Fooling Some of the People All of the Time, by David Einhorn

David Einhorn (born in 1968) is an American investor who co-founded and chairs Greenlight Capital, a long-short value-oriented hedge fund whose flagship partnership has returned 13% annualized over 1996-2022, net of fees and expenses.

Learning the trade

Einhorn learned the trade at hedge fund Siegler, Collery & Company (SC).

• SC sought to answer 3 questions when looking at investments:
  1. What are the true economics of the business?
  2. How do the economics compare to the reported earnings?
  3. How are the interests of the decision makers aligned with the investors?
• Analysts at SC did this by:
  1. Combing through SEC filings (business description, results discussions).
  2. Looking for signs of good or bad corporate behavior, and aggressive or conservative accounting.
  3. Building spreadsheets.
  4. Talking to management and analysts.

Starting up a hedge fund

In 1996, David Einhorn and his colleague Jeff Keswin left SC to start Greenlight Capital.

• Einhorn would be the portfolio manager while Keswin would be the marketer and business partner.
• They intended to raise $10 million, but with no track record, settled to launch in May 1996 with $900,000, more than half from their parents, realizing that in three years, they could get a three-year track record.
• They kept their prospects informed, and a few of them began to notice and send money. Existing partners received monthly statements, were invited to annual partner dinners, and some presented their wealthy friends.
• Their AUM hit $13 million by the end of 1996, $75 million in 1997, $165 million in 1998, $250 million in 1999, $440 million in 2000, $825 million in 2001, and $1.8 billion in 2003, due to a strong performance (+37% in 1996, +58% in 1997, +10% in 1998, +40% in 1999, +14% in 2000, +32% in 2001, +37% in 2003) and inflows from new partners.

Greenlight Capital’s investment program

Einhorn and his team have the following investment program:

• They use the skills learned at SC to analyze the economic value of companies and the alignment of interests between decision makers and investors.
• Like value investors, they analyze stocks to determine if they are cheap or overvalued, but instead of screening for statistically cheap stocks, they screen for likely misvalued securities (e.g., spin offs, demutualizations, misleading accounting, or outright fraud).
• They do not assume their counterparty on the other side of the trade is uninformed or unsophisticated, even if the stock is under-followed. Instead, they require an analytical edge.
• They strive to avoid losers and thus preserve capital on each investment.
• They have a longer than average investment period, viewing equities as long if not indefinite-duration assets.
• They do not use pair trades or indexes to hedge. Instead, they select long or short positions based on their individual merits, with sufficient mispricing so that if they are right, they will do well, but if they are wrong, will roughly break even.
• They avoid “evolving hypotheses”, so that if their investment rationale proves false, they exit the position rather than create a new justification to hold.
• They have an absolute return orientation, thus seeking to achieve positive results over time regardless of the environment instead of seeking to outperform a benchmark.
• They run a concentrated portfolio, with up to 20% of capital in a single long idea and 30-60% of capital in their five largest longs, and size the shorts half as large as longs of the same quality, to be able to endure initial losses while maintaining or even increasing the investment.

Early investments

Early investments described in the book included:

