Better Options for Ackman's Investment in Target

Source: Hedgeye.com

There are two main reasons why this investment did not work out for Ackman and his investors: overleverage and bad timing. This article--a follow-up to a previous posting--discusses these root cause elements and suggests a way that Ackman could have used options to better effect in his investment in Target.

Overleverage

The research I did to write the YCharts Focus Report onTarget convinced me that the retailer does indeed have some deep problems related to its culture and management style. Ackman, as an activist investor, invests in companies that have value-destructive faults, so it is no wonder that he was drawn to Target.

The position of an activist investor is sort of like that of a house flipper, except in the latter case, the house is not actively attempting to thwart the owner’s attempts at rehabbing it!

Knowing that Target was a “fixer-upper” I question whether a levered strategy was appropriate at all. Buffett also uses leverage in his portfolios, but he buys companies that have little “valuation risk”—assets that have a good track record of performance and for which he has a reasonable expectation that the track record will continue.

Finding a company with little valuation risk and designing a levered strategy to invest in it is a great idea. Finding a company that has a material valuation risk and using leverage to invest in it opens the investor to the possibility of large losses.[1]

In The Intelligent Option Investor, I talk about investing as being a meal; the main course should usually be the underlying asset; ITM options are side dishes that enhance the enjoyment of the main course; OTM options are spices you sprinkle on for zest, or a savory snack between meals.

Looking back at the first graph in this article, it’s clear that Ackman had not prepared a very balanced meal for himself and his investors. Most of his meal was made up of side dishes rather than entrées (like a kid at the Chinese buffet who comes back with five egg rolls and only a single ladleful of chicken and broccoli). Considering the cultural / operational issues at Target, and the uncertainty this might have on the stock price, this meal seems especially unbalanced.

Also, from a public relations perspective, the fact that over four-fifths of the investment was in derivative instruments made it very easy for management to argue that Ackman was not a long-term shareholder, but rather a speculator. And of course, no one likes speculators—including shareholders voting their proxy statements.

Timing

As for the bad timing side of things, Ackman not only chose to invest in this company that has a fairly large valuation uncertainty, but had the bad fortune of doing so just before the mortgage crisis and financial panic of 2008.

It’s evident from his short investment in mortgage insurer MBIA[2] that Ackman understood the house of cards that was the pre-crash CDO market. However, he—and a lot of others—failed to recognize just how many secondary and tertiary effects from the collapse of the mortgage market would bring about. Target’s stock price fall was one of those.

The way Ackman structured his option investment, it would take a 20% drop in Target’s stock by expiration before Ackman would suffer a 100% loss of value on his options.[3] While such a large decline is not unheard of for small cap stocks or stocks that are in some special situation (i.e., experimental drug company waiting for FDA approval, a company fighting for a bridge loan to stay in business, etc.), it is rare for a large retailer with as strong of a brand and market position as Target.

The mortgage crisis, however, made “rare” occurrences commonplace and Ackman had to watch the ground suddenly disappear from beneath his feet as Target followed the market down.

In addition, with the exception of the $147 million worth of 45% ITM options (representing only 11% of Ackman’s option-based investment in Target), Ackman’s entire position was made up of options on which he paid a significant amount of time value. As I discuss in The Intelligent Option Investor, money spent on time value should be thought of as a realized loss. That loss may ultimately be partially or wholly offset by investment profits, but the money spent on time value wastes away with the passage of time.

Target’s large drop in price coupled with the foreseeable expiration of Ackman’s options, shifted the power in the battle away from Pershing Square and toward Target’s board and management. Target’s board understood that if they could keep stalling, Ackman would suffer more and more financial pain as the options neared expiration. Indeed, after an expensive and ultimately futile proxy battle, Ackman did throw in the towel.

In short, the overuse of leverage in a stock with high uncertainty, coupled with a market drop that had a more serious and widespread impact than most people (even bearish ones) had expected, ended up sinking this investment.

Better Options

Hindsight is 20/20, so it’s easy to look back at Ackman’s failed investment and scoff at his choices, but in fact, at the time, the investment, while aggressive, must have seemed quite sensible.

However, a few things do jump out as areas in which intelligent investors could learn from.

1.       Take a relatively larger stake in the underlying stock up front. This would have reduced Ackman’s leverage—an appropriate idea for a fixer-upper investment like Target—and would have given him more credibility during his proxy battle.

2.       Choose options that are further ITM, so carry less leverage. This would have meant that much less of his investors’ money would have been spent on time value (I write in The Intelligent Option Investor about any money spent on time value being an immediate realized loss), and he would have felt much less pressure as the option expiration became closer.

3.       Use short put strategies during large market drops. This would have meant that Ackman not take his entire position in Target all at once, but hold some capital in reserve. It is easy to say this looking in the rear-view mirror, but of course impossible to know at the onset of an investment. At the very least, if he could have done another capital raise as Target tanked (and option prices were very high), he could have supported a short put position with that capital and perhaps even bought a long-tenor OTM call option in a strategy I term a “Diagonal.”

Taken in total, these steps would have drastically lessened the leverage, removed a good bit of the time pressure, allowed for less money to be spent on wasting time value, and allowed widespread investor fear (i.e., high implied volatility) to be one’s friend rather than one’s foe.

(Those of you interested in seeing the spreadsheet I used to analyze Ackman's Target position, please click here to download the file).

Notes:

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[1] Along with the possibility of severe losses, it also opens the investor to the possibility of spectacular gains. The most dangerous investor in the world is the one who experiences—in his or her first time using a levered strategy on an asset whose value is highly uncertain—a success. Confusing the wonderful results of that success as skill, rather than luck, encourages the investor to make a similar, though usually even more levered, investment in the future. This eventually ends very badly.

[2] Ackman opened a short position in MBIA in 2002 and closed it at an enormous profit in January 2009.

[3] This is true for most of the position, but he did allocate about $147 million of his investment in the Pershing Square IV fund to calls struck 45% ITM. These options certainly held their value better even during the darkest days of this position, simply because they were less levered.