Pershing Square Is A 75-Cent Dollar Primed To Grow

ETFS

Pershing Square Holdings (PSH) is an under-followed and over-looked closed-end fund (CEF) run by a shareholder-friendly value manager with skin in the game and trading at a 25% discount to net asset value (NAV).

Pershing Square’s discount to NAV is, in my opinion, unsustainably high and likely to narrow. If this happens, investors’ returns will outperform Pershing Square’s portfolio. In other words, the current discount creates an attractive asymmetric risk/reward profile – free leverage on the upside and a margin of safety on the downside.

In this article, I’ll first describe what Pershing Square Holdings is and why it is priced at a wide discount to NAV. Next, I’ll discuss Pershing Square’s current portfolio and prospects for its NAV in the years to come. Finally, I estimate Pershing Square Holdings’ forward returns and discuss the risks to my assumptions.

What is Pershing Square Holdings?

Pershing Square Holdings is a closed-end fund managed by Bill Ackman that makes concentrated investments in North American equities. PSH typically owns fewer than ten stocks and is often the largest investor in each. PSH usually owns enough shares to gain influence and board seats, but not outright control.

PSH’s objective is to maximize the long-term compound annual rate of growth in its net asset value per share. It prefers “investing in mid/large-cap companies generating relatively predictable, growing free-cash-flows with formidable barriers to entry and a compelling value proposition” and seeks “opportunities for improvement and often positions itself to work directly with management and the Board to unlock long-term value” (Source: 2018 Annual Report).

PSH aims to acquire investments at a discount to their intrinsic value, as a result of disappointing business progress or general stock market volatility. Unlike private equity, Pershing Square does not need to pay control premiums and can invest in businesses that are not for sale outright.

In the 2019 H1 report Mr. Ackman wrote:

We believe that our investment strategy continues to offer the potential for high, long-term rates of return because of our ability to:

  • Identify and purchase large stakes in underperforming great businesses at prices which do not reflect anticipated changes to the status quo,

  • Obtain a position of influence as a major shareholder including potential board representation, and

  • Catalyze changes to the governance, management, and strategy of a target company. In sum, our ability to effectuate successful corporate change is a huge competitive advantage over more passive investors.

Historical Performance

Though PSH was listed in 2012, Mr. Ackman’s track record begins in 2004 when he launched his first hedge fund. Since 2004 Mr. Ackman has earned investors 14% net of fees. This includes a period of underperformance that spanned 2015 through 2018. Over Pershing Square’s first eleven years, Mr. Ackman earned investors 20% net of fees.



Source: Pershing Square 2019 H1 Report

As you can see in the chart above, PSH’s IPO occurred near Pershing Square’s high water mark. This ill-fated timing has a lot to do with the current opportunity in PSH shares.

PSH shareholders who bought into the IPO or soon after have earned poor returns and are now using the strengthening NAV to cash out their original investment. They are looking through the rear-view mirror, not the road ahead. They’re telling themselves “I’d sell if I could only get back to even.” This is seductive but irrational thinking and helps create the present opportunity.

To be fair, PSH shareholders have had a rough ride. In Mr. Ackman’s words, PSH’s underperformance was the result of “unforced errors” such as their long position in Valeant and short position in Herbalife.

These are now sunk costs. What’s important for the future is that Pershing Square owns their mistakes and learns from them. That is exactly what appears to be happening.

Mr. Ackman says Valeant taught him that capital allocation skills are not sufficiently durable assets that you can assign intrinsic value to. Investments must stand on the business’s core earnings power. Herbalife appears to have taught Mr. Ackman that the poor risk/reward of short positions is not worth it – PSH’s 2018 Annual Report says “we have no current intention of shorting stocks in the future.”

In early 2018 Mr. Ackman announced that he would re-focus Pershing Square to get back to basics. He simplified PSH by reducing headcount and returning to the tried-and-true investment strategy of Pershing Square’s first fourteen years.

This back-to-basics policy appears to be bearing fruit in 2019: NAV is up 47% year-to-date. Today, simple, high-return franchises dominate PSH’s portfolio. Most are branded chains that appear well within Pershing Square’s demonstrated circle of competence.

Discount To NAV

PSH initially traded at a mid-single digit discount to NAV. It briefly traded as high as a 0.9% premium to NAV. As performance slumped, the discount to NAV widened. Despite NAV’s strong 2019 gain, PSH’s discount widened to a record 31% in August and currently sits at 25%. There are several reasons for the NAV discount.



Source: Author, with data from Pershing Square

On a micro level, Pershing Square says existing investors are using the strong NAV to “take some chips off the table” (2019 H1 Report). Meanwhile, new investors are waiting to buy the dip. Both of these lower demand for PSH shares and contribute to a widening discount.

Should investors wait to buy the dip? In PSH’s 2019 H1 report Mr. Ackman says “While our investment holding periods tend to be very long term by most investors’ standards, we sell our investments when they approach our estimates of intrinsic value. As a result, PSH’s portfolio is always “fresh;” that is, we believe it should always offer the potential for high rates of return over the long term.”

