Last week, I got a chance to hear a speech by William Ackman, the CEO and founder of hedge fund Pershing Square Capital Management. If you're not familiar with this activist investor you should be, because his investment approach offers some valuable lessons.

Ackman's been in the news a lot over the past year or so.
Bill Ackman, CEO of Pershing Square Capital Management
Bill Ackman, CEO of Pershing Square Capital Management.

He took a long position in General Growth Properties ( GGWPQ.PK) in November 2008 and then watched the stock go from 35 cents to more than $13. The company is now the subject of a bidding war between Simon Property ( SPG), Brookfield Asset Management ( BAM) and possibly Westfield and Vornado Realty Trust ( VRO)

He also ran a high-profile proxy contest against Target ( TGT) last year that failed to win him a seat on the retailer's board, although Target's shares are still still up substantially since he launched the contest.

Unlike most funds run by activist investors, Ackman's is not a long-only fund. He typically holds eight to 10 positions, with a couple of those being short. Because of that positioning, he's done well over the last few years and has remained active and outspoken.

Always a good speaker, Ackman has definitely ramped up his media appearances over the past couple of years. Pershing Square now manages more than $6 billion in assets, with a team of six investment professionals including Ackman.

Ackman describes the fund's strategy as "concentrated, fundamental, research-intensive, and long-short." The fund charges investors 1.5% in annual management fees and 20% in incentive fees.

Pershing Square has averaged 24% annualized returns since its founding in 2002. At the moment, the fund is 23% in cash.

It never uses leverage and almost never invests in industries that use a lot of leverage, are highly sensitive to interest-rate shifts or are commodity-related. (According to Ackman, the one investment that violated this rule was Borders ( BGP), which has lost 95% of its value since Ackman invested in it, although Ackman says at these levels it's a great value.)

Ackman wouldn't describe his firm's strategy as activist, either on the long side when he's gone to battle with Target or on the short side such as with bond insurer MBIA ( MBI), which Pershing Square first shorted in 2002.

Ackman has publicly criticized Carl Icahn and that type of histrionic activism.

Instead, he likens his approach to a modified/improved version of private equity:
"Private Equity doesn't work as an investing model, because it's prone to winner's curse and some things are only for sale at certain times. We don't pay a premium price when we take our positions, and they're always for sale. We're buying shares from the marginal retail or institutional holder. We built up a 25% stake in General Growth in November 2008 for a song because large institutions were dumping shares because they didn't want to have to list General Growth as one of their holdings at the end of the quarter. They would have had to explain to their investors why they owned something that went from $30 to $3."

Because Ackman makes just a few bets at any one time, he has to do lots of research. He also spends a lot of money on consultants and lawyers. Pershing Square shelled out $10 million on the Target proxy contest alone last year.

Ackman says he knows he'll have free riders who will mimic his investments, but he insists Pershing Square investors will still do best with his active and public approach than if they only invested in a passive portfolio.

Given that his fund makes so few bets, I asked Ackman how he manages risk at Pershing Square.

He replied that there are two ways to perform risk management: (1) using a Value-at-Risk (VaR) statistic or some variant of this in a complex analysis, or (2) asking yourself, "Can you sleep at night?" Pershing Square prefers the second approach. "If you can't sleep at night, something's wrong," said Ackman.

He continued:
"You shouldn't invest in something unless you've done a lot of research and are completely comfortable with it. I think most investors overdiversify because they're lazy. They haven't done enough research into any of their companies. If they've got 200 positions, do you think they know what's going on at any one of those companies at this moment? As a result of overdiversification, their returns get watered down. Diversification covers up ignorance. We do extensive research and then feel totally comfortable with our eight or 10 positions. That's our risk management."

I asked Ackman how he decides whether to cut his losses on an investment that has gone bad or to stick with it.

He responded:
"We're typically contrarian, like we were in General Growth, so you have to be confident in yourself in order to make bets like that. You have to be confident. You've got to trust your original analysis -- or you shouldn't be in this business. However, you have to be humble enough to see new information that comes up or that questions some of your original assumptions. If you don't do that, you're dead. We don't get it right all the time, but we don't have to in order to be successful."

Ackman offered some final suggestions on how governance in Corporate America should be improved:

Compensation for executives should be more like compensation for hedge fund managers: The people making big bets of capital at their firms need to feel more ownership and accountability over that capital being risked.

Senior, long-term investors need to be able to nominate directors for elections to corporate boards on a Universal Proxy Card (i.e., one single list of nominees) next to management's nominees. "Many investors in Target told us after that they wished they could have voted for two of our nominees instead of either our nominees or Target's," Ackman said.

All corporate election voting by investors should be anonymous. "Can you imagine if we didn't let political election voting be anonymous?" Ackman asked.

There should be a Zagat guide to corporate directors. "That would change behavior quick," Ackman said.

Ackman was speaking at last week's Active/Passive Investor conference in New York, which brings together top activist investors with institutional investors and pension funds. The conference suggested that, after a quiet couple of years, many activist investors are planning for a busier 2010.
At the time of publication, Jackson was long shares of General Growth Properties.

Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd. You can follow Jackson on Twitter at or @ericjackson

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