- By Stepan Lavrouk
Pershing Square founder Bill Ackman (Trades, Portfolio) employs an activist approach to investing, meaning he takes a sizable stake in a business and then pushes management to make the changes he and his colleagues think are necessary to unlock value and improve profitability. Most investors don't have the millions of dollars required to engage in this kind of activism, but that doesn't mean they can't learn something from Ackman's basic philosophy. In an interview with Reuters, Ackman explained how he evaluates companies.
Simple and predictable
For Ackman, the best businesses are simple and predictable, and produce large amounts of free cash flow. In particular, he looks for companies that have economic moats - durable competitive advantages that make it hard for competitors to unseat them by simply copying their product. Coca-Cola Co. (NYSE:KO) is the classic example of a company with a very wide moat - it's not very difficult to make sweet carbonated water, but Coke is valued at orders of magnitude higher than a generic soda company.
Similarly to Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), Ackman's Pershing Square seeks out high-quality businesses - those that are expected to survive for a long period of time going forward and to continue producing large quantities of cash. If the value of any asset is the amount of cash that asset will produce over the course of its useful lifetime, the long-lasting businesses clearly have something going for them.
This is also why predictability is so important - not only does the asset need to be durable, it needs to reliably be productive. Once value is accurately assessed, all an investor needs to do is to see whether the asset is trading at a lower price and, if so, what the reason for this discrepancy is. If the reasons are not disqualifying - i.e., the stock is not a value trap - then it is worth the investment. This type of philosophy is applicable to any capital allocator, not just a billionaire activist investor.
Know when you're wrong, but don't be afraid
Another tenet of Ackman's philosophy is that he's not afraid to cut his losses if he realixes that an investment has gone against him. Unlike many other investors, he doesn't have price stops - if a stock goes down by 50%, that doesn't necessarily mean he will throw in the towel:
"The best investments are the ones where we're confident that we're right when everyone else is wrong. I've been accused of being arrogant, but there's a difference between arrogance and confidence. If you're arrogant in investing, you'll get killed. If you're not confident, you'll never make an investment. You have to do a sufficient amount of work to be confident enough to have the conviction to make an investment. We bought the stock of a soon to be bankrupt retailer during the financial crash - you have to be willing to look silly when you do something like that. It's up ninety fold since our original investment."
When changing one's mind, what matters is what is happening inside the business. If new information comes to light that comes into conflict with one's beliefs, then it's the duty of the investor to change their thesis accordingly.
Disclosure: The author owns no stocks mentioned.
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This article first appeared on GuruFocus.