A Dozen Things I’ve Learned from David Einhorn About Investing

David Einhorn is the President of Greenlight Capital which is “a value oriented investment advisor… that emphasizes intrinsic value will achieve consistent absolute investment returns and safeguard capital regardless of market conditions.” “He learned the hedge fund business from Gary Siegler and Peter Collery, who managed the SC Fundamental Value Fund. David Einhorn is one of the most successful long/short equity hedge fund managers of the past decade.” He is the author of Fooling Some of the People All of the Time: A Long Short Story. http://www.amazon.com/Fooling-People-Complete-Updated-Epilogue/dp/0470481544/ref=sr_1_1?s=books&ie=UTF8&qid=1439654903&sr=1-1&keywords=long+short+story+Einhorn

“We take the traditional value investor’s process and just flip it around a little bit. We start by identifying situations in which there is a reason why something might be misunderstood, where 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. That’s as opposed to starting with something that’s just cheap and then trying to figure out why. We think our way is more efficient.” David Einhorn is at his core a value investor who has developed a twist on the customary process. Finding reasons for a likely mispricing of assets and then doing the traditional value investing analysis is not fundamentally different than doing the traditional value investing analysis first. He feels his approach consumes less of his firm’s resources since they are not doing the work on businesses which are unlikely to see substantial asset appreciation. Reasons for an asset being mispriced include spin-offs, accounting issues and changes in secular or technology trends.

“What I like is solving the puzzles. I think that what you are dealing with is incomplete information. You’ve got little bits of things. You have facts. You have analysis. You have numbers. You have people’s motivations. And you try to put this together into a puzzle — or decode the puzzle in a way that allows you to have a way better than average opportunity to do well if you solve on the puzzle correctly, and that’s the best part of the business.” Value investing when done right is a lot of fun if you like to solve puzzles. The process is like being a detective. Sherlock Holmes might have been a good value investor. The task of a investor is to discover puzzle solutions in situations that involve different combinations of what Richard Zeckhauser calls risk, uncertainty, and ignorance (see the chart below). The process of discovering puzzle answers is inherently probabilistic in nature.

“Our goal is to make money, or at least to preserve capital, on every investment.” “Securities should be sufficiently mispriced, so that if we are right we will do well, but we are mostly wrong, we will roughly break even.” “The trick is to avoid losers. Losers are terrible because it takes a success to offset them just to get back to even.” Risk is always relative to the price paid for the asset. If you buy at an attractive price you can have a margin of safety. You can see this margin of safety principle at work in Warren Buffett’s two rules of investing: “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” Howard Marks and Seth Klarman all espouse this same philosophy. How do you “not lose money?” Always protect the downside. If you buy at a substantial discount to intrinsic value you can make a mistakes and still end up with a solid investment.

“There were three basic questions to resolve: First, what are the true economics of the business? Second how do the economics compare to the reported earnings? Third, how are the interests of the decision makers aligned with the investors?” The best value investors have an investing system that involves asking and answering a series of questions. For example, does the business have a moat? What should the economics of the business be in a normal situation? Then: Do earnings reports match the strength of the moat? Is there untapped pricing power? Is management underperforming? Are there problems you have not yet seen? Then: Are the incentives of management aligned with the incentives of investors? In the book Fooled By Randomness Nassim Taleb writes: “… instead of relying on thousands of meandering pages of regulation, we should enforce a basic principle of ‘skin in the game’ when it comes to financial oversight: ‘The captain goes down with the ship; every captain and every ship.’ In other words, nobody should be in a position to have the upside without sharing the downside, particularly when others may be harmed.”

“I’m not really good a predicting the market on a very near term kind of basis. So what it does from day-to-day is not within my competency to even hazard a guess at.” This comment is a blend of Ben Graham’s Mr. Market metaphor and the “circle of competence” concept. When David Einhorn buys assets he does not have a short term timeline in mind for how long he will own the assets. The objective of a value investor is to buy the assets at a bargain price and then wait. this word wait is an important one. What is meant by the value investor is waiting would any short term timing. Trying to make short-term forecasts instead of waiting is folly and value investors instead rely on the combined long term effects of a buying with a margin of safety knowing that over the long terms prices will return to the mean.