In the same report Mr. Ackman also said, “This year’s high returns are not unusual in the context of the historical performance of Pershing Square. During the last 15 years of Pershing Square, our fund with the longest track record, Pershing Square, L.P. has had five years – on average, every third year – with net returns of 36% or more.” Similarly in the 2016 Annual Report he wrote: “The concentrated nature of PSCM’s portfolio is likely to lead to lumpy investment performance on both the upside and the downside.”

Mr. Ackman does not view PSH’s 2019 performance as irregular, but as a return to the norm. PSH’s portfolio, while not as undervalued as a year-ago, is not yet trading at intrinsic value.

On a macro level, PSH is an overlooked and under-followed stock because it owns North American equities yet trades in Europe. PSH is domiciled in Guernsey for tax efficiency. The pro of this structure is that PSH itself does not pay taxes on capital gains. The con is that PSH cannot list shares in the U.S., where its logical pool of investors are.

In PSH’s 2015 Annual Report Mr. Ackman wrote, “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.”

A 25% discount to NAV is surely below PSH’s intrinsic value. The odds favor a smaller discount at some point in the future. PSH initially traded with a single-digit discount, and Mattisse Capital found that the average equity CEF traded at a 6.4% discount to NAV between 2005 and 2019. A 6.4% discount would value PSH shares 25% higher.

Shareholder Friendly Actions

Pershing Square is run by shareholder-friendly management with skin in the game. Mr. Ackman’s actions suggest he is committed to doing anything he can to minimize PSH’s discount to NAV.

These actions include:

  • Listing shares in London to tap into an additional center of demand

  • Declaring a $0.10 quarterly dividend to make PSH’s yield comparable to the S&P 500’s

  • Executing a $300 million tender in May 2018 at a 20% discount to NAV, which increased NAV by 2.1%

  • Initiating a $100 buyback program, which, at present prices and its present run-rate, can retire approximately 6% of PSH’s outstanding shares (2019 H1 Report)

  • Removing its 4.99% ownership limit

  • No longer seeking to raise capital for Pershing Square’s private funds. Investing, not marketing, is now PSH’s sole focus.

  • Allowing PSH to account for the majority of Mr. Ackman’s assets under management.

  • Buying, along with other PSH executives, $520 million of shares on the open market after the tender offer closed. (2018 Annual Report)

Future Prospects

PSH is only worth buying its NAV will compound at a satisfactory rate over the long-term. The current discount to NAV offers an opportune time to invest and a margin of safety. But the discount is not a reason to invest on its own.

Historically, PSH has compounded capital at 14% (NET) since 2004 and 20% (NET) between 2004 and 2015. However, past performance is not indicative of future returns.

One way to think about PSH is on a look-through earnings basis.

Name

Allocation

P/E Ratio

(1-Discount) x P/E

Chipotle Mexican Grill

23%

134

101

Restaurant Brands International

17%

20

15

Hilton Hotels

16%

36

27

Lowe’s

16%

35

26

Starbucks

13%

26

19

Berkshire Hathaway

12%

12

9

Howard Hughes

2%

95

71

Look-Through P/E:

40

Source: Author

Note: The table above uses Mr. Ackman’s estimate of Berkshire’s earnings, net of cash, instead of the GAAP figure, per his comments in PSH’s 2019 H1 letter. Also, the table omits PSH’s investment in Fannie Mae and Freddie Mac which are special situations and do not lend themselves to this type of analysis. The impact of their omission on the total portfolio is relatively small.

PSH’s look-through PE is 40x. That’s after accounting for PSH’s most recent portfolio weights and a 25% discount to NAV. This is hardly a bargain compared to the S&P 500’s 22x P/E.

However, there’s more to value investing than low P/E multiples. A more nuanced approach considers a business’s capacity to reinvest profits at high rates of return. Over long periods of time, a stock’s return is likely to approximate the underlying business’s incremental return on invested capital (I-ROIC).

In the table below I broke down each of PSH’s investments based on their ten-year incremental ROIC to bolster their growth potential. I also normalize their ten-year dividends and net stock repurchases relative to their current prices to approximate their shareholder yield

Name

I-ROIC

Reinvestment Rate (RR)

Growth (I-ROIC x RR)

Shareholder Yield

Total Return (Growth + Yield)

Portfolio Weight

Weighted Return

Chipotle Mexican Grill

23%

44%

10%

1.7%

11.7%

23%

2.7%

Restaurant Brands International

9%

174%

15%

0.0%

15.1%

17%

2.6%

Hilton Hotels

3%

29%

1%

3.1%

4.1%

16%

0.7%

Lowe’s

13%

32%

4%

4.6%

8.8%

16%

1.4%

Starbucks

25%

37%

9%

3.2%

12.2%

13%

1.6%

Berkshire Hathaway

6%

106%

6%

0.0%

6.2%

12%

0.7%

Howard Hughes

5%

329%

15%

0.0%

15.4%

2%

0.4%

Average:

10.5%

Total:

10.1%

Source: Author

The data suggests PSH’s portfolio could manage a 10% annual return before accounting for any change in their P/E ratio. While this analysis is simplistic, it should be in the right ballpark.

