“… an investment approach that emphasizes intrinsic value will achieve consistent absolute returns and safeguard capital regardless of market conditions.” -David Einhorn
Most of us know David Einhorn (Trades, Portfolio) from his controversial short positions. In the early 2000s, it was his battle with Allied Capital, and in 2008 he profitably and famously shorted Lehman Brothers.
But beyond the controversies, Einhorn also has a unique approach to value investing. In addition to fundamental research, he dips into technical analysis, psychology (particularly of crowds) and liquidity analysis.
The latter form of analysis, liquidity, opens another door to understanding and profiting from the relationship between money flows and the size of an asset class.
Who is Einhorn?
Born in New Jersey in 1968, Einhorn graduated from Cornell University in 1991 with a Bachelor of Arts in government. After graduating, he took a job as an analyst at Donaldson, Lufkin & Jenrette. That was followed by a stint at hedge fund Siegler, Collery & Co., where he learned investment research.
In 1996, Einhorn started Greenlight Capital with a colleague from Siegler, Collery & Co., Jeff Keswin; they described it as a "long-short value oriented hedge fund."
Since 2002, he has taken numerous controversial positions, starting with a recommendation to short Allied Capital.The matter was resolved six years later, with the U.S. Securities and Exchange Commission ruling Allied violated securities laws on accounting and valuation of illiquid securities. After the battle with Allied, Einhorn wrote a book, "Fooling Some of the People All of the Time," which details his fight with the company.
Later battles involved Lehman Brothers (which made him famous), Green Mountain Coffee Roasters (GMCR), Punch Taverns (LSE:PUB), Pioneer Natural Resources (PXD), Concho Resources (CXO), Microsoft (MSFT, Financial), Apple (AAPL, Financial) and General Motors (GM, Financial).
The Punch Taverns issue did not end well for Einhorn, with the U.K.'s Financial Services Authority ruling he and his company had participated in insider trading. He called the fine of 7.2 million pounds "unjust" and "inconsistent with the law," but opted to pay the fine rather than continue fighting it or the decision.
In short, Einhorn is a colorful man who has taken controversial positions but also managed to keep his firm going past the two decades mark. His short successes have helped build his public profile.
What is Greenlight?
Greenlight Capital Inc. describes itself, in its Form ADV Part 2A, as an investment management firm that is value-oriented. It invests primarily in long and short stocks, as well as distressed debt that is the right cyclical phase.
While shorting stocks can be highly profitable, it is generally a high-risk strategy. Investopedia lists these potential expenses and risks:
- Margin interest.
- Stock borrowing costs.
- Dividend payments (the short seller must pay them to the lender).
- Risk of short squeezes.
- Risk of buy-ins.
- Regulatory changes, including occasional outright bans on short sales.
- Swimming upstream, against the market's long-term propensity to go up.
- Skewed payoff ratios: maximum gains are limited but maximum losses are theoretically infinite.
According to its Form ADV, filed at the end of the first quarter of this year, the assets managed are for a wide array of clients, including individuals, high-net-worth individuals, banks, investment companies, pension and profit sharing plans, charitable organizations, corporations and other businesses, state or municipal governments and insurance companies.
At the end of the first quarter, Greenlight was managing $8,676,280,334 on behalf of those clients.
Einhorn stands apart from many value gurus by the amount of attention he focuses on weak companies by shorting their shares. His professional profile resembles that of Bill Ackman (Trades, Portfolio) of Pershing Square Capital Management.
What is Einhorn’s investment philosophy?
As noted above, Greenlight invests in both long and short stock trades. In addition, he reports in the Form ADV Part 2AÂ the firm also buys distressed debt, if cyclically appropriate.
Einhorn also states that, on behalf of their Capital Funds, they try to maximize the capital of investors by buying securities trading "materially lower" than their intrinsic values, and they try to sell short securities that are trading "materially higher" than their intrinsic values. Within that context, they seek to earn high absolute rates of return while minimizing the potential of capital losses.
To try to achieve that result, they do fundamental analysis combined with "rigorous" scrutiny of financial statements. Einhorn says they believe capital markets are efficient over the long term. They can also be inefficient over the short term in some circumstances, however.
Investors who want to outperform a market, therefore, need to recognize temporary inefficiencies and capitalize on these value dislocations in a timely way. The factors that influence a security’s trading value are:
- Fundamentals: Refers to intrinsic value, which he defines as the present value of the cash flows to be received by the owners. Against the valuation from cash flows, Einhorn subtracts the time value of money, the risk the cash flows will not be delivered, the volatility of the cash flows and the liquidity of the security.
- Technicals: Refers to historical trading patterns and prices. For example, momentum investments involve the acquisition of securities that have gone up in price recently with the expectation the price will continue to rise; the momentum will continue.
- Psychology: Refers to the propensity of investors to make decisions based on the emotions of greed and fear. When large numbers of investors—groups—make emotional decisions together, there can be excessive movement in security prices.
- Liquidity: Refers to the volume of capital going into an asset class in relation to the size of the asset class. If the intrinsic value of an asset class remains unchanged, then the law of supply and demand means prices will go up when new capital enters the asset class and prices go down when capital leaves the asset class. As an example, Einhorn cites a situation in which investors add liquidity by buying mutual funds, forcing fund managers to buy securities regardless of how expensive or inexpensive they are at that time.
