Did this Legendary Hedge Fund Manager Make a Big Mistake? His Loss Can Be Your Gain…

We often talk about the prowess of the big-time money managers on Wall Street, but we often neglect to talk about their mistakes. After all, if it’s worth learning from the successes of these guys so that we can profit like they do, then surely it’s worth learning from their mistakes to avoid losing our shirts.

Consider the case of  legendary hedge-fund manager Bill Ackman, who started dumping shares of a stock in early 2011. He had been extremely bullish on the company since 2009, with a near 10% ownership stake. Soon, Ackman’s fund, Pershing Square Capital, had dumped its entire holding of 8 million shares on the open market

Did the shares plunge, as could be expected? Well, they certainly fell during his selling but never dipped below $18 a share, signalling the raw strength of the company.

The trade was profitable for Ackman, although the stock lagged the benchmark S&P 500, perhaps the reason for his selling. Subsequently, shares have rocketed to a high of $32 a share prior to pulling back.

So was Ackman wrong?

Ackman was very correct with his original call on this stock but made a mistake selling when he did. His mistake created a great buying opportunity for savvy investors. This same opportunity is setting up now.

Imagine a company with guaranteed customers, an average 5% overall market growth rate a year and major hedge fund ownership. Now, add in the bonus of operating within a government-sanctioned, localized monopoly and a very compelling investment picture begins to emerge.

Unlike Facebook and other Internet businesses, this business is nothing new. In fact, it has been part of civilized society for thousands of years. One could safely say it is one of the world’s oldest industries. Not only is it a time-tested concept, it relies on man’s primal nature for its success. Believe it or not, this business thrives on the decay of society. In other words, the worse things get, the better it is for this business. For centuries, this business was the domain of governments. But there was so much demand for the services offered that many of the government operations are overcrowded.

At the Federal level, the latest statistics indicate this industry runs at 140% of capacity. Presently, the state level is operated at a 98% capacity rate. Talk about demand build up! The industry remains 92% government-owned and operated, leaving plenty of upside for the few private businesses within the sector.

If you haven’t guessed it, I am talking about the prison industry — and Correction Corp. of America (NYSE: CXW), specifically.

Correction Corp. of America is the largest private prison company in the United States, with nearly 50% of the market. It also holds the title of fifth largest prison manager. What I find very compelling is out of the 11 major institutional stock holders, only three have decreased their shares recently. Out of the remaining eight, five have ramped up their holdings, two are new buyers and only one remains at the same level.

A REIT conversion on the way?
In addition, recent chatter from hedge funds Corvex Management and Marcato Capital Management indicates that management at Correction Corp. is exploring turning part of the company into a REIT (real estate investment trust), which has added an extra layer of intrigue. Basically, they want to split the company into a REIT and an operating unit. (Corvex and Marcato together own a 7.04% stake in the prison owner/operator.) In fact, this idea has been taken out of the rumor stage with an official SEC filing.

The funds argue that a REIT conversion would result in significantly lower cost of equity capital, additional growth prospects and better trading multiples. The company will not comment on this possibility, but it isn’t exactly new territory. Believe it or not, in 2000, Prison Realty, Correction Corp.’s original name, changed its REIT status and merged back with Corrections Corp. of America. In 1997, Prison Realty was divided from Corrections Corp. to become a REIT. This move was timed to take advantage of the hot REIT market. As luck would have it, the REIT market collapsed the following year.

So what are benefits of converting back into a REIT? Well, there are tax benefits, and the metric for measuring profits is different than a standard public company. REITs are exempt from most corporate taxes as long as they pay out at least 90% of their taxable income as dividends. This could be music to your ears if you like a nice dividend. The profit metric will change from earnings per share (EPS) to funds from operations (FFO). This change will make the profit level significantly higher than it is currently. 

There are risks, however, should the change take place. The conversion may result in Correction Corp. being forced to renegotiate some of its contracts and potentially lose clients. Is this just a smoke and mirror hedge fund play in an attempt to ramp up the share price so it can be quickly dumped at a profit, or is it a legitimate change that will benefit long term shareholders? Truthfully, I don’t know for sure. There are compelling arguments on both sides of the fence. Time will be the final arbiter of the change, should it occur.

Shares are setting up for a buying opportunity right now. The price has recently broken through the 50-day simple moving average, but remains nicely above the 200-day simple moving average. Shares have just dipped into my trademarked value zone region, creating solid odds for a bounce higher.

Risks to Consider: Although Correction Corp. of America is built on a solid business model, has good fundamental metrics and the odds favor a buy now, the potential REIT conversion could throw a monkey wrench into the opportunity. In addition, like any stock, no matter how good it looks, there are always unknowns that we simply are not privy to. With this said, position size accordingly and always use stops, mine would be outside of the lower value zone line.

Action to Take–> This stock is a buy now. I would average into the position as shares fluctuate in the value zone. It would not surprise me to see new highs by the end of January 2013.