Sunday, June 15, 2014

Investing Lessons From David Einhorn

I recently finished reading David Einhorn's Fooling Some of the People All of the Time, which is primarily focused on his hedge fund's (Greenlight Capital) take down of Allied Capital.

The Allied Capital case study is a must-read in itself, as it not only lays out Allied Capital's shenanigans in great detail, but also exposes the "system" that cushions corporate executives and the failures of the media, regulators, and investing community to wake up to what was going on.

My favorite part of the book, however, were the first few chapters where Einhorn talked about his approach to investing. Here are some of my top lessons from those chapters.

  • (On evaluating investments) 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?
    • One thing I've picked up over the years is that many of my favorite investors (Buffett, Akre, Lynch, etc.) spend a substantial amount of their research time on understanding management -- can they be trusted, are they good capital allocators, will they sacrifice the short term for the long-term, etc. You should do the same. Einhorn's third point also reminds me of Charlie Munger's insistence of understanding incentives. To do this for yourself, have a look at a company's most recent proxy filing or remuneration report and ask yourself if the board has established reasonable incentive metrics for management.
  • In order to invest, we need to understand why the opportunity exists and believe we have a sizable analytical advantage over the person on the other side of the trade...It would be foolish to assume that our counterparty is uninformed or unsophisticated.
    • What's your advantage over the person on the other side of the trade? For most individual investors, our most common advantage is our ability to think long-term and buy when others are selling for an emotional reason. Information advantages are possible, but they're not easy to come by in a relatively efficient market. The key either way is to identify why you think you have an advantage before you invest.
  • Greenlight believes the traditional investment horizon is too short because equities are long, if not indefinite-duration, assets...If the downside of an opportunity is no short-term return or “dead money,” we can live with that. We are happy to hold for more than a year before succeeding.
  • The trick is to avoid losers. Losers are terrible because it takes a success to offset them just to get back to even.
  • Our goal is to make money, or at least to preserve capital, on every investment.
  • (On shorting) It is psychologically challenging to manage a portfolio that outperforms only in a falling market. I have no desire to spend my life hoping for a market crash.
  • We avoid “evolving hypotheses.” If our investment rationale proves false, we exit the position rather than create a new justification to hold.
  • We consider ourselves to be “absolute-return” investors and do not compare our results to long-only indices. In assessing an investment opportunity, a relative-return investor asks, "Will this investment outperform my benchmark?" In contrast, an absolute-return investor asks, "Does the reward of this investment outweigh the risk?" This leads to a completely different analytical framework.
    • Instead of trying to "beat the market" with each investment, focus on whether or not the potential returns outweigh the risk. Do this consistently over time and the relative market outperformance will come anyway.
  • Given the different frameworks, comparing the results of an absolute-return strategy to a long-only benchmark is almost meaningless. It is almost like observing that the Dallas Cowboys (football) have a better winning percentage than the New York Yankees (baseball).
  • I decided to run a concentrated portfolio...It is hard to find long ideas that are ones and twos or shorts that are nines and tens, so when we find them, it is important to invest enough to be rewarded.
    • For an investor like Einhorn who does this full-time and has decades of experience, concentrating his portfolio in a few names works. For individual investors with less experience or who might only research their investments on the weekend, concentrating your portfolio can be more complicated. It's important to understand your emotional response to a concentrated position -- that is, can you stay patient and focused while a 20% position in your portfolio has short-term ups and downs? Personally, I couldn't comfortably hold a 20% position, but I could afford to invest more in my top ideas.
  • Of course, making a mistake on an actual investment is far direr than missing a good opportunity.
  • There are two types of bad outcomes. Sometimes, after analyzing the risk and reward, an investment appears attractive, but the unfortunate or unlikely happens. Such is life. Other times, the analysis is simply flawed: the investment is poor and we deserve the eventual loss.
    • It's important to know when investment outcomes -- both good and bad -- are a result of "luck" versus "skill" (or lackthereof). Sometimes a well-researched idea simply doesn't work out and you shouldn't beat yourself up over those. That's just bad luck. Other times, your investment underperforms due to a poor research process. Those are the outcomes that you need to avoid as they're due to incompetence rather than bad luck.
  • Over the years, we have found that carefully selected spin-offs are terrific opportunities.
  • Market extremes occur when it becomes too expensive in the short-term to hold for the long-term.
  • But, sooner or later, the truth wins. If you know you are right, all you need is patience, persistence, and discipline to stay the course.
  • It occurred to me that people who are willing to lie about small things have no problem lying about big things. 
    • This lesson sounded familiar to me and then I remembered why -- a similar lesson can be found in the New Testament (Luke 16:10). It's a good lesson for evaluating character -- both of management and of people in general.
What I've been reading this week:
Happy Father's Day!

Stay patient, stay focused.


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