There’s no such thing as the perfect investor. No one exists who knows with absolute certainty which companies are good, which are bad, and when to buy or sell them. Perfection may not be possible, but we attempt to get as close as possible by never resting on our laurels and studying different investment styles to get a better idea of what works and what doesn’t.

There are names on Wall Street who can be associated with a specific investment philosophy. Warren Buffet is a legendary value investor while George Soros is known as a leveraged short-term speculator. There are countless others who have their own unique investment style and can teach us something about how to better our own trading strategies.

Some investors have a style that seems to fly in the face of everything we know about diversification and risk management but still manage to post steady returns year after year. Such is the methodology of activist investor Bill Ackman.

His style of investing in just a few large, well-known companies has netted him impressive returns and given him the reputation of being one of the most accurate investors in the market. His hedge fund, Pershing Square Capital Management, has posted gains of 1,199% since 2004 compared to the S&P 500’s 119% over the same time period.

Analyzing Ackman

Ackman’s approach focuses on 5 major themes that allow him to take advantage of opportunities and walk away with over-sized returns. Some of them are similar to strategies espoused by many investors, while others contradict standard Modern Portfolio Theory and mainstream investment philosophies. While each criterion has its own weakness, it also has a strength that when used together, can form an unflappable portfolio in the face of any economic situation.

Large Cap, Blue Chip Stocks

It’s easy to see the appeal of large cap, blue chip companies. They’re brand name institutions with quality products and services that have sound financial statements and the strength to withstand economic downturns. Keeping a portfolio of these types of companies takes out of the equation a lot of the risk with small cap and speculative stocks, making it easier to manage.

One of the stocks Ackman has an interest in right now is Allergan (NYSE:AGN ). He’s been aggressively building a large position in the stock and he’s been very successful so far. Year-to-date the stock is up over 65%. He hasn’t always been so fortunate though. In 2009 Ackman lost $1.8 billion in Target (NYSE:TGT ) proving that just because a company is large and well-known, it doesn’t make it a winner.

Picking only blue chip stocks can come with disadvantages though. Large, well-established companies often find growth more difficult to come by and may not offer the same kind of explosive growth found in smaller companies that have the flexibility to invest and profit in a variety of opportunities. In order for a company worth $100 billion to grow 10%, they would have to come up with $10 billion in new investments or acquisitions. A smaller competitor worth $2 billion would only need to find $200 million to achieve the same rate of growth.

Concentrated Portfolio

Take a look at Ackman’s portfolio and you’ll find a sparse selection of stocks. According to his latest 13F filing, he only owns 6 stocks: 39% in Allergan (AGN ), 21% in Air Products and Chemicals (NYSE:APD ), 20% in Canadian Pacific Rail (NYSE:CP ), 8% in Burger King Worldwide (BKW), 7% in Platform Specialty Products (NYSE:PAH ), and 4% in The Howard Hughes Corp. (NYSE:HHC ).

Diversification is one of the most repeated investment adages you’ll hear and for good reason. Modern Portfolio Theory, which advocates diversifying your investments, was established after extensive research and back-testing in order to show how a diversified portfolio compared to a non-diversified portfolio would perform with the clear winner going to diversification.

The tech bubble in the early 2000’s taught a powerful lesson to investors who didn’t diversify. The same thing was repeated during the mortgage crisis in 2008. A non-diversified portfolio is subject to magnitudes of more risk than a diversified one. If you wanted to see a quick example of how diversification can be a benefit, just take a look at how each stock market sector has performed so far this year. If you happened to hold a majority of your investments in real estate, you’d be up almost 13%, but if you held a large number of cyclical stocks, you’d only be up a quarter of a percent year-to-date. It would be great if you could always pick the winning sector every year, but even most market professionals fail to do that.

There’s a strong case for diversifying, so what’s the case against it?

Warren Buffet famously said that diversification was just protection against ignorance. In other words, if you have exceptional research skills and perform due diligence, you might not need to diversify. You may eliminate the need for diversification by doing your homework and having confidence in your investments, at least in theory, at least in theory.

Even the most rigorous investor can be surprised by missed earnings or corporate mismanagement. Keep in mind all of the scandal-ridden companies that took everyone by surprise like Enron and WorldCom.

Have A Catalyst

It may be obvious, but many investors fail to realize that true growth happens for a reason. A stock with a great balance sheet, positive cash flow, low debt levels and cheap valuation might not be considered a good buy even though it looks good on paper. You have to ask, what is the catalyst that is going to allow a company to grow and outperform its competitors?

