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Bill Ackman Could Learn A Thing Or Two From Technicians

Taking concentrated fundamental bets is no different than playing craps in Vegas.

By now you’ve heard about Bill Ackman and his white whale — Valeant Pharmaceuticals (VRX). In 2015, Valeant plummeted and Ackman’s fund was down 20.5%. His misfortune continued into 2016, with his fund losing another 26% year-to-date after Valeant’s latest drop. Valeant’s share price was cut in half that day, and the troubled manager lost a cool billion on his position. Talk about a bad day at the office…

A billionaire like Ackman could really use a lesson in risk control from a market technician. His hubris and ego has literally cost him billions. He’s failed to execute the most important rule to successful investing and trading — cutting losses. You would think he learned something from his first rodeo when he went “all in” on a failing company. Ackman’s first hedge fund, Gotham Partners, doubled down on a bad bet and blew up as well. But remarkably, he was able to convince more people to come ride the pain train again in his new fund — Pershing Square.

The importance of risk management and trade management in the market cannot be overstated. That’s why at Macro Ops we use both fundamentals and technicals in our process. Stock picking and conviction is not enough to succeed in this game.

In pure fundamental investing, it’s believed that the lower the price (all else equal), the more attractive the trade. This is because price is further away from the investor’s best guess (and yes it’s nothing more than a guess) of “fair value”.

This is not the case in technical investing. Technicians approach the market in the opposite fashion. They would tell you that price below your cost is a signal to exit. You’re wrong and receiving negative feedback from the market. The attractiveness of the trade decreases as the price moves against you.

We side with the technicians on this one.

Arrogant fundamentalists like Ackman never admit defeat and never cut losses. Instead, they buy more because they believe they’re buying at a “better” price.

At the beginning of 2016, Ackman doubled down and bought more Valeant shares despite piss poor performance in 2015. That’s called doubling down on stupid…

Valeant just continued to fall lower after his purchase. As you can see below, from it’s high, Valeant has lost over 87% of its value.

VRX_Fall

This approach of averaging down and holding onto losing bets is nothing more than gambling. Investing icons such as Ackman like to make big calls. If they’re right, assets under management swell. If they’re wrong… the fund blows out. Which is exactly what happened with Ackman’s first fund, Gotham Partners.

This approach to markets has zero risk control. It’s the “pennies in front of a steamroller” trade in different form.

No one can continuously outsmart the market, even with a Harvard MBA. If you don’t cut your losses the market will do it for you with a margin call. And to make matters worse, your precious investors will redeem their assets once they see a big loss on their statements.

This may come as a shocker, but the most important thing in trading has little to do with whether you find an undervalued stock that rises in price.

Don’t take this the wrong way, trade selection has value, but it’s vastly subordinate to the path the underlying investment takes after you enter it, including how you manage that path. In other words, trade and risk management are a priority over everything else.

A lot of people get confused when we talk about the “path of the underlying”, but the concept is simple.

Take a look at the chart below:

path_diagram

The three lines represent three different “paths” that could play out after you buy a stock. The blue line trends straight to the target with little drawdown. The yellow line gives you a lot of heat, but eventually comes back and hits your target. And the purple line rewards you right off the bat, but then takes a turn for the worse. The purple line is Ackman’s Valeant.

It’s impossible to predict this path with any amount of accuracy. You can try, but attempting to do so is akin to guessing what next Saturday’s Powerball numbers will be.

You have 0 control over whether people will buy your stock after you.

You have 0 control over what management will do in a company you don’t even operate.

You have 0 control over what the stock price does at all.

But you DO have control over when you decide to hop on or off the path.

At the end of the day, what shows up on your account statements are your entries and exits. Not your 80 page thesis that you touted to your Ivy League colleagues. The cold hard profits and losses created by your buying and selling is the only thing that matters.

Take any of your favorite performance metrics: sharpe ratio, gain-to-pain ratio, sortino ratio, and calmar ratio. They all look at your equity curve, not your research. Your equity curve is what graphs your trading account’s performance. So ultimately, how you manage risk is what moves these numbers up or down. Your returns over your drawdowns is what matters the most, not whether you ended up being right on a thesis. This is why trade and risk management are far more important than investment selection for longevity and performance in the markets.

To better explain this concept, let’s go back to the path diagram:

path_diagram

Pictured are three different scenarios, all of which you were “right” at some point during the trade.

Scenario one is the blue line. The blue line is the easiest path to stomach. It has little drawdown and slowly trends upward towards your valuation target. In raging bull markets, like we had since 2009, a lot of hotshot investors saw their picks trade in this fashion. They touted their “genius” and “insight”, which the investing public bought into, causing those managers’ AUM to soar.

Scenario two is the yellow line. This is where things become tougher. Yes, your target was eventually hit, but look at the drawdown you had to suffer through to get there. Could you realistically stomach paper losses for the first year or so you were in the trade? How much doubt would you have? Also, holding this will put a dent in your performance metrics. Holding onto any type of drawdown will.

Guys like Ackman will typically hold the yellow line or even double down on the yellow line.

This may work great for a while, until a purple line pops into your life… which can happen even if you’re a seasoned billionaire.

