I picked up a book, Fooling Some of the People All of the Time, by David Einhorn who is the founder of Greenlight Capital.
It is a story about how Greenlight Capital sold short Allied Capital’s shares, and about the multi-year fight among Allied Capital, Greenlight Capital, and the SEC. It is a case where the Government and the regulator sided with Allied Capital, to the point where Allied Capital engaged people to steal the phone records of Einhorn’s family and other critics of Allied Capital.
I have not yet gone though the book, but the first 4 chapters (42 pages) was interesting to me because it talked about how Greenlight Capital was started, and some of the thinking behind the strategies they employ.
- Einhorn’s father and grandfather ran Adelphi Paints in New Jersey.
- After selling the business in the early 1970s, his father opened his own M&A shop in the basement of his house in Demarest, New Jersey. They moved in 1976 to Fox Point, Milwaukee after a year of little success.
- His parents often discussed business at the dinner table. His father’s M&A business eventually became successful.
- Einhorn spent most of high school working on the debate team where he had great training in critical analysis, organisation, and logic.
- Majored in Government at Cornell University.
- Interned during junior year at the Office of Economic Analysis at the SEC in Washington.
- Started in August 1991 as an investment banking analyst at Donaldson, Lufkin & Jenrette (DLJ).
- After 2 years, got asked by a headhunter to interview at a hedge fund, Siegler, Collery & Company (SC), and got the job.
- He had a patient and dedicated mentor in Peter Collery. Einhorn would spend weeks research a company, reading the SEC filings, building spreadsheets, talking to management and analysts. He would then discuss the opportunity with Peter, who would come back with a detailed list of questions. He learnt how to analyse the economic value of companies and the alignment of interests betwen decision makers and investors. [There is this article here that wrote that Einhorn’s 9 analysts in Greenlight would spend weeks, if not months, researching on a company.]
- In early 1996, started Greenlight Capital with an SC colleague, Jeff Keswin.
Greenlight Capital’s Early Days
- Greenlight launched in May 1996 with $900,000 ($10,000 each from Einhorn and Keswin, $500,000 from Einhorn’s parents).
- Keswin was the marketer and business partner, and Einhorn is the portfolio manager.
- Rented a 130 sq ft space from Spear, Leeds & Kellogg, their custodian / prime broker, shared a photocopier with 5 other trading outfits. Wrote their investment brochure in Feb 1996.
- Initial investments include
- Long MDC Holdings – still own
- Long EMCOR – took until 2001 to work
- Long C. R. Anthony with 15% of the fund – went up 500% by end of 1996
- Long U.S. Trails’ bonds – bought at 77%, got called at 100% in 1 month
- Long Tylan General – semiconductor capital equipment manufacturer which got sold at a premium
- Short Microwarehouse – announced terrible results due to systems problems and the stock collapsed
- Almost bought claims in bankrupt retailer Best Products, could have doubled overnight because of an acquisition by Service Merchandise.
- 1996: Returned 37.1% without a down month, and AUM hit $13M. More than 25 clients.
- 1997: Returned 57.9% with AUM of $75M. More than 50 clients.
- 1998: Returned 10% with AUM of $165M. Lost money for 5 months from May to Sep 1998 due to the Russian default, Long-Term Capital Management failure, and Asian economic crisis.
- 1999: Returned 39.7% with AUM of $250M.
- 2000: Returned 13.6% with AUM of $440M.
- 2001: Returned 31.6% with AUM of $825M.
- 2002: Up 12.9% by end April.
Investment Approach at Siegler, Collery & Company
- Peter Collery combs through SEC filings and spots signs of good/poor corporate behaviour, and aggressive/conservative accounting.
- Three basic questions to resolve
- What are the true economics of the business?
- How do the economics compare to the reported earnings?
- How are the interests of the decision makers aligned with the investors?
- Largest investments were ‘pair trades’. It matches two companies in the same industry trading at widely disparate valuations. SC would buy the cheaper one and sell short the more expensive one. In the best case, the long had better prospects or more conservative accounting than the short. The pair trade eliminates both market risk and industry risk and captures the valuation convergence over time.
- Bias towards purchasing more if a stock dropped, even if it required coming up with a new rationale for the position. [This is similar to Bill Miller at Legg Mason. While it is true that the further a stock drops, the greater chance of it rebounding (assuming it is not going to oblivion), it would mean that “new cash” could be thrown into a position simply to make that position work out. I think the right way is to consider in which investment would the “new cash” make the highest potential return at low risk rather than used for the sake of averaging down.]
Investment Approach at Greenlight Capital
- What They Do
- Start by asking why a security is likely to be misvalued in the market (e.g. spin-offs, demutualizations, aggressive accounting by franchise owners). Once they have theory, analyse the security to determine if it is, in fact, cheap or overvalued.
- Need to understand why the opportunity exists and need to believe that they have a sizable analytical edge over the person on the other side of the trade.
- When an investment is made, they usually do not have an idea of how long they will be invested.
- Strive to avoid losers and preserve capital.
- What They Don’t Do
- Generally does not do pair trades. On a scale of 1 (perfect long idea) to 10 (perfect short idea), pair trades typically will have 3s and 4s paired with 6s and 7. Greenlight would rather accept industry risk but have their longs being 1s and 2s, and their shorts being 9s and 10s. Pair trades would also mean that capital is spent on negative-expected-return propositions (e.g. one position in a pair is to hedge and not for positive expected returns in and of itself).
- Do not hedge with indexes. An index hedge has a negative expected value because the market rises over time and the short pays only in a falling market. Selling short individual names offers two ways to win — either the market declines or the company-specific analysis proves correct.