• MDC Holdings (long): a homebuilder.
• EMCOR (long): an electrical and mechanical systems contractor that had recently emerged from bankruptcy. It took until 2001 (5 years) to really work.
• CR Anthony (long): a small retailer that had recently emerged from bankruptcy and returned to profitability. The market valued the company at $18 million despite its having twice that in net working capital (current assets less all liabilities). This position was 15% of the fund and returned 4x, generating 1/3 of the return in 1996.
• US Trails (long): a campsite operator whose bonds traded at 77% in June and were called at 100% in July.
• Tylan General (long): a semiconductor capital equipment manufacturer. It later announced it would be sold at a good premium.
• Microwarehouse (short): it announced terrible results due to systems problems, and the stock collapsed.
• Reliance Acceptance (long): a provider of car loans to people with tarnished credit. The analysis of the economics of the business turned out to be flawed (the interest rate charged was not sufficient to cover losses) and Greenlight lost half of their investment.
• Insurance company demutualizations (long): when mutuals convert to stock companies, and sell 100% of the shares in an IPO, investors get the company for free, as ownership includes both the IPO proceeds and the company itself. [Personal note: this was highlighted decades ago by Peter Lynch who made a fortune with these].
• Spin-offs (long): A spin-off is when a large company divests a subsidiary by distributing the subsidiary’s shares to the parent company’s shareholders. [Personal note: as other investors have pointed out, some shareholders who receive such shares are not interested in holding them, which makes for good buying opportunities].
• Pinnacle Systems (long): a technology company which traded at book value, which was mostly cash, after a couple of disappointing quarters. When Pinnacle reported better results, the shares tripled.
• Boston Chicken (short): a franchisor which financed the openings and up-front fees and earned interest on loans to the franchisees, and recognized up-front revenue and profit when franchisees opened restaurants.. The underlying restaurants were not profitable enough to support the payments to the parent. Greenlight shorted the stock on the expectation that growth would stop, but it turned out even worse: franchisees defaulted on their loans and the company went bankrupt.
• Samsonite (short): a luggage manufacturer. Grenlight shorted the stock as the company had raised prices and extended its network, resulting in significant excess inventory and discounting by luggage stores. The stock went from $28 to $45 before collapsing to $6.
• CLCX (short): a for-profit education company. Greenlight shorted the stock as it offered a poor product (it charged $20,000 a year, financed by government student loans, to teach computer skills to uneducated people on obsolete technology) and engaged in misconduct (e.g., gave answers to students so they could pass the admission tests). Following a Department of Education investigation and the filing of a suit, the stock sank and Greenlight increased its position. The suit resulted in a meager $500,000 fine, at which point the stock doubled and Greenlight covered its short. It took two years for the Department of Education to complete its inquiry and demand the repayment of all student loans, which eventually put the company out of business.
• Sirrom Capital (short): a business development company (BDC) making mezzanine loans to private companies. Sirrom funded rapid growth through a virtuous cycle where it raised equity at a sizable premium to net asset value (book value), which increased its net asset value and provided fresh, cheap capital to grow its portfolio. Greenlight shorted the stock due to red flags: rapid asset growth masked poor results, management was slow to recognize problems in portfolio markings, and the auditors changed the wording in their opinion letter. The shares fell $32 to $10, at which point Greenlight Capital covered its short, and then collapsed to under $3.
• Summit Holdings Southeast (long): a demutualized Florida workers’ compensation specialist. Greenlight invested 15% of the fund at $14 a share due to a combination of conservative accounting, all the IPO proceeds going to the company, and a management team with a large stock and option grant. The company was sold at $33 a share a year after.
• Century Business Services (short): a “rollup” of accounting service firms. Greenlight shorted the stock due to accounting tricks (revenue recognition on acquisitions before closing, valuation of the stock used to pay for acquisitions at a 40% discount to market value). The shares fell from $25 to $1.
• Agribrands (long): an animal feed manufacturer that had been spun off from Ralston Purina. The stock had fallen in a sell-off due to its Asian market exposure. It was bought two years later by Cargill at 2x.
