David Einhorn (Trades, Portfolio) is a hedge fund manager who is particularly well known for the short positions he has taken against a number of high-profile companies. In recent years, these have included Tesla (TSLA, Financial) and Netflix (NFLX, Financial). I believe that even investors who only deal on the long side can learn a lot by studying the short-selling process - after all, figuring out whether a business is too expensive requires much of the same skills and information as figuring out whether something is undervalued.
Anatomy of a short portfolio
So how does Einhorn decide which businesses to short? For him, it’s not enough for a business to simply be overvalued - he looks for companies that also have some sort of underlying problem:
“We’ve always insisted on overvaluation [as a criterion to short a company] combined with some sort of deterioration...We decided that we would look at a company [from a shortlist] where we didn’t know what this business was, but we knew what the financial statements were, and what the projected financial statements were, and just looked at the current and future financial circumstances, without knowing what the company did and asked “what would you pay for the stock?”
Einhorn and this team then created a basket of 40 to 50 stocks that they thought should be valued less than 90% from the current trading price, and shorted a small amount of each. This illustrates two interesting facts about shortsellers like Einhorn. First, although they are often portrayed as being heavily focused on one particular company, many of them hold highly diversified portfolios. They recognise that even the best analysts are right slightly more than half the time, and have the humility to not put all of their eggs into the same basket. Like long-only investors, they make sure that they are diversified.
Second, Einhorn tries to abstract himself from what the company actually does and focuses solely on the numbers. Too often, we are influenced by our preconceived notions about how certain companies are "destined" to develop. This tendency is particularly visible in the tech sector, where it is widely believed that the futuristic nature of the industry will eventually make unprofitable businesses cash flow positive.
The best investors don’t let themselves be swayed by "story" stocks. It shouldn’t matter whether you’re selling lumber or access to a video streaming service: cash is cash, and it's a lot easier to appraise a business based on the money that it generates in the here and now than to forecast what it might do in the future.
For instance, Einhorn’s well-publicized short against Tesla (TSLA, Financial) is often portrayed as a bet against the electric vehicle market as a whole. But if you examine his statements, there are no predictions there about the future of the industry. His shorts are based on the perceived overvaluation and financial difficulty of the businesses that he bets against. Long-only investors can learn a lot from this kind of mental discipline.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Seth Klarman: Areas of Opportunity, Part 2
- Seth Klarman: Areas of Opportunity, Part 1
- An Old Question Revisited: Is Value Investing Dead?
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