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Hello Value Investor friends. I believe that in Value Investing, it could be a great idea to set very stringent rules, as if we had a sort of investment fund with a bylaws—that is, rules so strict that they prevent us, for example, from investing in certain companies—that is, a sort of checklist with the requirements a company must meet to be eligible for inclusion in our portfolio.
And this is very useful, in my opinion, because it can prevent us from making decisions driven by our current mood. It often happens, when we analyze a company, that we can get overly excited about the products and services the company sells, for example, causing us to turn a blind eye to other aspects of the company that are just not working, and therefore risk losing money.
So, these written rules, possibly, could be useful in helping us remain cool and rational. And to help you better understand what I mean, in this video I share the eight rules of the Pershing Square fund, the fund of the famous value investor Bill Ackman, who in my opinion is one of the best investors of all time.
Actually, no, not in my opinion. If math isn't an opinion, the numbers speak for themselves and tell us that his fund, since 2004, has had a compound annual return of over 15% versus the S&P 500, which has only returned 9% annually. So, let's look at these eight rules from Bill Ackman, and rule number one is to only invest in businesses that are simple to understand and predictable.
Bill Ackman invests in companies that the average person can understand. Many would call these companies he invests in almost boring. Indeed, his portfolio includes retail chains like Lowe's, restaurant companies like Chipotle and Restaurant Brands, hotel chains like Hilton, and railway companies like Canadian Pacific.
He invests in these companies because they are businesses he understands well and can therefore forecast their cash flows 5-10 years out. Forecasting doesn't mean knowing exactly what the free cash flow will be in 2033, for example. But making very conservative assumptions, based on, for example, the current number of stores and how much profit each store generates, the number of stores that could be opened in the next 5-10 years, etc., imagine what the worst-case scenario free cash flow the company could generate in 10 years, for example.
And we can only do this if we have an excellent understanding of the company's business model and industry. And what do ordinary people do instead? It invests in companies in robotics, biotechnology, aerospace, etc. They have little knowledge of these products and therefore have no idea where these companies might be in 5-10 years, and this is often a recipe for losing money.
Rule number two, companies must generate free cash flow. Bill Ackman is very risk-averse and doesn't want to bet on companies that aren't yet generating free cash flow or that are doing so intermittently. You're likely to miss out on many investment opportunities with this approach , but the number one rule of investing is not to lose money, and often the best investing results come from managing risk, not returns.
Rule number three, the company must have a dominant position in the market. As Peter Thiel says, competition is for losers. Ackman wants companies that operate as monopolies or oligopolies, with few competitors, or companies with a very strong brand or other competitive advantage, which are often the first choice for their target customers, in order to keep margins high.
Rule number four, the company must have a moat. A company can grow as much as we want, even 50% a year, but if this company doesn't have a moat, a barrier to competition, in two or three years it could even find itself losing money, because many competing companies will want a slice of its pie, and without a barrier to entry, without a moat, the business risks degenerating.
Rule number five, the business must have a high return on capital and this is what all the great investors in history say, from Warren Buffett to Charlie Munger and in the end, in the long term, what determines the value of a company? It is the ability to reinvest the profits generated and do so at high rates of return for many years.
This matters much more than how much of a discount we bought the company for. Rule number six, the company must have low exposure to external risks that it cannot control. If the company operates in a business that is dependent on economic cycles, heavily dependent on commodity prices, or heavily influenced by industry regulations, then Ackman is not a good candidate for it, simply because it is risky and unpredictable.
As we've said, these are key requirements for Ackman: being risk-averse and being able to predict the company's cash flows. Seventh rule: the company must have a solid balance sheet and not need external capital to survive. Quite simply, Ackman doesn't buy companies that are barely able to service their debt, and he doesn't want companies that can't self-finance—that is, finance their business solely with their profits.
He doesn't want companies that must constantly dilute shareholders to survive or take on debt, because these situations could be very damaging to share price if the business starts to pick up pace or faces a difficult period like an economic crisis. Eighth and final rule, the company must be well managed and have talented management.
Ackman wants managers who are, above all, honest and transparent, who care about the company's future and believe in it, demonstrating this, for example, by buying their own company's shares or by being paid primarily on performance. So, these are Ackman's eight rules . Are these eight rules a guarantee that you will never fail?
Obviously not, because in the end we are not robots, but human beings and therefore emotional, often irrational, beings. And Bill Ackman says that every time he's made a bad investment, it's because he was somehow immature, irrational, and violated one of these eight rules. And the most famous recent case, I think, is that of Netflix, where at a certain point it decided to sell its shares at a huge loss a few months after purchasing them.
Maybe we can say he was wrong in hindsight? Maybe, but the fact is that Netflix bought it in violation of some rules. Netflix's free cash flow wasn't perfectly stable and predictable, and the business itself wasn't predictable because earnings growth depended heavily on subscriber growth, which was slowing significantly at the time .
The debt at the same time was increasing a lot, etc. And so Ackman, having a very concentrated portfolio, could not afford to have an unknown in his portfolio. So he decided to accept a loss of 40% if I remember correctly 40% rather than a potential higher loss which in such a concentrated portfolio would have really hurt him a lot and obviously he was also brave in agreeing to sell quickly with such a high loss.
How many of us would have done that? Very few. Even knowing we'd made a mistake, we'd have crossed our fingers and hoped the stock would magically break even , maybe even after a year or two . The risk of doing this is that first, we may have missed out on other opportunities by having our capital tied up, and second, above all, that the 40% loss could have gone up to 70-80%, given that we had realized we had chosen the wrong company.
So, we in the Value Investor circle have already talked about the importance of setting rules, and if you'd like to join us to talk about Value Investing, you'll find the link in the description to support the channel with Patreon and thus gain access to the Discord group. Let me know if you have any rules and what they are in the comments. Like the video if you enjoyed it, and see you next time. Hello from Davide.
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