What Makes Something an Investment and Not Merely a Gamble?
In October 2013 I wrote a blog post in response to a New York Times interview with William Ackman, hedge fund manager. My purpose was to gently nudge myself and others to be critical consumers of the wisdom of hedge fund managers and of this one in particular. Ackman has been in the news again recently, and I am prompted to pursue a line of questioning that has been occupying my mind for some time: What exactly do we mean when we say we are investors, or when we say we’re making an investment? Do we all mean the same thing? The Ackman example seems tailor made for this inquiry.
On March 9, 2014, the New York Times featured a front-page article on Ackman and his efforts to ruin the company Herbalife. Among other things discussed in the October interview, Ackman was particularly proud of his $1 billion short sale of Herbalife stock due to his conviction that the company is a pyramid scheme that exploits its salesforce. Ackman has rallied individuals and organizations to expose what he considers shady dealings by the company, specifically, exploiting and manipulating people of color, primarily black and Latino, into joining a pyramid scheme that purports to provide good incomes and healthy products. He has paid for lobbying efforts with legislators and government entities including the SEC, and has recruited members of advocacy groups to participate in a letter-writing campaign urging regulatory action.
As of March 12, 2014, his campaign seems to have worked—the FTC has announced an investigation into the company’s practices, and, by the way, its share price declined 15% on the news. There are more than 500 comments on the New York Times website related to this article and undoubtedly thousands of other responses posted in cyberspace. Reactions range from nausea to bravo to so what. One person, referencing the fictional politician in the Netflix series House of Cards, quipped: “Frank Underwood would be proud.”
I was particularly amazed by one of Mr. Ackman’s comments in the most recent NYT article:
“Yet Mr. Ackman’s staff acknowledges that this crusade is really rooted in one goal: finding a way to undermine public confidence in Herbalife so that his $1 billion bet will produce an equally enormous return. Mr. Ackman has said he will donate any profits he personally earns to charity, calling it “blood money.” The clients who invest in his hedge fund, however, would still benefit enormously.”
Ackman claims a noble purpose—saving the world from the evil of Herbalife—and then he turns around and refers to any personal profits he might make as “blood money.” So which is it?
What about his clients? At what point, and by what logic, does Ackman’s “blood money” transform into respectable investment returns for his clients? Is this really an investment?
What a fascinating question! What makes something an investment? As I discussed in my recent newsletter, the term is so broadly used as to be almost meaningless, except that it possesses a certain aura of respectability and import. Ah, yes, an investment…..legitimate, admirable, and so on. But would you call Ackman’s strategy, and associated financial transactions, an investment?
Ackman sold shares of Herbalife’s stock even though he did not own the shares. He did this because he thought the price was too high and that it would (or should) decline. If he had owned the shares, he could have sold them and then repurchased them later when they reached a “fairer” price, but that doesn’t appear to be what he intended. There is no indication that Ackman ever planned to actually own shares of Herbalife. No, he simply wanted to profit from a decline in the share price in order to have more cash for himself and his investors.
The activity of selling shares you don’t own is called short selling. In order to make good on his sale, Ackman borrowed the shares from someone else and delivered them to the buyer or buyers to whom he sold. When he or others say he made a “billion dollar” bet on Herbalife’s stock price going down, he didn’t really commit one billion dollars in cash. He borrowed shares of the stock and then immediately sold the shares and got paid for the stock from the purchaser. Then he used the cash he got from the sale as collateral for the borrowed shares (which were still owed to the lender).
This is a very risky strategy. If the share price goes down, Ackman can “cover his short” by buying the stock, transferring it to the lender of shares, getting back the cash collateral, and realizing a big profit. However, if the share price rises, he will have to buy the stock at a price higher than he sold at (shorted). The cash he received when he made the short sale will not be enough to cover the purchase at the higher price, and he will have a loss.
The activity of selling shares you don’t own is common in the financial industry. It’s all handled electronically, so it’s relatively easy. Most of us, whether we know it or not, are complicit in this kind of betting. Brokerage firms such as Schwab and mutual funds such as Fidelity and Vanguard routinely lend the securities that are held in their custody. If you read the fine print, you will find language to this effect. Shares are loaned with cash as collateral; the lender can then invest the cash while the shares are on loan.
One example of a simple definition of the term “invest” is to commit capital to an endeavor with the expectation of future income. To whom did Ackman commit capital? From whom would future income be received? It seems clear that this was a bet, a gamble, a speculation. Question: does a high degree of risk in a regulated arena qualify something as an investment? Do we ever say we’re going to the casino to invest in a game of blackjack or roulette? What exactly is the difference between the short sale and the spin of the wheel or the deal of the cards?
Ackman and others would say the difference is that they are smarter and more sophisticated than gamblers. In the case of Ackman and Herbalife, there’s another significant difference. It turns out that money buys power and influence, so it’s possible to fix the game in a way that is not so easy in a casino. Still, the language and culture of Wall Street is rife with gambling references—betting, speculating, throwing money at, putting money on the table, etc. This language flows easily from the tongues and pens and keyboards of portfolio managers, researchers, politicians, economists, analysts, pundits, newscasters, and reporters. It is not uncommon to read or hear references to investors making “big bets”, as we have seen in the coverage of the Ackman story.
What, then, makes something an investment? I have found this question frustrating and exasperating while at the same time motivating me to look more deeply into the relationships, connections, and implications of my financial endeavors. I strive to pause and reflect on what it means to invest. I am clear that selling a stock short, bad mouthing the company, and buying influence does not for me constitute an investment. I am also clear that the simple definition cited above (committing capital with the expectation of income) is insufficient. At the moment, my personal working definition of investing is: a commitment of financial capital in expectation of a fair financial return in relation to my contribution, the efforts of others (particularly employees), and the extent to which the enterprise is operating within ecological limits.
For people who strive to express their personal visions and values in the way they work with money—AND for whom vision and values are more complex than short-term profit maximization, there is great value in defining for themselves what investing means. How do you personally define investing? What are you trying to accomplish? Where are the lines and gray areas?
I created an online survey to gather reflections on the language of finance and investing. If you feel these questions are important, please consider taking the survey or sharing your thoughts by email. I would love to hear from you!