market folly

In late June/early July, Bill Ackman's hedge fund Pershing Square Capital Management liquidated its stake in Citigroup (C).  In his second quarter letter to investors, Ackman detailed why.

We wanted to highlight this because investing is a continual education and great investors are always looking for how they can refine their process.  Learning from mistakes is a necessity and when you can learn from others' mistakes, you can often gain the knowledge without the battle scars.

Ackman's experience with C underscores two principles: 1. Invest in what you're comfortable with (or as Warren Buffett would say: stick to your circle of competence).  And 2. If you can't sleep at night, sell.


Ackman on Why He Sold Citigroup

The Pershing Square founder writes, "Since the inception of Pershing Square, I had been opposed to making long investments in financial institutions.  The inherent leverage, limited transparency, and regulatory risk discouraged us from investing in banks.  Historically, most of our profits in financial institutions have been generated on the short side.

"We were attracted to invest in Citigroup beginning in April 2010 because of its strong balance sheet after the U.S. government-led recapitalization, the bank's low-cost deposit and liability funding, the favorable environment for making new loans, its conservatively marked balance sheet post-crisis, its dominant global-banking franchise, its strong senior management team who we believed was executing a strategy that made sense, and a price which we believed offered an attractive return when compared with the risk.

Over the course of our ownership, our predictions with respect to the bank's earnings power and improvements in its asset portfolio proved accurate.  Over the same period, however, the regulatory and political environment for financial institutions deteriorated, sovereign credit and European financial institutions' creditworthiness weakened, and an important catalyst for value recognition was postponed when the government denied Citi the ability to return capital to shareholders.  While the impact of these macro events affects nearly all businesses, they disproportionately and negatively affect financial institutions.

While we have constantly reassessed our decision to retain our stake in Citi over the last two years, at each previous moment of reconsideration, we elected to retain our shares because at successively lower valuations the stock price appeared to continue to offer sufficiently greater profit for the associated risks of the investment.  In other words, while risk increased, the stock price quickly declined to reflect those risks, and the investment thereby continued to offer apparent compelling value versus a sale.

In recent weeks, I have reassessed our thinking on Citi.  While I believe that our initial fundamental analysis was correct, we erred in overpaying for our stake because we did not demand a large enough potential profit from this investment in light of the inherent environmental uncertainties of investing in a financial institution.  Recent events in the banking world - in particular, a large surprise derivative loss at JP Morgan and the recent LIBOR manipulation scandal - were the proverbial straws that broke this camel's back.

Our approach to risk management at Pershing Square relies in part on what I have deemed the 'Sleep at Night Test.'  After one bad night's sleep thinking about Citi, I pulled the rip cord.  While I still believe that Citi is a very cheap, well managed, high-quality banking franchise that is likely to increase in value over time, there are much easier ways for Pershing Square to make money.  As a result, we redeployed the capital from the Citi shares into our new investment in Procter & Gamble.  We thereby benefit with a large tax loss for our U.S. investors, reduced exposure to systemic risk in the portfolio, and fewer sleepless nights."


Takeaways From Ackman's Lesson

There are a few key takeaways here:  Ackman had a clearly outlined thesis and constantly re-assessed both it and the risk/reward skew of the investment.  He then recognized he made an error, knew exactly what that error was, and cut his losses.

Investors often fixate on the upside of a potential investment.  Great investors focus on the downside and the degree of risk/reward.  In this case, Ackman concluded that the risk he was taking outweighed the potential upside.  

Since in this case his error was "overpaying for our stake," this just goes to reinforce Warren Buffett's old adage: "price is what you pay, value is what you get."  As always, price and determining a margin of safety are some of the most important aspects of the investment equation.

  
Bill Ackman will be presenting his latest investment ideas at the Value Investing Congress in NYC in 3 weeks along with David Einhorn, Barry Rosenstein, Jeff Ubben & many more hedgies.  You can register to attend here.