Hedge fund managers are usually considered the smartest investors in the game, but even the best sometimes make bad bets. Bill Ackman of Pershing Square Capital Management is one such hedge fund manager. He's an investor with a $1.6 billion net worth and an $8.9 billion portfolio of stocks in his fund, and despite his expertise and experience, he let one bad bet ruin his returns for probably years to come.
Here's what happened, and the lesson you need to learn from his unfortunate experience.
Bill Ackman's painful lesson in diversification
As of March 31, Pershing Square reported total assets under management of $12.3 billion, with an investment portfolio worth $8.9 billion, consisting of just nine stocks. Two stocks, Zoetis (NYSE:ZTS) and Canadian Pacific Railway Ltd. (NYSE:CP), are the fund's two largest holdings, each representing more than 20% of the portfolio. Three other stocks come in above 10% of the total portfolio. For most investors, that's an incredible amount of concentration risk.
Until this year, Ackman successfully managed the risk of the portfolio's high concentrations in just a few stocks. That streak ended, however, in the fund's 2015 investment in Valeant Pharmaceuticals International Inc. (NYSE:VRX). That stock is now 91% off its all-time high from last August. Ackman and Pershing Square first began buying the stock just before those all-time highs, investing $3.3 billion in total. Pershing Square's investment is down 70% in 2016 alone.
Other than the Valeant investment, the rest of Pershing Square's portfolio is doing well. With the exception of just one other stock, all of the fund's investments are in the black so far in 2016. Restaurant Brands International (NYSE:QSR), the fund's third largest holding, has beaten the S&P 500 year to date 3.6 times over. Canadian Pacific Railway, the second largest holding, has nearly doubled the index. Broadly speaking, Ackman's stock picks remain wise.
Those successes hardly matter though in light of Valeant's overwhelming decline. Thanks to Valeant, Pershing Square was down 18.6% through the end of May. The S&P 500 was up 2.59% over the same period.
No one, not even Bill Ackman, can invest perfectly. So diversify your risks instead.
Valeant's fall stems from an accounting scandal last October that forced the company to restate certain financial reports. The company later came under fire for cutting its R&D budget while raising the prices for its drugs. The company replaced the CEO in March and has since lowered its guidance for 2016 results. It's been a nearly perfect storm.
Ackman could never have predicted many of Valeant's issues, nor could anyone else outside company management. And in some cases, even executive management couldn't have seen the approaching storm. That's why this investment will go down as such a powerful case study in diversification.
A more diversified portfolio would mitigate Valeant's decline both by reducing the exposure to that bad bet and by giving more weight to Ackman's other investments, which are performing well. He's proved himself throughout his career to be a world-class stock picker and value investor; there's little doubt he could find 20 or 30 additional stocks that would probably succeed, diversifying risk without sacrificing too much profit.
Yes, a more diversified portfolio would have limited the potential upside if Valeant had continued its climb. But as this example and countless others in history have shown, no one can successfully bet correctly every time. Don't make the same mistake in your portfolio. Don't be greedy. Diversify your investments. It's just not worth the risk to put your entire nest egg all in the same basket.
Jay Jenkins has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Valeant Pharmaceuticals. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.