In October 2015, Bill got up on stage.
He was giving a four-hour speech on why Valeant Pharmaceuticals was a buy.
That year the stock would climb more than 60% in seven months, before dropping rapidly to finish the year down 33%.
Bill was giving his speech just as Valeant had collapsed from its high.
His firm was carrying more than a million-dollar paper loss on the investment.
Yet that didn’t seem to matter much.
He knew why the stock was going down. A notable Wall Street short seller, Citron Research, had the company in their cross hairs.
This is when an investor borrows a stock to sell it in the market. Their hope is that the price will go down. And when it does, they can buy back it back, returning it to whomever they borrowed it from for a profit.
Citron issued a report labelling Valeant Enron-like.
Over hyped nonsense, Bill thought. The situation wouldn’t turn out nearly as badly as Citron expected.
Bill told the crowd the stock could be worth $448 in the next three years. At the time, the stock was trading for $93.77.
‘Life will go on for Valeant. While this has been a very damaging moment for the company … we think the Valeant business is quite robust,’ Bill said.
The stock is ‘tremendously undervalued’. The upside is at least ‘89%’ he added.
Yet it didn’t matter much.
A year later and a month before hitting a low of $8.51, Bill sold his Valeant position for a US$4 billion loss.
‘Clearly, our investment in Valeant was a huge mistake,’ Bill later told investors.
And today I want to show you an important lesson from Bill’s huge mistake.
The downfall of a concentrated portfolio
You may not have seen the Valeant saga.
Or maybe you just don’t remember it.
But Bill is the notable hedge fund manager, William (Bill) Ackman.
And he’s one smart cookie.
He attended Harvard College in 1988, and then went to Harvard Business School to get his MBA.
Upon graduation Bill started Gotham Partners, a small investment firm. Within a few short years Bill was convincing enough to be intrusted with US$500 million to manage.
He was also one of the few to buy credit default swaps leading up to the 2008 financial meltdown.
Just before disaster hit, Bill was shorting a financial services company called MBIA. Not only was the firm’s market value in jeopardy, so too was their debt, Bill thought.
So, he bought credit default swaps against MBIA’s debt.
And if Bill was right, he would not only profit from a declining stock price, he’d also profit if MBIA failed to pay their debt.
Turns out he was right.
MBIA couldn’t afford their debt, and both Bill’s short position and credit default swaps became extremely valuable.
A couple more smart moves and Bill now finds himself managing US$8.2 billion.
He’s also got a team of the brightest analysts. He himself has decades’ worth of experience in the market. He hobnobs with many other bright investors, bouncing ideas off their analytical minds.
How could he have made such a blunder with Valeant?
Because even someone as bright as Bill can’t get it right all the time.
Everyone will pick up losers at some point or another. Why do you think so many fundies hold a wide variety of stocks?
They know they can’t always pick winners.
So, they spread their bets over hundreds of names. That way, if they do have a couple of losers in their portfolio (and they will), it doesn’t hurt total returns all that much.
But this is not Bill’s bag.
He’s not one for index hugging (where managers buy a little bit of everything in an index).
Bill runs one of the most concentrated portfolios around.
And it hurts when he’s wrong.
Take a look at his funds’ performance from 2015–16.
From 2015–17, Bill lost investors 16.2%, 9.6% and 1.6% respectively. And that’s was while the market (S&P 500) gained 1.4%, 11.9% and 21.8%.
So, what’s the lesson?
If you’re going to run a concentrated portfolio you better be right.
As of 2018, Bill and his fund like just seven stocks.
Some of those picks have done pretty well this year. Others…not so well.
You can see, Bill has bet 23.7% of the fund on Restaurant Brands International [TSE:QSR].
It’s something he obviously believes is well worth paying up for. If he didn’t, he wouldn’t stake almost 24% of the fund on it.
And if he’s right and QSR is a winner, then his total returns will be that much better for it.
In contrast is The Howard Hughes Corp [NYSE:HHC]. It makes up just 5.1% of the fund. If it turns out to be a loser it will affect overall returns, but not to the extent that QSR might.
How can you reduce the risk?
No one is right all the time.
Not Bill, not even Buffett.
And that’s OK.
All you’ve got to do is get a few big bets right.
If you only buy three or five stocks next year, you’re running a very concentrated portfolio.
There’s nothing wrong with that. But all it takes is one big loser to ruin the year. It’s why you’ve got to be sure you’re right.
It also goes without saying that you’ll have to learn to live with volatility.
Even if you make big bets on future winners, they won’t necessarily be winners in the interim. So, you’ve got to get comfortable with paper losses.
But if that’s not your thing, you could always just hold 15–20 stocks you think will do well over time.
Most studies show that about 15–20 stocks can eliminate large amounts of volatility (a proxy for risk among academics).
But if you can get concentration right (make big bets on winners) the rewards are enormous!
Above you saw Bill’s returns after years of concentration. Even with the losses of 2015–17, his fund comfortably beats the S&P 500 by a wide margin.
And that’s because Bill has been right on a few big bets over the years.
Editor, Money Morning
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