“We don’t try to solve the most intractable problems. At Greenlight, when we look at investments, some opportunities are just too hard to assess. We pass on those, even though many may work out perfectly well. We prefer situations that play to our strengths, where we can develop a differentiated analytical edge. This enables us to make investments where we are confident that the reward exceeds the risk.” Having what Charlie Munger calls a “too hard pile” is a tremendously valuable thing. If an investment is too hard, just move on to the many other opportunities that are not hard. Why get involved in investments where you do not know what you are doing especially when there are other bets where you do? Playing against weak competitors is not a sin in investing or business. There are no bonus points in investing for doing things that are really hard.

“Investing and poker require similar skills. I don’t play a lot of hands. But I don’t just wait for the perfect hand. They don’t come up often enough.” “With poker, you have a resolution of the hand within a couple of minutes.” “Whereas, even if the thought process in investing is very much the same, you’re looking at an outcome that could be 2, 3, 4, 5 years from when you make the original decision. And the mindset related to that is very different.” “We find things that we think are exceptional only occasionally.” Markets are far from perfectly efficient. But they are efficient enough that finding mispriced assets is hard, especially inside your circle of competence, which narrows the possible universe of bets. When the markets do serve up a mispriced bet an investor should act quickly and aggressively to place a bet if it is within their circle of competence. A number of very successful investors are excellent card players. Charlie Munger puts it this way: “The right way to think is the way Zeckhauser plays bridge. It’s just that simple.” Warren Buffett has a similar view: “Bridge is the best game there is. You’re drawing inferences from every bid and play of a card, and every card that is or isn’t played. It teaches you about partnership and other human skills. In bridge, you draw inferences from everything and that carries over well into investing. In bridge, similar to in life, you’ll never get the same hand twice but the past does have a meaning. The past does not make the future definitive but you can draw from those experiences. I think the partnership aspect of bridge is a great lesson for life. If I’m going into battle, I want to partner with the best. I was playing with a world champion and we were playing against my sister and her husband. We lost, so I took the score pad and I ate it.”

“We believe in constructing our portfolio so that we put our biggest amount of money in our highest conviction idea, and then we view our other ideas relative to that.” “I decided to run a concentrated portfolio.” This statement illustrates that David Einhorn is a “focus” investor like Charlie Munger and that he adopts an opportunity cost approach. At Greenlight 20 percent of capital might be put in a single long bet and up to 60 percent in its five largest long bets. David Einhorn cites Joel Greenblatt as an inspiration for his view. Greenblatt argues that the addition of more stocks in a portfolio that already has six to eight stocks in different industries doesn’t significantly decrease volatility. In any event, volatility is only on type of risk. You can see his recent holdings and his most recent letter here: http://www.octafinance.com/david-einhorns-greenlight-capital-had-a-bad-q2-bringing-2015-ytd-loss-to-3-3/101385/ David Einhorn currently has a significant position in gold. Some value investors own gold (e.g., Eveillard) and some don’t (e.g., Buffett, Munger). I have never owned gold since it doesn’t have earnings that can be used to calculate an intrinsic value. While some value investors may buy gold, buying gold is not value investing since it does not fit with the Ben Graham system. Why buy gold when you can buy a partial ownership interest in a real productive business instead of a lump of inert metal?

“On any given day a good investor or a good poker player can lose money.” A good process can lead to a bad outcome in the real world, just as a bad process can lead to a good outcome. In other words, both good andbad luck can play a part in investing results. But the best investors understand that over time a sound process will outperform. The best way to understand this point being made by David Einhorn is to read Michael Mauboussin, who tells this story: “[A baseball executive] was in Las Vegas sitting next to a guy who has got a 17. So the dealer is asking for hits and everybody knows the standard in blackjack is that you sit on a 17. The guy asked for a hit. The dealer flips over 4, makes the man’s hand, right, and the dealer sort of smiles and says, “Nice hit, sir?” Well, you’re thinking nice hit if you’re the casino, because if that guy does that a hundred times, obviously the casino is going to take it the bulk of the time. But in that one particular instance: bad process, good outcome. If the process is the key thing that you focus on, and if you do it properly, over time the outcomes will ultimately take care of themselves. In the short run, however, randomness just takes over, and even a good process may lead to bad outcomes. And if that’s the case: You pick yourself up. You dust yourself off. You make sure you have capital to trade the next day, and you go back at it.”

