When following smart money is stupid

Advisors often mistakenly believe that so-called “smart money” institutional investors don’t make major blunders. We mean “smart money” in the context of billionaire investors like Warren Buffett, Bill Ackman and Prem Watsa.

Back in 2012, we recommended investors sell the shares of Just Energy Group at roughly $11.50 per share based on an unsustainable dividend and questionable financial metrics published by the company. Within a few months, the shares slid below $7.00 per share.

Enter two Canadian billionaires who made large bets on the stock. The first was Ron Joyce, former owner of Tim Hortons and former director of Just Energy. He bought roughly 13% of the company between 2013 and 2016 at an average price of around $7.75 per share. In total, he invested roughly $150 million.

Next came Jim Pattison, the 10th richest person in Canada. He’s well-known for making large investments in Canadian companies including West Fraser Timber, Canfor Corp and Westshore Terminals. Pattison bought roughly 15% of the company between 2013 and 2015 for a total investment near $170 million.

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To many investors, these endorsements seemed better than any analyst recommendation. Unfortunately, the shares have continued their downtrend and, as of mid-November 2017, were trading at roughly $5.60 per share, leaving substantial paper losses for the two investors.

Joyce and Pattison are far from alone. The Canadian investment landscape is littered with smart money bets gone wrong.

Back in 2011, Sino-Forest was reeling from a short-seller’s fraud allegations. In stepped billionaire investor Richard Chandler from New Zealand, who bought 11% of the company but eventually lost it all when the stock became worthless.

In fall 2015, Valeant Pharmaceuticals started collapsing in value despite significant backing from Pershing Square Capital and Paulson & Co., headed by U.S. billionaires Bill Ackman and John Paulson, respectively.

Ackman initially made money on Valeant. At the height of his investment, he owned roughly 8% of the company but took a US$3-billion loss when he liquidated the investment in March 2017.

Paulson also invested in Valeant on its way up in 2015, and continued to buy more shares as the price collapsed throughout 2016. He hasn’t sold much of his stake, which sits near 6% of the company, but he’s facing billions in unrealized losses.

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Prem Watsa, Canadian billionaire and founder of Fairfax Financial, is known for making large investments in Canadian companies including BlackBerry and restaurateur Cara Operations, owner of Harvey’s and Swiss Chalet. Not all his deals go well.

Watsa and Fairfax owned roughly 19% of Canwest Global shares back in 2008. Canwest eventually filed for bankruptcy. Watsa has also been carrying a large investment in Torstar for many years (currently 40% of the B class shares, which have lost 90% of their value over the past six-and-a-half years).

The really smart money

And then there’s Warren Buffett, who does things differently when making marquee investments. Earlier in 2017, Buffett rescued Home Capital Group, buying 20% of the common shares at a 36% discount to market in exchange for providing a $2-billion liquidity lifeline. The shares rebounded 27% the day the deal was announced, providing an immediate 100% gain to Buffett. While the shares have come off those highs, he is still sitting on substantial profit.

The Home Capital investment terms were reminiscent of two large U.S. financial institutions he bailed out in the aftermath of the credit crisis. In 2008, Buffett invested US$5 billion in troubled investment banker Goldman Sachs. The deal was for preferred shares, with warrants to purchase 10% of the common shares at a strike price of US$115 (8% below the market price at the time). Goldman eventually redeemed the preferreds at a 13% premium, and Buffett bought 43.5 million common shares at a discount (Goldman shares closed at US$250.65 on Dec. 4). While Buffett has sold shares over the years to fund other acquisitions, he’s made about US$4 billion on the deal.

Buffett made a similar investment in Bank of America in 2011, purchasing preferreds with common share warrants attached. He exercised those warrants in June 2017 and is looking at a current gain of around US$12 billion on an initial outlay of US$5 billion.

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The common theme in these Buffett deals is providing major financial assistance to troubled companies, and instantly cashing in on the cachet of his investment prowess. Buffett’s rescue deals contrast significantly to those of other billionaires who simply make outsized bets without special terms or advantaged positions.

While advisors can’t invest on the same opportunistic terms as Buffett, they can avoid the investment fallacy of believing that a large investment by a billionaire means anything more than a small investment by a random stranger.