• Seitel (short): the owner of a multi-client library of seismic data used to find hydrocarbons. Greenlight shorted the stock due to shoddy accounting. Seitel shot the data and sold it to energy companies for an exclusive period, after which it could re-license the data to other energy companies. Seitel capitalized the investment in shooting the data and expensed it in proportion to the expected licensing and re-licensing revenue. Seitel assumed that a dollar invested in data would generate $2.50 in revenue and a 60% margin, which burned cash and inflated earnings. Greenlight held the short for three years until Seitel went bankrupt.
• Reckson Services (long): an entity spun off of Reckson Services, with speculative real estate ventures in student housing and gaming, a shared-office space business, a concierge services provider, and OnSite, a money-losing start-up that wired office buildings for Internet access. At $5 a share, Greenlight calculated that there was a free option on OnSite. Reckson hired a manager from GE, changed its name to Frontline Capital Group and turned the business into an incubator. The stock reached $60, at which point Grenlight sold 1/3 of its stake; the stock subsequently fell in 2000.
• Triad Hospital (long): a spin-off from Columbia/HCA.
• Chemdex (short): a start-up setting up a business-to-business (B2B) network for companies to sell chemicals to one another. Greenlighted invested 0.5% of the fund to short at $26 a share, as the company stood little chance of generating enough revenue to cover high upfront investments and uncontrolled expenses. The stock went to $71, at which point Greenlight doubled it position, and then to $164, at which pointed it covered the short.
• 1-800 Contacts (short): a mail-order contact lens seller. Greenlight shorted the stock as it sold lenses without properly verifying the prescriptions. The FDA decided not to act, causing Greenlight to short at a large loss. The stock later collapsed.
• CompuCredit (short): a credit card issuer to customers with poor credit. Greenlight shorted the stock, whose rapid asset growth masked losses. The stock doubled before falling after disappointing results.
• Conseco (long bonds, short stock): an insurance and annuity company. Greenlight purchased the bonds, which traded at 65 cents on the dollar, yielding 20%, and shorted the stock, as the company lost its A rating. Greenlight initially lost on the short, as Conseco hired a GE executive who promised a rapid turnaround. The shares doubled until the market realized the figures did not add up, the CEO resigned, and the company went bankrupt.
• Orthodontic Centers of America (short): a rollup of orthodontist practices. Greenlight shorted the stock based on improper accounting practices which accelerated revenue-recognition (by recording more than all the profit from patients in the first months of a multiyear treatment cycle) and backloaded expenses (by recognizing the orthodontists’ compensation expense on a “cash” basis rather than on an accrual basis). The stock fell as the SEC required it to change revenue recognition, went back up, then collapsed as cash flows badly lagged earnings. Orthodontists were discontent, and the company restated results significantly and eventually filed for bankruptcy.
• Elan (short): an Irish specialty pharmaceutical company that had a small portfolio of branded drugs and a drug delivery technology. Greenlight sold Elán short due to accounting anomalies: the company entered into licensing deals that appeared to be shams (Elan invested in biotechs, which used the money to license the drug delivery technology, recognized as revenue at 100% margins), and played games with off balance sheet SPVs to consistently beat estimates. With an SEC review behind them, the share peaked at $65, before falling to $1 after the Wall Street Journal ran a story on their questionable accounting.
• Allied Capital (short): a business development company making private-equity and mezzanine investments in small businesses, and buying mortgages. The short idea was brought in 2002 by a fellow hedge fund. Greenlight concluded that Allied, like Sirrom, was slow to write-down troubled assets (marked down the equity kickers of problem investments, while holding the related loan at cost). The company had a qualitative method of valuation, where write-downs occurred only when they determined money would be permanently lost. It was thus able to report a loss rate superior not just to high-yield bonds, but also to much safer senior bank loans. It also valued its holdings well above quoted market prices, disclosed limited facts about controlled companies BLX and Hillman, and financed dividends with equity issuance. Greenlight put 7.5% of the fund into a short sale at $26 a share. Einhorn shared the idea at a charity conference. This ultimately led to a 6-year long public feud, with investigations, attacks, attempts by Allied to cause a short squeeze (they advised shareholders to move heir shares from a “margin” account to a “cash” account to prevent brokers from lending the stock, then attempted to issue “non-transferable” rights that allowed the holder to subscribe for more shares if they held the stock continuously), and other events described in detail in the book. In 2009, BLX filed for bankruptcy, while Allied settled with the DOJ, and was eventually sold to Ares. The short paid off after 7 years.
• Lehman Brothers (short): an investment bank. Greenlight shorted the stock due to concerns about leverage and accounting. The bank eventually went bankrupt.