In his book, Fooling Some of the People All of the Time, David Einhorn discusses the importance of understanding your counterparty on the other side of the trade. Here’s an excerpt from the book:
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.
You can find a copy of the book here:
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