David Einhorn (Trades, Portfolio) knows a thing or two about investing. He started his hedge fund, Greenlight Capital, in 1996 when he was just 27. Over the next 18 years, he posted annualized returns of about 20%.
During this period, Einhorn made two career-making calls, including avoiding the dot-com bust and the demise of Lehman Brothers. One of his most successful bets was against bond insurer MBIA, which he shorted in the run-up to the financial crisis.
Unfortunately, Einhorn started to run into trouble in 2015. That year, Greenlight lost 20%. Three years later, in 2018, it declined at least another 30%.
This series of losses severely tarnished the hedge fund manager's reputation, and he has suffered a continual outflow of investors ever since.
I wanted to highlight Einhorn's history not to attack the hedge fund manager, but to show his track record with complete transparency. Readers might not realize he was an incredibly successful money manager during the first 18 years of his career. This is not entirely clear if one only reads recent news on Greenlight.
A strategy built on value
I believe that no matter how well or poorly a hedge fund manager has performed, it's always possible to learn something from their experience.
In 2005, at the height of his career, Einhorn took part in an interview with Value Investor Insight.
In the interview, the hedge fund manager described his strategy. In particular, he focused on the approach he used to find equities and the thought process he went through to assess the prospective opportunity. Describing his investment strategy, Einhorn said:
"We take the traditional value investor's process and just flip it around a little bit. The traditional value investor asks 'Is this cheap?' and then 'Why is it cheap?' We start by identifying a reason something might be mispriced, and then if we find a reason why something is likely mispriced, then we make a determination whether it's cheap."
This approach is similar to the one advocated by Seth Klarman (Trades, Portfolio).
Any investor who has tried to follow a value-focused strategy will know it is relatively easy to find cheap stocks. The problem is finding cheap stocks that are worth buying.
Generally speaking, cheap stocks are cheap for a reason. It could be the fact that the market does not believe they have the money to continue functioning as a going concern. Or it could be the fact that they've experienced a bad year due to a one-off factor, such as exceptional costs or lack of demand.
Recognizing whether or not a stock is cheap for cyclical or more structural reasons is vital. A company suffering from negative structural factors may continue to struggle and get cheaper. Meanwhile, cyclical headwinds are, by their very nature, temporary.
In the interview, Einhorn emphasized he always approaches companies by trying to identify why they're cheap first:
"We start by identifying situations in which there is a reason why something might be misunderstood or mispriced, why it's likely investors will not have correctly figured out what's going on. Then we do the more traditional work to confirm whether, in fact, there's an attractive investment to make."
Einhorn went on to add that the level of the mispricing dictated the hedge fund's positioning:
"We find things that we think are exceptional only occasionally. So if we find something that is really set up, where we think it's mispriced, where we have a good understanding of why it's mispriced, where we think the mispricing is very large and the overall risk is very small, we take an outsized position to make sure we give ourselves the chance to be well compensated for getting it right."
This kind of mentality, whether it be seeking out cheap stocks or looking for growth opportunities, makes a huge amount of sense for any investor.
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