Bill Ackman's Pershing Square Annual Report

The benefits of Bill Ackman's strategy are relatively clear. But to address the opposite, the downsides, a few of my criticisms are how shortsighted – meaning short-term – and market-obsessed this approach is. I have explained some of these criticisms before, and the charts included in the presentation show how Pershing is essentially pursuing a classic trading strategy, as opposed to a value investing strategy of intense patience and being unconcerned with whether the stock exchange is open or closed. Mr. Ackman and Mr. Market appear to take each other very seriously. And this approach works – just look at George Soros or Steven A. Cohen or whichever successful trading operation. But it probably isn't replicable by individual investors, even if they're attempting to buy the same securities. One example is Borders Group, where Pershing intervened in a potential liquidity crisis and became a creditor, obtained valuable warrants, as well as an agreement to potentially buy Borders' high-quality Paperchase business at an undervalued price. This delivered substantial value to Pershing at the expense of common shareholders. (Why would shareholders benefit from selling Paperchase to Pershing for half price? Would Warren Buffett make this move?) That said, Ackman makes it clear that Borders is exactly as I noted – a very cheap call option – and also makes clear that a mere 1% of his portfolio is at risk. Yet, another distinction between Pershing and common shareholders is that the former began accumulating Borders shares at above $20 each, whereas the latter can now accumulate them for about 50 cents. I strongly believe that shareholders are best served by owner-operators, who make disciplined decisions – often unpopular decisions, when short-term fixes are available – to deliver excess returns over the long term, and to build great businesses.

Taking Stock in H&R Block

Today's Bloomberg News reported an interesting fact about H&R Block, the country's largest tax preparer. H&R Block's chief executive, Russell Smyth, expects to have over $1 billion in cash by April, driven by consumers' desire to maximize tax refunds in a deteriorating economy. This is a marked turnaround from a year ago, when H&R Block took $1 billion in losses from a subprime mortgage unit, which was subsequently acquired by the financier Wilbur L. Ross.

H&R Block piqued my interest when I saw their services being prominently advertised in a Sears store, which I mentioned in this recent article. The company is very impressive, primarily for its first-class economics. As CEO Russell Smyth said, "We are in a cash business and we’ll have a lot of it at the end of this fiscal year. That’s a tremendous competitive advantage because we’ll be able to make great strategic choices about what to do with that money."

In fact, Warren Buffett was the second-largest shareholder in H&R Block beginning in late 2000 and early 2001, riding a handsome run-up in the stock price. Buffett sold his stake in 2007, probably due to H&R Block's diversification away from its core business, as well as its exposure to subprime.


But what did Buffett initially see in the company?

First, H&R Block fits the classic Buffett mold: founded by visionary entrepreneurs Henry and Richard Bloch, the family remains active in the business unto this day.

Second, the fact that H&R Block is a tremendously profitable "cash business," as its current CEO kindly reminded us. H&R Block's five-year average ROE is nearly 25%, with very little capital reinvestment needs. In other words, the company consistently generates impressive free cash flow, from a business that is both fundamental and predictable.

Third, relative to its size, H&R Block has no major competitors. It is a consumer monopoly, another Buffett hallmark. The closest competition appears to be Jackson Hewitt, with a market capitalization of $400 million, relative to H&R Block's towering $7 billion size.

As a measure of H&R Block's dominance, it generates roughly $700 million in EBIT off a roughly $990 million equity base. By contrast, Jackson Hewitt generates a mere $66 million in EBIT, off a $236 million equity base. In other words, H&R Block operates using about four times the equity of Jackson Hewitt, yet H&R Block reaps over ten times the pretax profit!

There is no doubt that H&R Block is a unique and impressive business. And with shedding its mortgage division and refocusing on core lines of business, H&R Block could represent an attractive candidate for acquisition.