We’ve just been re-reading David Einhorn’s book – Fooling Some of the People All of the Time, A Long Short Story, in which he discusses how Greenlight’s research process reverses the analytical framework that most traditional value investors use. Einhorn also provides insights into his portfolio construction. Here’s some excerpts from the book:
Our investment program employs the skills I learned at SC [Siegler, Collery & Co] to analyze the economic value of companies and the alignment of interests between decision makers and investors. Our research process reverses the analytical framework that most traditional value investors use.
Many value investors determine whether a security is cheap. If it is, they seek to determine whether it is cheap for a good reason. A typical process to identify opportunities is through computer screens that identify statistical cheapness, such as low multiples of earnings, sales, or book value combined with rising earnings estimates. Then, they evaluate the identified companies as possible investments. Greenlight takes the opposite approach. We start by asking why a security is likely to be misvalued in the market.
Once we have a theory, we analyze the security to determine if it is, in fact, cheap or overvalued. In order to invest, we need to understand why the opportunity exists and believe we have a sizable analytical edge over the person on the other side of the trade.
The market is an impersonal place. When we buy something, we generally do not know who is selling. It would be foolish to assume that our counterparty is uninformed or unsophisticated. In most circumstances, today’s seller has followed the situation longer and more closely than we have, has previously been a buyer, and has now changed his mind to become a seller.
Even worse, the counterparty could be a company insider or an informed industry player working at a key supplier, customer or competitor. Some investors believe they have an advantage trafficking in stocks that have minimal Wall Street analyst coverage. We believe it doesn’t matter if a stock is “ underfollowed ” because the person we are buying from probably has followed the stock and we need to have a better grasp on the situation than he does. Given who that may be, our burden is high.
Though our research process relies heavily on my SC training, Greenlight constructs the portfolio differently from SC. The largest investments at SC were “ pair trades. ”A pair trade matches two companies in the same industry trading at widely disparate valuations.
SC would buy the cheaper company of the pair and sell short the more expensive one. In the best cases, the long had better prospects or more conservative accounting than the short. Pair trades attempt to hedge a portfolio’s investments by eliminating both market risk and industry risk and capturing the valuation convergence over time.
Starting with a good idea and finding a disparately valued industry comparable to match creates a pair trade. Often, the second half of the pair trade is not a worthwhile investment other than as an industry and/or market hedge. If one ranked investments on a scale from one to ten, with one being a perfect long idea and ten being a perfect short idea, a portfolio of pair trades will have a lot of threes and fours paired against sixes and sevens from the same industry.
Greenlight generally does not engage in pairs trading. We accept more industry risk, but assemble a portfolio where we believe our longs are ones and twos and our shorts are nines and tens. We do not short to hedge. If we are uncomfortable with the risk in a position, we simply reduce or eliminate it. By having a portfolio of worthwhile longs and worthwhile shorts, we achieve a partial market hedge without having to spend capital on negative – expected – return propositions. Every time we risk capital long or short, we believe the investment has individual merit.
Our goal is to make money, or at least to preserve capital, on every investment. This means securities should be sufficiently mispriced, so that if we are right, we will do well, but if we are mostly wrong, we will roughly break even. Obviously, if we are massively wrong, we will lose money. We do not use indexes to hedge because we can add more value by choosing individual names with poor risk – reward characteristics to short.
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. In practice, we have more long exposure than short exposure because our shorts tend to have greater market sensitivity and volatility than our longs. Also, the market tends to rise over time and we wish to participate. It is psychologically challenging to manage a portfolio that outperforms only a falling market. I have no desire to spend my life hoping for a market crash.
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