Stock prices are often much more volatile than the underlying value of the business they represent and time arbitrage has been the major source of profitability at Pershing Square since the inception of the firm. Time arbitrage involves taking advantage of the opportunity for long-term profit offered when short-term investors sell due to disappointing short-term macro or business progress.
Bill Ackman has been an expert in exploiting this strategy, and has written about this in his 1Q, 2012 newsletter. Bill Ackman is the CEO and founder of Pershing Square Capital Management, a well-known hedge fund that started in 2003.
Business Valuation: The value of a business is the present value of the cash that it will generate for distribution to its owners over its lifetime. For the high quality, simple, predictable, low-leverage North American (SPY) businesses in which Pershing Square prefer to invest, their discounted expected lifetime cash flows generally do not change meaningfully due to events in Greece, greater Europe, or a few quarters of negative same-store sales. Despite this simple valuation technique, many investors choose to sell as a result of:
- Negative news
- Moments of company or market uncertainty because of fear
- Limited understanding of what they own
- Margin borrowings
- Investor redemptions
- Belief that other investors may sell first, driving down short-term values.
Public versus Private Equity: Many investors have chosen to avoid public market investing because of the high degree of stock market volatility in recent years, comforted by the fact that their private investment alternatives do not appear to be as volatile. In reality, there is a high degree of correlation between public market and private values because of the opportunities for arbitrage if there are large disparities between the two.
Private market values are, in reality, bouncing around as much as, and often more than, public market values. Because one cannot witness these price changes on a Bloomberg screen, however, private equity investors avoid the psychological effects of volatile public stock price movements. Since many private businesses have substantially more financial leverage than their public counterparts, the equity volatility of these more leveraged private companies is in reality substantially greater than their public comparables.
An investor should not conflate the apparent low volatility of their private holdings with the lower frequency of market value data one typically receives on a private equity portfolio. This is particularly true when private values are kept at cost until a significant development, and even when the values are determined by appraisal. A long-only, leveraged private equity portfolio is axiomatically more volatile than a portfolio of less levered comparable companies that trade publicly. One of the significant benefits of investing in public companies is that investors can choose to purchase or sell any day the market is open. The drawback of public liquidity is that volatile price movements can cause investors to make economically irrational decisions - for example, by selling an interest in a business at an irrationally low price - because of their inability to stomach market volatility.
Bill Ackman's Master Stroke: Bill Ackman's investment approach is to wait for the opportunity to purchase a great business at a highly discounted valuation, when investors overreact to negative macro or company-specific events. This is the time arbitrage part of the strategy. His time frame for value realization is long term and does not typically react to short-term factors that have little impact on long-term, intrinsic values. While the opportunity to take advantage of time arbitrage is a competitive advantage for Pershing Square, it is a limited one because there are other investors who share the longer-term horizon strategy.
Bill Ackman's greatest competitive advantage is the ability to buy a stake in a company with the ability to intervene in the decision making, strategy, management, or structure of the business, even with large corporations. We will now look at four of his portfolio companies - Canadian Pacific Railway (CP), JC Penney (JCP), Citigroup (C) and General Growth Properties (GGP). The opportunity for profit was principally created by the funds' ability to effectuate change and to take advantage of time arbitrage.
- It purchased stock in JC Penney from shareholders who had lost confidence in the sustainability of the company's strategy and management's ability to implement necessary structural changes. Pershing Square bought with the belief that it could catalyze a change in management.
- As the macro environment has weakened and worries over the fiscal situation in Europe have increased, the entire large-cap financial sector, including Citigroup, has experienced material share price declines. While there is a meaningful amount of uncertainty concerning the eurozone and European bank solvency, Bill Ackman believes the risks to Citi from potential negative outcomes are more than fully reflected in the current stock price in light of Citi's minimal exposure to troubled European institutions.
- The fund also purchased stock in General Growth from investors who believed that the probability of recovery from a delisted penny stock in a bankruptcy was extremely remote. Pershing Square bought with the belief that its 25% stake in the company would give them an important seat at the table that would allow it to drive a consensual resolution in bankruptcy and enormous profits for shareholders.
We will now look at two of his portfolio holdings in detail, where he has managed to bring about a management change in Canadian Pacific Railway and Citigroup is on track to witness a successful turn around
Canadian Pacific Railway: Canadian Pacific Railway is a $12.5 bn market cap transcontinental railway company providing freight transportation services in North America. Pershing Square Capital Management acquired a 12.2% stake during 3Q' 2011. In May 2012, Bill Ackman won a proxy vote to shake up the railroad's board and unseat the chief executive as shareholders voted to support the hedge-fund manager's seven-person slate of directors. CP's business issues are almost entirely operational in nature and its operating margins are half that of its Canadian competitor due to its inefficient asset utilization and productivity. The turnaround is substantially less risky than one predicated on increasing revenue growth. The bulk of the stake was purchased in Q4 2011 when the price-per-share varied between $46.05 and $71.82. The stock currently trades at around $72.
Citigroup: Bill Ackman owns close to 12%, which was increased marginally this quarter. The stake was first acquired in Q2 2010 when the price-per-share varied between the high-30s and low-40s. The stock underwent a 1:10 split in Q2 2011 (May 2011) and Ackman roughly doubled the stake in the same price-range. The company is one a sweet spot due to the following reason:
- 2012 stress test results showed that Citi as one of the best capitalized U.S. banks, which would make it unlikely to need to raise capital even in the event of a continued severe and long-lasting economic downturn,
- During 1Q'2012, Citi reported one if its strongest earnings results in the last several quarters. Revenue increased at a healthy rate in its core businesses, credit costs continued to improve, and capital levels continued to increase,
- Citi generated a more than15% return on tangible equity in its core business
- Citi's core businesses also generated operating leverage, as revenue grew more quickly than expenses which was a cause of concern before, and
- Citi remains extremely cheap - it trades at less than 60% of tangible book value, about six times last year's underlying earnings per share and about four times normalized earnings per share after giving credit to its net tax assets and excess capital.