Source: Insider Monkey

How do you earn $4.5 billion in investment profits on behalf of your investors in a single year? It helps to begin with $11.5 billion in capital, for a start. All the same, credit where it's due, activist hedge fund manager Bill Ackman put up fantastic numbers in 2014, posting a 32.8% net return at Pershing Square Capital Management (i.e., after subtracting the hedge fund manager's generous performance fees). Starting with a look at Ackman's biggest winner of the year, a controversial investment in Allergan (UNKNOWN:AGN.DL), the maker of anti-wrinkle compound Botox, here are three lessons individual investors can apply to their own investing.

The S&P 500 still contains undervalued stocks
Bill Ackman uses his influence to push for changes that unlock value at the companies he targets. That's not something retail investors can do; however, the undervalued stocks he identifies are hardly unknown. He told the Financial Times at the beginning of the month that "we invest in the S&P 500, and we are principally a long investor."

On April 22, Pershing Square announced that it had acquired almost 10% of Allergan's shares and that it was teaming up with Valeant Pharmaceuticals in a bid to acquire Allergan outright. The announcement pushed Allergan shares up 15.2% on the day.

Allergan gave as good as it got in an aggressive takeover battle and ultimately saw off Valeant's advances. But while Valeant was unsuccessful, Ackman emerged a huge winner as Allergan threw itself instead into the arms of another pharmaceuticals company, Actavis, in a transaction valued at $224.02 per Allergan share (as of Dec. 31), for a 75% return relative to Pershing Square's average cost of $128.14 (the value has continued to rise since then.)

As of Nov. 25, Pershing Square held 26.6 million shares of Allergan and there is good reason to believe it held them through the end of the year (and even now). On that assumption, the paper gain on those shares for 2014 was in excess of $2.5 billion. Pershing was then analyzing Actavis to determine "whether we should remain a long-term holder" of the Actavis shares it will receive as part of the company's cash-and-share offer for Allergan.

To reiterate: Ordinary investors couldn't have imitated Ackman's tactics in engineering Allergan's takeover. However, Valeant and Actavis' interest -- and the price tag they were willing to pay for Allergan -- suggests the company was substantially undervalued. Any stockpicker, professional or otherwise, could have spotted that undervaluation even if they lacked the means to force the gap closed themselves.

The "rule" of eight to 12 investments
There are other lessons to be learned from Ackman's approach. In his first letter to shareholders of his Amsterdam-listed vehicle, Pershing Square Holdings, he wrote:

We expect to continue to concentrate the substantial majority of our capital in about 8 to 12 investments, and estimate that our typical holding period will be long-term, typically four or more years. Our "subsidiaries" are represented by large minority stakes in a handful of public companies. Typically, we are the largest or second largest shareholder, may have representation on the board, and, at minimum, have substantial influence by virtue of our large stake and active voice.

There are two points to be made about this:

  • If you're a stockpicker, your aim is (or ought to be) to outperform the index, so it makes sense to focus on a limited number of ideas, consistent with Pershing Square's modus operandi.
  • On the other hand, since you don't "at minimum, have substantial influence" on your investments (not to mention Pershing Square's research resources), Ackman's rule of thumb of eight to 12 investments represents an absolute lower bound for virtually all individual investors.

Temper your expectations
According to data compiled by LCH Investments, a fund of hedge funds, last year's performance pushed Pershing Square into a rarefied circle, with a ranking of 19 on the list of the 20 top hedge fund managers by cumulative dollar profits earned for investors, starting from each fund's inception (Pershing Square is also the youngest fund on the list.) Since 2004, Pershing Square's first fund has compounded investors' capital at 21% per annum, 13 percentage points ahead of the S&P 500.

That's a remarkable record by any standard; in fact, your best bet of achieving anything similar over the next decade is arguably to invest in Ackman's publicly traded vehicle. Even that is hardly assured: As his letter states, "[P]ast performance is not necessarily indicative of future results."