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Ackman Off Target


The dangers of extreme leverage.

I don't know Bill Ackman, but I respect him a great deal. He was proclaiming loudly, and in great detail, that the financial complex was undercapitalized and unworthy of the credit ratings it carried. He made an unpopular call (particularly on the insurers MBIA (MBI) and Ambac (ABK)), was vilified, and was as right as rain. He backed his opinion with detailed research and with plenty of money.

But now comes the revelation that his unique hedge fund designed solely to invest in Target (TGT) (a store I really like, by the way) lost 40% in January even though the stock was down less than 10%. The 2-year-old fund is now down nearly 90% since its inception - even though Target is only down about 50% from its all-time high. How did he pull this off?

Leverage, friends; leverage.

I don't know all the details, but I know enough of them. The fund's investment was largely represented by one or more fairly short-dated call options on Target. Such a trade, as most Minyans know, is the financial equivalent of a baseball player who hits with great power but for a very low average. Lots of strikeouts, plenty of home runs, and very few singles and walks.

I imagine Mr. Ackman structured the fund this way both to avoid certain reporting requirements (in other words, to control enough stock to become an insider without actually becoming one) and to make a bigger score if he was really right.

But the irony is that someone so good at identifying the weaknesses in other capital structures could have built one of his own funds on such shaky ground.

The problem, as I see it, with using high leverage as an activist investor is that you're trying to be both a price-taker and a price-maker. And it's very hard to do both. Buying options makes sense when you are sufficiently small relative to the underlying trade. It's very hard, though not impossible, when you are trying to make the move happen yourself.

Apparently Mr. Ackman has restructured what's left of the fund so that it now holds primarily longer-dated options. These have a much greater resemblance to the stock itself than do the more speculative short-term ones.

I like the way Mr. Ackman thinks, and I wish him well. I'm just a bit surprised that someone so cognizant of the dangers of extreme leverage would have subjected his investors and his reputation to their perils quite so much.
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No positions in stocks mentioned.

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