“[Our] goal is to achieve high absolute rates of return.” “We do not compare our results to long only indexes. This mean out goal is to try to achieve positive results over time regardless of the environment. Does the reward of this investment outweigh the risk?” The goal David Einhorn sets for himself is not to outperform a benchmark. This section from Seth Klarman’s book Margin of Safety describes a value investor’s desire for “absolute return”: “Most institutional and many individual investors have adopted a relative-performance orientation…They invest with the goal of outperforming either the market, other investors, or both and are apparently indifferent as to whether the results achieved represent an absolute gain or loss. Good relative performance, especially short-term relative performance, is commonly sought either by imitating what others are doing or by attempting to outguess what others will do. Value investors, by contrast, are absolute-performance oriented; they are interested in returns only insofar as they relate to the achievement of their own investment goals, not how they compare with the way the overall market or other investors are faring. Good absolute performance is obtained by purchasing undervalued securities while selling holdings that become more fully valued. For most investors absolute returns are the only ones that really matter; you cannot, after all, spend relative performance. Absolute-performance-oriented investors usually take a longer-term perspective than relative-performance-oriented investors. A relative-performance-oriented investor is generally unwilling or unable to tolerate long periods of underperformance and therefore invests in whatever is currently popular. To do otherwise would jeopardize near-term results. Relative-performance-oriented investors may actually shun situations that clearly offer attractive absolute returns over the long run if making them would risk near-term underperformance. By contrast, absolute-performance-oriented investors are likely to prefer out-of-favor holdings that may take longer to come to fruition but also carry less risk of loss.”

“I’m a big believer in not making decisions before they need to be made. Circumstances change, people change, facts change, and options change. Why commit early when you can have the benefit of deciding later with more information?” Having the option to make the best choice at a later point in time when you have more information is valuable since markets are always changing. As an example, Craig McCaw has said to me many times over the years that “flexibility is heaven,” which means that he was willing at times to pay a financial price to keep his options open. When change is constant, having the ability to adapt at a later point in time is a very good thing.

“At the top of the bubble, technology stocks seemed destined to consume all the world’s capital. It was not enough for all the new money to go into this sector. In order to feed the monster, investors sold everything from old economy stocks to Treasuries to get fully invested in the bubble. Value investing fell into complete disrepute.” “Market extremes occur when it becomes too expensive in the short-term to hold for the long-term.” “One of the things I have observed is that American financial markets have a very low pain threshold.” David Einhorn is pointing out that people often need to act based on short-term needs. Often that short-term need is to generate liquidity. Sometimes liquidity is needed because some people selling an asset cause a drop in price, which causes more people to sell that asset due to the price drop [repeat]. George Soros calls this phenomenon “reflectivity.” When people start acting in some way because other people are acting in the same or similar ways nonlinear results can happen both to the upside and the downside. For example, cash can quickly move from being available quite easily, to being very scarce. As another example, the price of an asset can suddenly jump in a big way. The speed at which this can happen is often forgotten by people and is underappreciated until that time arises. Market extremes do occur since people do not make decisions independently. They are not perfectly informed rational agents. The longer you investment timeframe and the lumpier the returns you are willing to accept the happier you will be and the better your returns will be.

Notes:

Charlie Rose interview: http://www.businessweek.com/magazine/content/10_51/b4208052554248.htm

CNBC interview http://www.cnbc.com/id/102107346#

http://www.valuewalk.com/wp-content/uploads/2014/06/MarchTrial.pdf

Value Investing Congress Speech http://www.grahamanddoddsville.net/wordpress/Files/Gurus/David%20Einhorn/einhornspeech200611.pdf

Ira Sohn comment: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ayIKbq6xULBA

Fooling Some of the People All of the Time, A Long Short Story http://www.amazon.com/Fooling-People-Complete-Updated-Epilogue/dp/0470481544/ref=sr_1_1?s=books&ie=UTF8&qid=1439654903&sr=1-1&keywords=long+short+story+Einhorn

Presentation at Grant’s (Interest Rate Observer) Spring Investment Conference http://seekingalpha.com/article/73260-things-go-better-with-coke-in-the-market-too and http://www.naachgaana.com/2008/04/12/grant%E2%80%99s-spring-investment-conference/

Risk Mismanagement http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?pagewanted=all

Helping People Get Along Better http://www.gurufocus.com/news/325793/helping-people-get-along-better–a-lecture-from-david-einhorn