Of all the professional value investors out there, David Einhorn (Trades, Portfolio) is one of the most underappreciated. While he does not attract the same attention as Seth Klarman (Trades, Portfolio) or other more controversial managers such as Bill Ackman (Trades, Portfolio), Einhorn has still achieved impressive returns. From inception (May 1996) to the end of 2016, Greenlight returned 2,090% cumulatively or 16.1% annualized net of fees and expenses.
Einhorn knows how to make money, so it pays to listen to this experienced hedge fund manager. One exciting interview with Einhorn was published in a historical issue Value Investor Insight. What’s interesting about this conversation is that Einhorn discusses how he looks at stocks from the perspective of “how much can I lose” rather than the usual “how much can I make mantra.”
When asked to describe his strategy, Einhorn replied:
“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 entirely changes the way Einhorn and the team at Greenlight go about looking for securities:
“If you’re looking for something that’s cheap, you’ll probably do a variety of screens – on price-to-sales, price-to earnings, price-to-book, whatever – to identify stocks that appear to be inexpensive. Once you have that list, then you start to research if there are good reasons the stocks deserve to be cheap, or if maybe there’s an investment opportunity because they’re cheap without a good reason. We think that’s the way most value investors approach it.
We never do screens like that. 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.”
Looking for these dislocations, as it turns out, is relatively easy as there a few areas where the gap between price and value tends to form:
“It happens routinely [in such situations] that the historical performance of a company doesn’t give a particularly good view of what prospective performance of the business is likely to be. It may be due to how the performance had been reported when a now-independent business was part of a larger company. It may be that strategies or capabilities have changed in ways that aren’t immediately apparent.
We also find opportunities when there is a large upheaval or rejection of a particular company – or sometimes an entire industry – for reasons that are obviously just plain old cyclical or otherwise based on what the investment fashion of the moment is.”
And the key to making money from these situations, according to Einhorn, is to take big bets on high conviction opportunities, where the value is most apparent:
“We believe in constructing the portfolio so that we put our biggest amount of money in our highest-conviction idea, and then we view the other ideas relative to that. 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.”
Einhorn's investment strategy is interesting because it follows a route less traveled. Rather than asking "why is this asset cheap," Einhorn first looks for a mispricing before asking why it exists. It seems as if this strategy has certainly worked over the years, and while returns have sagged in recent years, this interesting approach should probably not be written off just yet.
Disclosure: The author owns no stock mentioned.
