Bill Ackman, billionaire hedge fund manager, sees a bright future ahead for Fannie Mae (FNMA -0.71%) and Freddie Mac (FMCC 0.46%) stock. In fact, Ackman has purchased 115.6 million and 63.5 million shares, respectively, of the companies.
While it's entirely possible that Ackman and his investors could make millions if he turns out to be right, it's important to understand his reasoning for buying the stocks -- and why it's probably not a smart idea for most investors to join him.
Why does Ackman like Fannie Mae and Freddie Mac so much?
Other than the U.S. Government, no investor owns more Fannie Mae and Freddie Mac common stock than Ackman's Pershing Square hedge fund.
In a nutshell, Ackman (and other hedge fund managers) bought shares in the two companies because he perceives a favorable risk-reward opportunity. In fact, in 2014, Ackman made the case that the stocks would be worth between $23 and $47 per share if they were allowed to recapitalize and return to shareholder control. Currently, Fannie and Freddie are worth $2.38 and $2.29 per share, respectively. So, even on the low end of Ackman's analysis-based estimates, this would be a tenfold increase in value.
In addition, Ackman argues that if the companies returned to the shareholders, the government's stake could result in an additional $600 billion in revenue for the Treasury. It would be a win-win scenario and would be in the government's best interest, as well as that of the shareholders, so Ackman reasons that there is a good chance the government would agree. He also feels that reforming Fannie and Freddie is the only viable solution the government has when it comes to the two companies.
Although it's taking longer than Ackman presumably had originally hoped it would for the Fannie and Freddie saga to play out, it appears that he is still as optimistic as ever about the investment. In a report earlier in 2017, Ackman said that "we (Pershing) believe the shares of a reformed Fannie and Freddie will be worth a multiple of their current price."
The Trump administration has also given Ackman renewed hope that reform is coming. During his confirmation hearing, Treasury Secretary Steve Mnuchin said, "What I've said and I believe, we need housing finance reform, so we shouldn't just leave Fannie and Freddie as is for the next four or eight years under government control, without a fix."
In his 2016 letter to Pershing Square investors, Ackman said, "We believe the new administration has the willingness and ability to make the necessary changes to Fannie and Freddie's business model to preserve widespread access to the 30-year fixed-rate mortgage market."
Why you shouldn't invest alongside Ackman
If Ackman is right and the companies are allowed to recapitalize and return to the private sector, these stocks could increase tenfold under the right circumstances. However, in the more likely scenario that this doesn't happen, it's entirely possible that they could ultimately go to zero.
It is also important to realize that while the investment could make sense from a risk-reward standpoint for a billionaire, that's not necessarily the case for smaller investors. As a simplified example, if an investment costs $2 and has an equal probability of going to either $10 or $0 in a year, the odds are definitely in your favor. Similar logic applies here.
However, the problem is that still leaves you with a 50% probability of losing all of your money. This can certainly make sense for Ackman, who can afford to take chances like this with a relatively small portion of the assets he controls. The same cannot be said for long-term investors with modest account sizes.
Fannie Mae and Freddie Mac may seem tempting. And to be fair, Ackman has made some excellent points about the stocks, and it's easy to see where he's coming from.
Even so, it's important to point out that these two stocks are little more than a lottery ticket at this point, not an investment. Unless you have some money sitting around that you'd be just as willing to wager at a casino, you're better off picking stocks with more probable long-term return prospects.