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When Smart Money is Dumb

Written by Briton Ryle
Posted March 15, 2017

Hedge fund managers are supposed to be the smartest of the Wall Street crowd. They're supposed to have an edge on making money that no one else has.

They buy the best research long before it becomes public knowledge. They bend the insider trading rules. They have top-notch computer programmers writing algorithms that can move the market. They can corner markets in commodities. And they can buy stakes big enough to get them on Boards of Directors and push for share buybacks or dividend hikes that directly benefit them...

And yet, the vast majority of hedge fund managers can't come anywhere close to the performance of a simple S&P 500 index fund. (Yeah, Warren Buffett is winning that bet, it's no contest.)

But then, there are at least 40 billionaire hedge fund managers out there. Some I've never heard of — Ken Griffin, David Shaw, Michael Platt, to name a few.

You might know some of the other names. George Soros is the wealthiest hedge fund manager, worth something like $25 billion. He famously made $1 billion in a single day selling the British pound to the point that the UK could no longer afford to defend the currency. 

And there's Steve Cohen, Ray Dalio, David Tepper, John Paulson, Carl Icahn, Bill Ackman...

Ray Dalio founded Bridgewater, the biggest hedge fund with something like $150 billion under management. Paulson became a billionaire during the financial crisis, but he hasn't done so well since. David Tepper had a couple huge years as the market rebounded from the March 2009 lows. 

Bill Ackman is a really special case. The guy seems to be a complete egomaniac. I guess that's what happens when you're worth $3.9 billion...

How to Lose $5 Billion

Anyway, Ackman was making headlines just the other day because he was getting out of a huge, well-publicized losing position. 

His hedge fund, Pershing Square, was selling out of a pharmaceutical company called Valeant (NYSE: VRX). Valeant had been a popular trade for a bunch of hedge funds. It was one of those pharma companies that made a lot of money by simply raising the price of its drugs. From 2013 to 2015, the stock ran from around $50 a share to nearly $300.

vrx 2 year

But in late 2015, the stock started falling apart. The blue line you see on this chart is the 200-day moving average (MA). Investors use moving averages to define the trend of a stock. A moving average calculates the average price of a stock (or index) over a set number of days. In this case, we're talking about the last 200 days. The idea is that if the average price is rising, even slightly, over the last 200 days, the moving average line will also be moving up, indicating that the trend is up.

When the average turns down, it looks like a sell-off might be at hand. Investors pay special attention when the price of a stock moves above or below a moving average. This action is seen as indicating that the trend has changed. Moving averages are about the simplest and most widely used technical analysis tools. 

So if you look at this chart, you can clearly see where Valeant's stock price drops below the blue line. And you'll also notice that it made a pretty big drop as it fell through the 200-day MA, stabilized, and then dropped sharply again. This is not surprising activity for a stock that breaks below its 200-day MA. Everybody sees it, and everybody knows what it means: the trend has changed, time to sell.

I mean, you don't have to even know what event was driving Valeant's share price lower. All you need is that moving average. Valeant breaks below the 200-day moving average, you sell, and everything's fine. 

Only Ackman didn't sell. He ignored the simplest, most obvious sell signal there is in the world. And it cost his hedge fund nearly $5 billion...

Still Has a Job...

So, that's why Bill Ackman was in the news. He was selling the last of his VRX stake that he seems to have bought very near the all-time highs for the stock. It looks like he was selling out under $12. Yeah, ouch.

This really is a case where Ackman thought he was smarter than the market. In fact, some pretty noteworthy investors tried to warn Ackman off Valeant. Warren Buffett's partner at Berkshire Hathaway, Charlie Munger, called Valeant "a sewer." A hedge fund guy named Jim Chanos who shorts companies with big problems even shared his research with Ackman in order to help him. Ackman wouldn't listen.

And the really amazing thing about all this is that Ackman has done exactly this kind of thing before. He was responsible for nearly driving J.C. Penney into bankruptcy. His fund lost around $500 million on the debacle. And of course, his dumb plan to turn J.C. Penney into a hip new store cost thousands of employees their jobs. 

Ackman has also very publicly lost a lot of money betting on the collapse of a company called Herbalife. It's pretty amazing that he still has a job, if you ask me. It's even more amazing that his net worth has been as high as $3.9 billion. I don't know what he's worth now. I expect it's less than it was...

It's pretty clear that Ackman is not the "smart money" these days. At least when it comes to making money for his investors. I guess if you just look at how he's played the hedge fund world to enrich himself, then maybe you could say he was smart. But when it comes to investing, he's kind of dumb. 

There are a lot of lessons we can all learn from big money losers like Ackman. The biggest one is: have an exit strategy for any investment you're in. It doesn't have to be complicated. Use a moving average. Watch for drops in quarterly earning per share. Use a trailing stop-loss order that will have you selling a stock if it drops 10% from any high. 

It's actually not that hard to invest like the smart money. Check your ego at the door, never think you're smarter than the market, and that will help a lot. 

Until next time,

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Briton Ryle

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An 18-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.

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