A good stock picker must resort to 'critical thinking'

Mar 28, 2018

This billionaire has always been very closely watched on Wall Street, though recently he has been garnering attention for the wrong reason. David Einhorn’s funds have run into rough weather leading him to recently confess that his hedge fund Greenlight Capital has never “underperformed like this”.

But don’t write him off. This is a man of convictions known for his prescient bets.

In 2007, he emerged as a thorn in the side of Lehman Brothers with his rabble-rousing rhetoric. He lambasted the investment banker on various media appearances and publicly announced that he shorted the stock. The CEO Dick Fuld complained to the Securities and Exchange Commission, or SEC, that his company was the victim of shorts because individuals like Einhorn were badmouthing the company’s accounting. He locked horns with CFO Erin Callan and in a private call in May 2008 asked her to explain discrepancies in the firm’s latest financial filing and valuations of its assets. Later that year Lehman declared bankruptcy.

And, his perseverance is awe-inspiring.

In 2006, he began researching Florida-based real estate developer St. Joe and shorted the stock. He was vindicated only in 2015 when the SEC charged the firm with improper accounting of its residential real estate developments and overstating its earnings and assets.

But his initial claim to fame was his tenacious short on Allied Capital way back in 2002. He accused the firm of improper use of fair value accounting, which inflated the stock price. Initially, the price actually climbed amidst an acrimonious battle fought publicly. But he stood vindicated in 2007, when the SEC investigated the firm and found it guilty of securities fraud. 

Einhorn is a value investor who approaches investing with a different bent. His views are well articulated during an interview with Value Investor Insight, a chat with the Oxford Union, and his book Fooling some of the people all of the time. The below has been taken from there and paraphrased.

  • On patience

Equities are long, if not indefinite-duration, assets. When he makes an investment, he usually does not have any idea how long he would be invested. If the downside of an opportunity is no short-term return or “dead money”, he is fine with it.

Sooner or later, the truth wins. If you know you are right, all you need is patience, persistence, and discipline to stay the course.

  • On the key to being a successful equity investor

Critical Thinking.

It's the ability to look at a situation and see it for what it is, which is not necessarily what is presented. When something makes sense, figure out what. When something doesn't make sense, question it, challenge it, look at it from a different way. In doing so, you may often come to the opposite conclusion.

  • On scouting for winners

The starting point is not: Is this cheap? Or, why is it cheap? Hence, his approach does not start with screens (Price-to-Sales / Prices-to-Earnings / Price-to-Book) which help identify stocks available at a bargain.

Einhorn sets the ball rolling by identifying a reason the stock could be mispriced, and then if he finds it, goes on to determine whether it’s cheap. He keeps an eye out for situations where a stock might be misunderstood or mispriced, and where investors have not accurately figured out what’s going on. Think spin-offs, post-bankruptcy, upheaval of a company or even an industry.

  • On analyzing a stock

The trick is to avoid losers, because it takes a success to offset them just to get back to even. His goal is to make money on each investment, or at least preserve capital. This means securities should be sufficiently mispriced, so that if he is right, the fund will do well. But if he is wrong, he will roughly break even. If he is massively wrong, he will lose money.

In all stocks, there are three basic questions to resolve:

1) What are the true economics of the business?

2) How do the economics compare to the reported earnings?

3) How are the interests of the decision makers aligned with the investors?

There are two types of bad outcomes. Sometimes, after analyzing the risk and reward, an investment appears attractive, but the unfortunate or unlikely happens. Other times, the analysis is simply flawed: The investment is poor and the eventual loss is inevitable.

He avoids “evolving hypotheses”. If his investment rationale proves false, he would rather exit the position than create a new justification to hold on. We exit when our analysis is wrong or we just can’t stand the pain, rather than when the market simply disagrees longer than we had imagined.

So why have his funds hit a turbulent run?

On January 16, 2018, Einhorn sent a quarterly letter to his investors stating that the net return (net of fees/expenses) of Greenlight Capital funds in 2017 was 1.6%. The corresponding figure for the S&P 500 index was 21.8%. His shorts on Caterpillar, Amazon, Netflix and Tesla (all performed excellently in the market) contributed to his poor performance.

In a missive to his investors last year, he sarcastically pondered if the market has adopted an alternative paradigm for calculating value: What if equity value has nothing to do with current or future profits and instead is derived from a company’s ability to be disruptive, to provide social change, or to advance new beneficial technologies, even when doing so results in current and future economic loss?

In another engagement, he noted that investors are beginning to believe that ownership of the company is something other than the risk adjusted future profits of the company. Maybe other factors such as social disruption, social desirability, or the charismatic value of the CEO, are contributing to the market’s mind of the equity value of the company. But, he warns, it is not different this time.

Have David Einhorn’s calls been wrong-headed? Maybe. But before you dismiss him, do remember that this unapologetic value investor has an amazing track record. Since its inception in May 1996, Greenlight Capital has returned 2,134% cumulatively or 15.4% annualized, both net of fees and expenses. It is not without reason that Wall Street listens when he speaks.

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