You know things have gone terribly wrong when a billionaire hedge fund manager — one of those “masters of the universe” — is forced to issue a public mea culpa.
That’s exactly what Pershing Square Capital Management founder and chief executive Bill Ackman did this week in a surprisingly direct apology to his shareholders. His letter was in response to the firm’s epic $4 billion loss on Valeant Pharmaceuticals, the controversial drug company he championed for years, even as the stock tumbled from $279 a share to $196 (the average price per share that Pershing paid for the stock) and then to $11, when Ackman finally admitted defeat and recently sold.
“Clearly, our investment in Valeant was a huge mistake,” wrote Ackman. He added: “We deeply regret this mistake, which has cost all of us a tremendous amount, and which has damaged the record of success of our firm … While I and the rest of the Pershing Square team have suffered significant losses from this failed investment as we are collectively the largest investors in the fund, it is much more painful to lose our shareholders’ money, and for this I deeply and profoundly apologize.”
In 2016 alone, Ackman’s Valeant stake caused his fund to lose 14% at a time when the S&P 500 index of U.S. stocks gained 12%.
Blind faith is hardly a trait unique to Ackman.
Even a legend like Warren Buffett errs from time to time. At the end of last year, for instance, the Oracle of Omaha finally gave up on his decade-long failed bet on retail behemoth Wal-Mart, selling $900 million in stock holdings, after its struggle to compete with Amazon.com. Shares of the big box discounter have trailed the S&P 500 by 14.2 percentage points since 2015.
It’s only natural to want to emulate successful investors like Buffett and Ackman after their well-publicized successes.
Their failures, though, can be just as illuminating. The key is to forget the schadenfreude, understand what led to their mistakes, and try to avoid those emotional missteps yourself.
Lesson #1: Strategy Matters as Much as Results
“Don’t bet on science — bet on management,” was one of former Valeant chief executive J. Michael Pearson’s mottos during his time in charge.
The former Mckinsey marketing consultant grew Valeant to a market value of $90 billion. But it’s how he did it that was telling. He cut funding for costly research and development, yielding fewer new products. Instead, his company bought up older drugs already on the market and jacked up the price.
Wall Street loved this model — until it dawned on investors that short-term profits don’t necessarily lead to long-term financial health, especially if that short game draws Congressional scrutiny.
As Ackman noted: “Intrinsic value can be dramatically affected by changes in regulations, politics, or other extrinsic factors we cannot control … In restrospect, our investment in Valeant was too large a percentage of capital in light of the greater risk of these factors having a negative impact on intrinsic value.”
After Valeant’s failed bid to take over well-regarded rival Allergen, the bloom was off the rose.
“Wells Fargo analyst David Maris, who soon put a ‘sell’ rating on the stock, noted in a report that he dug through the company’s financial statements and found that in almost every quarter most of its growth in the U.S. had come from price increases,” according to Vanity Fair’s Bethany McLean.
Lesson #2: It Pays to Follow Your Own Advice
In a discussion with University of Kansas students in 2005, Buffett was asked if he thought investor Eddie Lampert could turn the struggling retailers Sears and Kmart around. He famously responded: “Turning around a retailer that has been slipping for a long time would be very difficult. Can you think of an example of a retailer that was successfully turned around?”
In that same year, Buffett began buying shares of the retailing giant Wal-Mart, which at that time was already experiencing slowing growth and drawing comparisons to Kmart.
Still, Wal-Mart’s revenues jumped 10.1% to $285 billion back then, compared to just $8.5 billion for Amazon.
Since then, though, Amazon’s revenue has grown by about 1,500%, dwarfing Wal-Mart’s 70% gains.
Investors, meanwhile, enjoyed an annual return of 26.6% on Amazon’s stock over that time period, compared to 4.5% for Wal-Mart shares and 7.5% for the S&P 500.
In other words, Buffett should have listened to yet another bit of sage advice he likes to give: to just invest your money in an index fund that owns the broad market rather than trying to out-smart the market.
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As Buffett wrote in his recent shareholder letter: “My regular recommendation has been a low-cost S&P 500 index fund. To their credit, my friends who possess only modest means have usually followed my suggestion. I believe, however, that none of the mega-rich individuals, institutions or pension funds has followed that same advice when I’ve given it to them.”
The same might be said for the Oracle himself in this case.
Lesson #3: Don’t Fall Back on Aphorisms
When he was still in the thick of the battle, Ackman reportedly defended his Valeant bet to Pershing Square investors by quoting a famous Buffett line: “Be fearful when others are greedy, and greedy when others are fearful.”
It’s easy to imagine yourself quoting that old saw when the heat surrounding a stock like Valeant intensifies, or as Amazon advances on Wal-Mart’s flank. “Congress will move on,” you might reason. Or “Valeant’s being picked on.”
When you find yourself in a reflexively defensive position, it’s helpful to answer a seemingly simple question: Why do own this thing in the first place?
If the company’s financials and narrative no longer align with what you think you bought in the first place, it’s time to move on. And quickly.