A catalyst may be as visible as a stock reporting higher than expected earnings or as subtle as a change in the foreign policy of another country where a specific company does business. The catalyst is generally an event that finally calls attention to the intrinsic value of an undervalued stock, but it can sometimes be something temporary. An unexpected event such as negative press can knock down stock prices even though the company’s fundamentals may not have changed. That could be a good time to buy the stock while the price is low.

Ackman’s method is to buy a company that has a catalyst in the works. He makes sure that there’s a reason he bought a stock beyond the numbers. His position in Herbalife has been sensationalized in the media of late butting heads with another famed investor, Carl Icahn. Ackman’s hedge fund has a large short position in the stock despite the long positions of others like Icahn and Soros. Ackman believes that Herbalife’s multi-level marketing business model is essentially worthless and the stock should be worth nothing. His catalyst is the underlying fundamentals of the stock that you don’t see on paper and something he thinks will be realized later on down the road.

Low Leverage

Companies need funds in order to make capital investments, produce goods, and operate on a day-to-day basis. Most use a combination of both equity and debt financing to accomplish this and the ratio of debt to equity financing is called leverage. A large amount of debt financing means that a company must pay more interest payments which can hurt earnings and limit its opportunities for growth.

Companies with little to no leverage are the only one’s Bill Ackman will consider for his portfolio. He likes to stick with companies that aren’t economically sensitive and won’t be subject to cash flow problems due to large debt loads.

While Ackman prefers companies with low financial leverage, it doesn’t mean that all leverage is bad. Some sectors like utilities liberally fund operating activities by issuing debt while small, fast-growing companies will often use debt to quickly finance investments and purchase equipment. For example, an up-and-coming software company is probably not going to have much, if any, cash on hand to invest in itself so it issues debt to finance growth. If management expects an investment to return 20% annually, then taking on debt with an interest rate of 7% wouldn’t be a bad decision.

Leverage is all about risk. Ackman prefers to invest in low risk companies, but it doesn’t make highly leveraged companies bad. Due diligence is essential regardless of the corporate structure used in a stock.

Activist Investor

Perhaps Ackman’s most famous attribute is his activism. From Herbalife to Allergan, he is known for putting pressure on management to affect changes that he feels will increase shareholder value. He accomplishes this by buying a minority stake in a company, not enough to make him the majority shareholder, but enough of it to influence decisions and campaign for whatever he thinks will be a positive benefit.

The idea of a corporate raider has changed somewhat from the rebellious shareholder who swoops in and forces unwanted changes onto management. Activist shareholders are put in a more positive light because they focus on increasing value for all stock holders. However, even good intentions don’t always translate to gains.

In 2005, Ackman held a stake in Wendy’s International and encouraged management to divest itself of the doughnut chain, Tim Hortons. While the spin-off successfully raised money for Wendy’s shareholders and Ackman profited, the stock soon fell with many blaming Ackman for eliminating the fastest growing segment of Wendy’s International and cutting its growth rate.

While everyday investors can’t exactly mimic Ackman’s activism, you can look for companies that aren’t heavily controlled by a single shareholder or by another company. Voting shares that are owned by a majority of one or a different company may not have the best interests of all shareholders in mind. Like Ackman, you can look for a diverse shareholder group where voices are heard and changes come more easily.

Final Takeaway

Ackman’s investment philosophy may have some elements that are considered outside of the norm, but they aren’t arbitrary. When he combines a few large cap stocks with low leverage and a positive catalyst, he can look for big picture items to unlock hidden value like spinning off business segments or starting a stock redemption program. His style of heavy involvement means that he has to keep his portfolio limited to just a few names in order to establish a large enough position to be heard. He can’t afford to spread out his investments too far or he loses the ability to concentrate his efforts on just a few companies. It would be unrealistic to try to affect change on a large scale in a portfolio of 15 or more stocks.

You may not be able to be an activist like Ackman, but his strategies have merit nonetheless. While it’s hard to reinforce the idea of not diversifying, it is a good idea to be confident in your choices and have a reason to own them. Don’t just buy a stock and forget about it. Know what the reason was, whether you believed earnings would be an upside surprise, the stock was oversold on negative press, or the company had a new product release. A business is a dynamic operation that thrives on growth and opportunity.

While investing in a highly leveraged company comes with its own risks, you shouldn’t dismiss it out of hand. Many companies rely on debt financing, especially smaller ones that have high growth expectations. If you’re more risk-conscious, then stocks with low debt leverage may be a better route. The higher the debt, the more interest payments will eat into earnings. Steer clear of large corporations that are highly levered or companies that show a history of increased leverage. It could be a red flag that management is making poor investment decisions.

Ackman’s approach might not work for the average investor, but some of his points hold true no matter what your personal philosophy is. Don’t be afraid to take advantage of opportunities when they present themselves and know what you own and why you bought it.

This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions in the companies mentioned through stocks, options or other securities.