He says trading values over the long term are determined by fundamental analysis—intrinsic value. But in the short term, values are influenced by technical, psychological and liquidity factors, creating value dislocations. And, of course, dislocations created opportunities for the "alert, diligent and patient investor" who stays focused on intrinsic value.
Dislocations, Einhorn says, can be seen in two forms: First, the market temporarily focuses on something other than intrinsic value. Second, the market miscalculates intrinsic value because of a lack of effort or ability. In both cases, shrewd investors will buy on dislocation and sell when the market gets back to intrinsic value. He sums it up by saying, “... an investment approach that emphasizes intrinsic value will achieve consistent absolute returns and safeguard capital regardless of market conditions.”
When it comes to their methodology, Einhorn and his team look at investment as a four-step process:
- Opportunity identification: Gathering and analyzing information from multiple sources to generate ideas. In particular, it develops relationships with individuals such as investment bankers, lawyers, independent researchers, brokers, sell-side analysts, other fund managers and corporate managers.
- Opportunity analysis: In this stage, the team narrows down the opportunity universe, which often involves thorough financial analysis to identify dislocation (the difference between market value and intrinsic value). To identify systemic inefficiencies, they look to spinoffs and companies making significant structural or organizational changes.
- Investment strategy: Before they commit their capital, they thoroughly evaluate all available investment tools. Their portfolio is built bottom up by evaluating each company on its own merit. On the issue of portfolio strategy, they assess all four of the following: concentration of investments, liquidity, constant reassessment of intrinsic and trading value and leverage.
- Investment Execution: Across the firm, they have numerous experienced professionals and have good relationships with agents and principals who know the markets.
Despite all the emphasis on stocks, Einhorn is something of a gold bug, and it makes up a significant portion of his firm’s portfolio and his personal holdings. That puts him at odds with another prominent value investor: Warren Buffett (Trades, Portfolio). The "Oracle of Omaha," as reported by Investopedia, argues gold has few practical or industrial uses, so therefore it can have little intrinsic value. Einhorn responds by saying paper money has little intrinsic value because the Federal Reserve can print trillions more dollars at any time, deflating the value of the currency. He notes the American dollar has lost 90% of its purchasing power in the past 100 years.
As a value investor, Einhorn searches for dislocations that mean a stock’s intrinsic value is significantly lower or higher than the market value. If below market prices, it is a long candidate; if above the market price, it is a short candidate. It is also helpful to remember Einhorn believes markets are efficient in the long run, but often inefficient in the short run. In the long term, almost all dislocations will right themselves, presenting a savvy investor with opportunities to buy or short and then leave the market price to right itself.
Current holdings
Einhorn has one publicly traded entity, Greenlight Capital Re Ltd. (GRLE), a Cayman Islands reinsurance company. It uses essentially the same investing strategy as its parent company, Greenlight Capital Management. Einhorn is chairman of its board of directors and a "significant" investor, according to the latter’s Form ADV Part 2A.
GuruFocus provides this overview of Greenlight Capital Re’s sectoral profile:
At the end of March, the fund had a total value of $7,194,917 with the following companies making up the top 10 holdings; the percentages tell us how much of the portfolio each stock occupies:
- General Motors Co. (GM, Financial) 26.91%
- AerCap Holdings NV (AER, Financial) 7.96%
- Apple Inc. (AAPL, Financial) 7.93%
- Consol Energy Inc. (CNX, Financial) 5.29%
- Mylan NV (MYL, Financial) 4.71%
- Green Brick Partners Inc. (GRBK, Financial) 3.34%
- Voya Financial Inc. (VOYA, Financial) 3.12%
- Time Warner Inc. (TWX, Financial) 2.8%
- Yahoo (now part of Verizon (VZ, Financial)) 2.76%
- The Chemours Co. (CC, Financial) 2.68%
The big stake in General Motors sets this fund apart from its peers. Beyond that, it appears to be a fairly conventional portfolio.
Greenlight Capital Re performance
As this GuruFocus performance table shows, Greenlight Re has underperformed the S&P 500 for some time:
The Greenlight Capital Re fund had an outstanding year in 2008—because it lost about 20 points less that the S&P 500. Five of the first six years provided a solid overperformance against the S&P 500, but since then it has underperformed the index, particularly in 2015 when the index outperformed it by more than 20 points.
Conclusion
The publicly traded Greenlight Capital Re gives us a glimpse into the trading and perhaps the results earned by Einhorn. That fund, however, represents less than 10% of the assets he has under management.
We do know from his publicly filed documents that he looks for temporary inefficiencies and dislocations in the market. These dislocations provide buying opportunities when the market value exceeds the intrinsic value, and shorting opportunities when the valuations are reversed.
Einhorn also makes use of technical analysis to look for stocks with momentum; psychology to try to figure out where the herd is going (so he can go in the opposite direction) and liquidity, which involves watching money flows and the size of the asset class.
While we cannot know how well Einhorn has done with his privately held hedge fund, we can take several useful lessons from his investing philosophy, principles and processes.
Disclaimer: I do not own stock in any of the companies mentioned in this article, and I do not expect to buy any in the next 72 hours.