This analysis shows that PSH owns a portfolio of high-return, asset-light franchises. After reading each 10-K, I’d argue that the I-ROIC figures I derived here generally understate the portfolio’s potential. Hilton, in particular, has transformed itself into an asset-light business that is likely to earn well-above 3% I-ROIC’s in the future. Berkshire’s I-ROIC is diluted down by its large cash hoard. The Occidental Petroleum deal shows how quickly it can deploy cash at 10%+ returns when opportunity strikes.

However, Howard Hughes cannot indefinitely reinvest 300%+ of its operating cash flow. It can, however, grow 15% by using leverage responsibly to develop real estate. Debt is an unavoidable part of this game.

A detailed analysis of each holding is beyond the scope of this article. For those interested, Mr. Ackman’s comments in PSH’s 2019 H1 Report are a good place to start.

If we assume that PSH’s can compound at 10% annually for the next five years and its NAV discount narrows from 25% to 10%, then buying PSH should result in a 14% CAGR.

Year

Price

NAV

Discount

NAV Change

2019

18.97

25.25

-25%

2020

21.56

27.78

-22%

10%

2021

24.47

30.55

-20%

10%

2022

27.75

33.61

-17%

10%

2023

31.44

36.97

-15%

10%

2024

36.60

40.67

-10%

10%

CAGR:

14.0%

10.0%

Risks

There are a couple of key assumptions embedded in this analysis.

First, can PSH’s portfolio really compound at 10% annually for the next five years? This assumption is conservative in the sense that it’s lower than PSH’s historical 14% annual performance. It also assumes EPS multiples don’t increase (or decrease). If PSH successfully buys out-of-favor businesses and makes them more competitive, PSH should generally exit at higher multiples than they entered. The downside of this assumption is that 10% is likely to be an above-market rate of compounding – never a sure thing. Relying on outperformance means this investment is hardly a lock.

Second, PSH’s portfolio is dynamic, not static – there’s capital allocation risk. Mr. Ackman has proven himself as an adept capital allocator. But he has also proven that he is far from infallible. I find PSH’s recent transactions encouraging: exiting United Technologies after Mr. Ackman disagreed about the merits of the Raytheon merger, trimming Chipotle as it reaches all time highs, and buying Berkshire at the low-end of its historical valuation. So long as Mr. Ackman sticks to his back-to-basics strategy, portfolio changes should add, not subtract value. PSH’s portfolio is transparent so investors can look over Mr. Ackman’s shoulder to monitor trades.

Third, there’s no guarantee PSH’s discount to NAV narrows from 25% to 10%. Mr. Ackman says the buybacks are designed to increase NAV per share, not prop the shares up with an artificial bid. Actually, as buybacks reduce PSH’s float and liquidity, they could be increasing PSH’s discount to NAV.

That said, PSH’s dividend should put a soft floor under its price. And PSH has traded inside of a 10% discount before. Mattisse Capital found that equity CEFs trade at an average discount of 6.4% to NAV. Both data points suggest patient PSH shareholders will eventually get a chance to sell for less than a 10% discount to NAV.

The best cure for PSH’s discount will be continued NAV outperformance. CEFs, like all stocks, are driven in the short-term by investor enthusiasm. Enthusiasm for PSH is still low, which is why this opportunity exists. If PSH can prove its 2019 outperformance wasn’t a fluke in 2020, demand for PSH shares might perk up.

The flip side of this is NAV underperformance may drive the discount wider. The discount cannot widen indefinitely. The more it does, the more attractive PSH’s yield and the more accretive its buybacks. Investors should only consider PSH if they’re willing to ride out short-term volatility and believe NAV is more likely to go up than down.

Finally, there are fees to consider. PSH charges a 1.5% management fee and 16% incentive fee on profits above a high water mark. At the end of September 2019 the high water mark was $26.06, which is only a few percent higher than the current NAV.

PSH’s 2% dividend yield and 6% buyback yield cover the fees and then some right now, but there’s no mistaking the fact that fees are a drag on performance and a hurdle to overcome. Historically, PSH has compounded at attractive rates net of fees, but only time will tell if this continues in the future.

The Bottom Line

As Mr. Ackman wrote in PSH’s 2015 Annual Report: “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.” A 25% discount to NAV is surely below PSH’s intrinsic value.

At a 25% discount or wider, PSH offers investors an attractive asymmetric bet on a best-in-class capital allocator and concentrated equity portfolio.

If investors believe in Mr. Ackman’s strategy, PSH’s 25% discount offers an attractive entry.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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