaneously went long stocks, plowing $2.1 billion into the stock market beginning in mid-March, timing the market trough near-perfectly. Understanding the history of markets equips one with the ability to gauge the probabilities of events occurring (a little) better than most; such nuanced understanding can be the difference between action or inaction on the investor’s part during crises.
6. Cash is king: Ackman’s hedge fund had $800 million in cash reserves entering 2020. After profitably unwinding his CDS positions, Ackman was effectively playing with an additional $2.6 billion of “house money”. If the stock market had dropped 50% further after Ackman reinvested profits from his Big Short play, his initial windfall would have still amounted to $1.3 billion. (He had actually only reinvested $2.1 billion by March 18th — some of the CDS profits, plus $800 million from cash reverses.) Within three weeks of his pivot into stocks, the stock market was up 30%. In the ensuing weeks, Ackman’s hedge fund netted an additional $1.0 billion from its long positions. Cash reserves position investors to capitalize on an oversold stock market. Without cash reserves, few mental frameworks, genius ideas (or simple heuristics), can be profitably applied.
Once Every Blue Moon
Bill Ackman’s career reinforces the notion that asymmetric bets, especially those made during crises, are ultimately the main drivers of long-term “alpha”. Unveiling our eyes to this fact is an important first step in adopting the mental framework that enables us to appreciate the merits of betting on moonshots.
For individual investors, a barbell investment strategy is one of the most optimal portfolio constructs in which to incorporate moonshot investments, such as in (but certainly not limited to) Bitcoin and Altcoins.
The riskier the bet, the more volatility it will add to one’s portfolio. A barbell portfolio strategy enables one to corral this volatility to 10%–15%, with the rest of the portfolio safely guarded in cash or cash equivalents. Akin to locking a wild animal in a cage.
Once every blue moon the beast we refer to as the market will be driven by its animal spirits to wreak havoc. Investors’ barbelled exposure to it will protect them during such events. Other times, the beast will perform crowd-pleasing tricks that are desirable by those seeking fun — and investors seeking exponential profit.
Antifragile investors can inject rocket fuel to their barbell portfolio by only adding asymmetric bets into it. Doing so will increase the odds that the stars will, eventually, align in their favor.
Perhaps aligning even more often than once every blue moon.
Stargaze and picture that.
Author also wrote: N. Taleb’s Minority Rule | Your Inner Voice | Bitcoin’s Volatility | Blockchain Stocks | 50 Investment Lessons | Flywheel Effect | Bitcoin: Mental Framework | Crypto Moonshots | 4 Crypto Stocks | Bitcoin: Insurance | Brief History: Money | Spontaneous Order | Fragility Inducing Events | Antifragile: Definition | 1% Bitcoin: 99% Cash | COVID-19: Market
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Disclaimer: Topics covered herein are for informational purposes. Before acting on investment information consult with a financial professional. This article is intended for people who understand the pro/con impacts of “tail-risk,” “convexity” and asymmetric risk-reward in the context of an investment portfolio.