- Do not deploy new capital into existing positions (esp. when a position has already progressed gradually from its inception) unless they are either fresh ideas or positions where they originally already wanted to add.
- Have more long exposure than short exposure. Their shorts tend to have greater market sensitivity and volatility than their longs. Markets tend to also rise over time.
- If their investment rationale proves false, they exit the position rather than create a new justification to hold.
- Portfolio Allocation / Position Sizing
- Runs a concentrated portfolio. Greenblatt highlighted that holding 6-8 stocks in different industries reduces most of the risk.
- Up to 20% in a single long idea.
- 30% to 60% in their 5 largest longs.
- Shorts are half as large as longs of the same quality
- Gives them the ability to ensure initial losses and maintain or even increase the investment.
- When shorts move against them, they become a bigger portion of the portfolio.
- In most successful shorts, they lose money gradually for a period of time until they suddenly make a large gain (often in a single day).
- On the dot-com boom
- Technology companies that are not losing money, are trading at book value, and have a viable product, are good investments.
- During the dot-com boom, they short companies with high valuations + misunderstood fundamentals + deteriorating prospects or fraud case, they do not short a company just because it is over valued.
- The Internet bubble made its ultimate top the day the last short-seller could no longer afford to hold his position and was forced to cover. Market extremes occur when it becomes too expensive in the short-term to hold for the long-term.
- 1997: Short Boston Chicken because it recognised up-front revenue and profit when franchisees opened restaurants. Thesis was that franchisees were not profitable to pay the parent.
- 1997: Short Samsonite at $28, before it went to $45 and dropped to $6. It had raised prices and opened many of its own stores. Consumers did not accept the price increase and competition with its wholesale retailers resulted in excess inventory and price markdowns.
- Short Sirrom Capital, a Business Development Company (BDC) that made mezzanine loans to private companies. It grew its earnings and dividends by stock offering at higher and higher stock prices. Good portfolio-level statistics was hiding the fact that 40% of the loans went bad. Management did not write down loans to their ‘fair value’ at one shot, instead it gradually wrote down the loans when it was inevitable.
- Bought Summit Holdings Southeast (SHSE), a Florida workers’ compensation specialist. Conservative accounting as a mutual, management team had large stock and option grants, risk was reduced through reinsurance at very favourable rates. Invested 15% of capital at $14 per share in May 1997. Bought out by Liberty Mutual for $33 per share in cash in June 1998.
- Short Century Business Services (CBIZ). Serial acquirer that boosted its EPS through accretive M&A, bad accounting practices.
- Short Seitel in 1999 which had fraudulent accounting. It capitalised operating costs and assumed revenue that didn’t materialise. It went down, then recovered in 2000, then went bankrupt in Spring 2002.
- 1999: Bought Reckson Associates in early 1999 at $5 which had a free option in OnSite. It then changed its name to Frontline Capital, hired someone from GE, changed its strategy to be an incubator of Internet companies. Stock price went to $60 by year end.
- 2000: Bought Triad Hospitals (spin-off from Columbia/HCA) and MDC which both doubled.
- 2000: Short CompuCredit where rapid asset growth masked losses in its reported results. Looked at losses on a ‘lagged’ basis meaning that the loss in one period should be attributed to loans from a particular period before (e.g. 1-3 periods before). The stock doubled after the company held an analyst day then went down due to poor results.
- 2001: Did a ‘capital structure arbitrage’ on Conseco, where bonds were trading at 65 cents on the dollar while equity was doing well. Greenlight purchased the bonds and sold short the common stock. Conseco hired Gary Wendt from GE Capital who had a great record. Through meetings, management avoided questions on unclear accounting. Greenlight sold their bonds (the bond market was correct!) and shorted more stock. Stock kept going up until the shares imploded and the company went bankrupt.
- 2001: Short Orthodontic Centers of America (OCA) which recognised revenue in the first month of a multiyear treatment. The stock dropped and later recovered after changing its accounting, but the business was bad and it went bankrupt.
- 1999: Short Elan (Irish specialty pharmaceutical company) because it set up a biotech company where funds were flowing round and round between the two while both clocked revenue + other accounting anomalies. SEC reviewed the company and passed it. Stock went to $65 in June 2001. Brokerage analysts did not care since Elan kept beating estimates. WSJ in Jan 2002 ran a story questioning Elan’s accounting and the stock crashed to $1 in Oct 2002 (this was just after Enron).
- Large holder in New Century Financial, a subprime mortgage originator which imploded in early 2007. Einhorn was a director.
- In 1998, closed out of their short position in Computer Learning Centers (CLCX) too early, lost 2.5% of their capital. CLCX took advantage of generous government student loans to teach obsolete technology to uneducated people. It had a poor product and engaged in misconduct. The stock dropped when the Government initiated a review, it survived the review and the stock doubled, subsequent business didn’t do well which killed the stock.
- Short Chemdex because it was literally paying customers to use its service. Used 0.5% of capital, shorted at $26 in September 1999. A strategic alliance with IBM caused shares to double in November. Einhorn doubled his position at $71. Mary Meeker gave a outperform rating in December and the stock went up 50%. Company changed its name to Ventro. Einhorn covered the short at $164 in Feb 2000, losing 4% of capital. Stock went to $243 three days later. The stock went to $2 by end 2000.
- 2000: Short 1-800 Contacts which sold mail-order contact lenses without verifying prescriptions as required. FDA investigated but didn’t act. Greenlight covered at a large loss and subsequently J&J fearing legal consequences stopped its supply and the shares collapsed.