The Perils of Following Hedge Fund Manager Advice

11/11/2015 6:00 am EST

Focus: STOCKS

Bob Lang

Founder and Chief Analyst, Explosive Options

Citing a few recent examples of hedge fund manager advice for support, Bob Lang, of ExplosiveOptions.net, stresses the importance of a trader doing his own homework first before turning to activists to see if they happen to support his position or thesis.

We are all looking for an edge when investing or trading, one little nugget of information that will, over time, transform our stake into an overflowing pot of gold.

One common strategy is to follow the big money and hedge fund manager advice. When a hedge fund manager takes a position (either short or long), many traders decide to ride his/her coattails, especially because he/she has been so generous in letting us know what they’re doing. After all, hedge fund managers are much smarter than us and must have special access to information, ensuring they get it right all the time, right?

Not necessarily. Some may have special information, but some of the most successful hedge fund managers are winners for many other reasons. While it is true that they have made vast amounts of money (for themselves and their clients), there are perils to following them. Recent examples of failure show us why it is better to do our own due diligence.

The latest hedge fund manager to take his place in the hot seat is the well-known Pershing Square Management’s Bill Ackman. A known activist, Ackman has been successful over the years presenting his case for or against some companies and investors have followed him into some nice wins. Should we expect big wins each time Ackman is vocal? After all, an activist shareholder is looking out for the little guy.

Many are well aware of his disdain for Herbalife (HLF) and its management team. Ackman has frequently called Herbalife a Ponzi scheme and he has been short the stock for years. That position is currently suffering a substantial loss.

Valeant Pharmaceuticals (VRX), on the other hand, has caught his eye...in a good way. Ackman seems to have put his money where his mouth is. He hasn’t missed an opportunity to extol the virtues of the company or trumpet it as a worthwhile investment.

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The stock peaked in August at a little over $260, up well over 80% for the year. Then some negative news hit the company and the stock has been in free fall, losing all of its gains and then some. As of the November 6 close, Valeant was at $81, losing more than 70% of its value in just two short months. Apparently, Ackman has doubled down on his bet believing the troubles are going to disappear. Yet, if you followed him into the stock, you are sitting on a loss, probably a big one. What do you do now?

Some activists like Carl Icahn, Nelson Peltz, Jim Chanos, and Dan Loeb, provide real value. They often do not trust management and provide a loud voice for the small investor. But we have to be careful. For every Netflix (NFLX) or Apple (AAPL) suggested by Icahn (both stellar), there is a Transocean (RIG) (awful). Likewise, Ackman has had far more wins than losses over his career and has extracted value for investors, but just blindly following him—or any other investor—could lead to a disastrous outcome (like Valeant).

Want to place winning bets? Do your own homework first before turning to activists to see if they happen to support your position or thesis. Remember: hedge fund manager advice is secondary to your own due diligence.

By Bob Lang of ExplosiveOptions.net

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