Scenario three is the purple line — the most painful of them all. You bought the stock, and were immediately rewarded. But it didn’t quite hit your valuation target. You were hoping for more from your little darling. Then, unforeseen information comes out and the stock starts to take a turn for the worse. But the initial run up made you confident that the stock is a good company and that it’ll “come back.” Yet as time passes, the stock drops, and you become more and more wrong. The anxiety and pain is now at level 11 out of 10. You aren’t sleeping at night. You’re pulling your hair out and questioning whether you had any investing skill in the first place.

The problem is you never exit and control risk because you believe in your own story over the market. The purple path is what finally blows out the arrogant who refuse to respect price. Holding onto a purple path is a career ender. It involves PERMANENT capital loss. And permanent loss in equities happens a lot more than you would think. You just never hear about the losers.

Technicians wouldn’t stay on the purple path. They would react to the adverse price action and protect their profits. Or at least exit that trade for a small loss.

If stocks were illiquid like private investments, you would be stuck on the “path” and all the anxiety and negative emotions that come with it. But lucky for us, they aren’t! You don’t need to suffer through a purple path if you have appropriate trade and risk management.

Fundamentalists can take a page from the technician’s handbook and have their entry and exit rules determined before they enter a trade. With rules in place, you can recover when you’re wrong and limit your account drawdowns to something that’s not career ending.

If you don’t control the path, the path will control you.

 

 

  • Trigger Reed

    Great Read. Your knowledge has not fallen on deaf ears.

    • Thanks! Glad you enjoyed it.

  • Kevin

    Really? I thought the focus with Macro Ops was “macro” economics. I hope the voodoo worship of technicals doesn’t fall over to other areas of analysis. It’s rolling the bones and interpreting birds paths in the sky. I mean first of all, it’s been awhile since I’ve read an article where someone has the arrogance to denounce Graham and Buffett. Value investors invented the margin of safety. But let’s be clear, this ackman, is no value investor nor is anyone who invests in the wild rodeo of pharmaceuticals. The beta is too high, especially for a fund I would think, Jesus I would have bailed as soon as they bought in. That seems to be the underlying problem here. Pharmaceuticals take wild swings and people love betting on them. Buts that’s all they’re doing. You haven’t provide a counter-argument of any kind. Such as when a stock that you purchase keeps going down even though they’re profitable and and/or growing. Which happens all the time. Or when a good company restructures and people become afraid. The fact is that fundamentals are more able to predict long term stock price than technicals. Technical data can’t predict the strength of a company at all. I know you’re advocating for both but the whole entry and exit nonsense is akin to foretelling the future. If you make a good investment in a good company and it goes down, value investors buy more because the thesis of a good company at a good price hasn’t changed. If it’s pharma, then I guarantee no one ever looked at the book value- they’re only concerned with their future intangible assets- something that truly can’t be divined. So the article ignores the inherent risk of pharma and inherent strength of long terms investing in good, undervalued companies in order to talk up technicals and that’s frightening to me. Just an opinion.

    • Tyler

      Thanks for your opinion, you make some valid points. We don’t “worship” anything here at Macro Ops. We are beholden to no camp whether that be value, quant, techs, or fundies. They are all inputs that can be used to make successful trading operations. What really matters is that the inputs you use produce logical, actionable, and effective outputs in line with your personal trading goals. We can measure “effective” in a myriad of ways, whether that be backtesting or real time account performance. Nevertheless we are never quick to dismiss anything as “voodoo.” That is closed minded. We’ve seen it all, both camps fight each other, and at the end of the day there are great things to learn from everyone. Billionaires have been made on the quant side and fundamental side. I also think the title mislead you a bit. This article is actually about risk control more so than if a trend line or fib line adds any value. Because we certainly don’t believe a line on a chart is predictive. Exiting/entering has nothing to do with prediction and everything to do with risk management and drawdown profiling. There is no possible way that you can keep drawdowns shallow and hold onto stocks as they take a 50-60% dip. It is just not possible. Now some guys like Buffett don’t care about drawdowns, he’ll take a 50% drawdown in stride and keep on trucking. That is his style and it works well for him and his personal makeup. But like many other Global Macro based investors, we focus on shallow drawdowns, And that means never giving back more than 10-15% of account equity highs. We like to focus on Macro more than anything but in order to survive in this business risk control cannot be ignored.

    • JesseLivermore

      This article makes its point pretty clear early on — taking concentrated fundamental bets, with no risk control, is like gambling. It doesn’t matter what the analyzed and theoretical margin of safety is…if the position is concentrated enough, and it goes against the investor enough, doubling down until a margin call occurs leads to a permanent loss of capital. It doesn’t matter if the fundamentals and thesis ended up being right in a few years if you’re taken out of a position because you were too early and too concentrated. Technical analysis is more than “rolling the bones and interpreting birds paths in the sky”. The concepts of risk management, cutting losses quickly, and letting winners run are central to both technical analysis, and to macro investing. Paul Tudor Jones, George Soros, Ray Dalio — they all incorporated some form of trend based timing and strict risk management to supplement their macroeconomic and fundamental analyses, and they were able to maintain an asymmetric gain/loss ratio for many years as a result. Victor Niederhoffer, on the other hand, is an example of a very smart macro fundamental trader who shunned technical analysis and the concept of cutting losses short, and blew up his fund twice while attempting to double down on what he perceived as a sound macro analysis. If risk is managed properly, a portfolio of long term, fundamentals-only value investments will do well. No one is going to argue against that. However, buyers and sellers are what ultimately make prices go up and down, not 10-K reports, and so the behavioral and the accompanying risk management aspects of investing are not merely “voodoo”.