Pershing Square 2015 Letter: 2015 is a year we will not forget
Pershing Square 2015 Letter
2015 is a year we will not forget. There was no financial crisis except perhaps in the energy, commodity, and currency markets.1 There were no major new wars except for the rise of ISIS and growing global terrorism. The global economy has shown signs of weakness, most notably in China, but U.S. core growth appears sound. The substantial majority of our portfolio companies made continued business progress despite currency headwinds and a weakening global economic environment. Yet, the Pershing Square funds suffered their greatest peak-totrough decline and worst annual performance ever. What happened?
Pershing Square 2015 Letter – Mistakes and Lessons Learned in 2015
The first place to look for an explanation is mistakes we made in 2015, and we did make some important mistakes. Principally, we missed the opportunity to trim or sell outright certain positions that approached our estimate of intrinsic value. Our biggest valuation error was assigning too much value to the so-called “platform value” in certain of our holdings. We believe that “platform value” is real, but, as we have been painfully reminded, it is a much more ephemeral form of value than pharmaceutical products, operating businesses, real estate, or other assets as it depends on access to low-cost capital, uniquely talented members of management, and the pricing environment for transactions. When we purchased Valeant at an average price of $196, we bought the company at a modest discount to intrinsic value as represented by the company’s existing portfolio of products and businesses, but at a very substantial discount to fair value in light of its acquisition track record,
the large number of potential targets, and its competitive advantages which include its low-cost operating model and favorable tax structure. When the stock price rose this summer to the mid- $200s per share, we did not sell as we believed it was probable the company would likely complete additional transactions that would meaningfully increase intrinsic value. In retrospect, this was a very costly mistake. Our failure to sell stock wasn’t entirely an unforced error as we found ourselves largely restricted from trading during this period. During the summer, we were made aware of a large potential transaction that Valeant was working on, and as a result, we were restricted from trading at a time when it would have been prudent to take some money off the table. In retrospect, in light of Valeant’s leverage and the regulatory and political sensitivity of its underlying business, we should have avoided becoming restricted to preserve trading flexibility, or alternatively, we should have made a smaller initial investment in the company.
We made a similar error in not trimming our Canadian Pacific position when it reached ~C$240 per share. While we still believed CP was trading at a discount to intrinsic value at that price and there was the potential for CP to complete an industry-transforming, value-creating merger, in light of the size of the position as a percentage of the portfolio, and concerns we had about the Chinese economy, it would have been prudent to sell a portion of our investment. Our most glaring, albeit small, unforced error was buying additional stock in Platform Specialty Products at $25 per share to assist the company in financing an acquisition. We paid too much as we assumed the new transaction would create substantial value, and because we assigned too much platform value to the company. Our assessment was incorrect as execution difficulties, operating issues, currency effects, and financing issues have destroyed rather than created value. While not quite a lesson learned, as this has been a principle we have always believed, 2015 was also an important reminder that stocks can trade at any price in the short term. This is an important reminder as to why we generally do not use margin leverage in our investment strategy. We expect that there have been many margin loan liquidations in recent weeks which have contributed to dramatic stock price declines. We do not believe that our investment performance in 2015 was primarily due to unforced errors, but rather due mostly to the market’s reappraisal of our holdings without a corresponding material diminution in their intrinsic value. While stocks can trade at any price in the short term, it is rare for companies to trade at material discounts to intrinsic value for extended periods. Fortunately, the lessons we have learned in 2015 should be easy to avoid in the future.
Pershing Square 2015 Letter: – What Other Factors Contributed to Our Negative Performance in 2015?
The inception of the portfolio’s decline began with Valeant in August. We have discussed at length the events at Valeant which catalyzed the stock’s initial decline: political attention on drug pricing and the industry, regulatory scrutiny, attacks by short sellers, and the termination of a distribution arrangement representing ~7% of Valeant’s sales. But, we would never have expected that the cumulative effect of these events would have caused a nearly 70% decline in the stock, nor do we believe that they will permanently impair Valeant’s intrinsic value.
Contemporaneous with the decline of Valeant, the rest of our portfolio went into free fall which has continued up until the present. While our portfolio is highly concentrated, we are highly diversified in the industries in which we invest: sweet snacks and chewing gum, industrial gases, real estate, specialty pharmaceuticals, specialty chemicals, frozen foods, animal health, housing finance, railroading, and quick service restaurants. One would not expect a substantially greater than market value decline in our portfolio due to recent company-specific and macro events as has occurred since August as shown in the table below:
You will note that the best performers in the long portfolio since August were Mondelez, Zoetis, and Air Products. These three companies are the only ones in the current portfolio which are in the S&P 500. Despite their large market caps and business quality, which would ordinarily qualify them for inclusion in the S&P 500 index, Canadian Pacific, Valeant, and Restaurant Brands are Canadian-domiciled and therefore not eligible. Their shares have also likely suffered because they are components of Canadian market indexes that have experienced large capital outflows and substantial declines due to Canada’s large energy and commodity exposures. The companies in our portfolio that have suffered the largest peak-to-trough declines are Valeant, Platform, Nomad, and Fannie and Freddie. The inherent relative risk of their underlying businesses and their more leveraged capital structures partially explain their greater declines in market value as markets moved to a “risk off” mentality. But their massive declines in value, in our view substantially more than can be accounted for due to fundamental issues in their respective businesses, cannot, we believe, be attributed to these factors. Importantly, none of these companies is in any of the important market indexes. Their shareholder bases are, therefore, largely comprised of hedge funds and other active managers, which we believe has contributed to their underperformance.