Authors: David Einhorn
Tags: #General, #Investments & Securities, #Business & Economics
PART ONE
A Charity Case and Greenlight Capital
CHAPTER 1
Before Greenlight
My father and grandfather were businessmen. The family business was Adelphi Paints in New Jersey. When the first energy crisis came in the early 1970s, the business suffered. My grandparents decided to sell. Though my father was a chemist, he worked on the sale of the company. When it was over, he enjoyed the work so much he decided that his future would be in mergers and acquisitions (M&A). He tried to get a job on Wall Street but did not have the right background.
My dad decided to open his own M&A shop in the basement of our house in Demarest, New Jersey. After a year with little success, my mom convinced him to move us back to Milwaukee, where she grew up and where her family remained. We moved in 1976, when I was seven. My father started his business again by working out of a converted bedroom in our house in the suburb of Fox Point.
Suburban Milwaukee was a great place to grow up. I rooted for the Milwaukee Brewers and its stars, Robin Yount and Paul Molitor. I went to a lot of games, including the World Series in 1982. The Brewers may have been a bad team for most of my life, but to have your team at its peak when you are thirteen years old is an experience I wish for every fan.
I was a pretty good student, especially in math. I spent most of high school working on the debate team, probably at some expense to my grades. Being a member of the team was great training in critical analysis, organization, and logic. I was very excited when my wife, Cheryl, announced that in honor of the tenth anniversary of Greenlight Capital, she had sponsored the creation of an Urban Debate League in Milwaukee, where hundreds of high school students will get debate training and experience. Apparently, debate raises test scores, literacy, and graduation rates. I am not surprised—I benefited enormously from the experience.
My parents often discussed business at the dinner table. Like his father, my dad has an enormous reservoir of patience and persistence. My mom is much more demanding. The M&A business was tough. My dad was paid mostly on contingency. This means that he would often work hard for a deal that did not close and would get paid little, if anything, for his effort. Other times, the deal would go so smoothly that the client would look at Dad’s work and conclude that it was so easy that the fee was not fair. Because the fee was not due until after the closing, many of the clients would take the opportunity to renegotiate. Mom always thought Dad was soft in these negotiations. Dad tended to take a longer-term view. Eventually, he moved the business out of the house. As it grew, it became successful and enabled Dad to provide well for our family. On my best days, I fancy myself a combination of Dad’s persistence/patience and Mom’s toughness/skepticism.
I majored in government at Cornell University, but became more interested in economics after I interned during my junior year at the Office of Economic Analysis at the SEC in Washington. I wrote my thesis on the cyclical regulation of the U.S. airline industry. Policy makers balance two competing interests: Airlines want to make money, but consumers want cheap, ubiquitous air transport. In the anticompetitive phase of the cycle, regulators allow airlines to generate generous profits by operating monopolies on routes, capturing cities as hubs, and eliminating competition by merging. This leads to unhappy consumers and politicians, who then require procompetitive measures to provide more and cheaper service, which kills the profitability of the industry. After the airlines suffer through losses or even bankruptcies, policy makers realize that having airlines is a good thing. To induce airlines to buy planes and provide service, there has to be a profit opportunity, so the anti-competitive phase of the cycle returns. This vicious pattern perhaps explains Warren Buffett’s quip that investors should have shot the Wright brothers’ plane from the sky at Kitty Hawk. This thesis won me highest honors in the Government Department, and Greenlight, not surprisingly, has never owned a U.S. airline stock.
I started to look for a job through on-campus recruiting. I met with a lot of companies, including
The Company
—the Central Intelligence Agency. I received a few offers and decided to take the one as an investment banking analyst at Donaldson, Lufkin & Jenrette (DLJ), even though it offered the lowest salary. I chose it because I liked the people I met during recruiting. I later realized I needed to work on my judgment.
I had two miserable years at DLJ, which provided a different kind of education. Working there felt like pledging a fraternity, except the hazers had no interest in even pretending to be friends. I won’t go into the gory details, but a few years ago John Rolfe and Peter Troob wrote
Monkey Business,
a graphic account of life as a junior investment banker at DLJ. Their description is consistent with my memory, including the true-to-life, hysterical description about managing the copying-center personnel. The main difference between their experience and mine: I was one level on the totem pole junior to them, which made life that much worse.
Part of my problem was that I did not have any idea what the job entailed when I started working there. When DLJ recruited its analysts, it sought a mix between finance/economics types and liberal arts types. As a government major, I fell into the latter group. I did not have any friends who had taken junior investment banking jobs, so I did not understand what the company’s representatives meant when they asked me during the recruiting process, “Are you willing to work hard?” I gave the right answer, but I didn’t realize I had just committed to 100-hour-plus workweeks. When I grew up, Dad made it home for dinner every night, and, I believe, so did all of my friends’ dads. I had never heard about jobs that required sitting in the office all day waiting for assignments that were generally passed out around dinner. The work lasted into the wee hours and often overnight. I did not understand the concept of staying in the office until everyone senior to me left—even when I had nothing to do. Further, I did not understand that being an analyst was a rite of passage that required “sacrifice” for its own sake, even when it provided no benefit to the project at hand. But I did it anyway because that was the culture.
I would often sleep on a pillow under my desk while the word-processing department prepared documents or the copy center made them into presentation books. Cheryl, my wife, would bring me a clean shirt in the morning on her way to work. I had certainly never before heard the adage, “If you aren’t coming in on Saturday, don’t even think about coming in on Sunday!” I started in August 1991 and by Thanksgiving had lost fifteen pounds.
After two years, analysts were expected to need a break that would be provided by business school. I had no intention of continuing my life as an investment banker, so I decided not to go to school. When a headhunter called and asked if I would like to interview at a hedge fund, my first response was, “Yes.” Then I asked, “What’s a hedge fund?” That is how Siegler, Collery & Company (SC) found me.
Gary Siegler and Peter Collery managed the SC Fundamental Value Fund, a mid-sized hedge fund with about $150 million under management. Today, a similar fund would have a couple of billion dollars. SC grew to about $500 million by the time I left. It was a great place to learn the business.
There, I learned how to invest and perform investment research from Peter, a patient and dedicated mentor. I spent weeks researching a company, reading the SEC filings, building spreadsheets and talking to management and analysts. Then I went into Peter’s office to discuss the opportunity with him. He heard me out and then took my file on the train. The next morning he returned to work having read everything and made a detailed list of questions that I
wished
I had asked. When I started working at SC, I would not know the answers to any of them; after a couple of years, I usually could answer about half.
Peter combed through the SEC filings for ambiguities in the description of the business or the discussion of the results. He spotted signs of good or poor corporate behavior, not to mention aggressive or conservative accounting. 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?
In early 1996, along with an SC colleague, Jeff Keswin, I resigned from the firm to start Greenlight Capital. Cheryl named the firm, giving me the green light. When you leave a good job to go off on your own and don’t expect to make money for a while, you name the firm whatever your wife says you should.
CHAPTER 2
Getting the “Green light”
Jeff Keswin and I made our initial business plan on a napkin at a restaurant around the corner from SC’s offices. He would be the marketer and business partner, while I would be the portfolio manager. He did not know exactly where he would raise the initial capital, but figured that with his contacts we could start with $10 million. I told my parents about it, and to my surprise, in a vote of support, they volunteered to invest $500,000.
Jeff and I each wrote a $10,000 check to start Greenlight. It was the only check I ever wrote for the business. We printed stationery and bought computers, a TV, and a fax machine. We rented a 130-square-foot space from Spear, Leeds & Kellogg, our custodian or prime broker. It was a tight squeeze getting past the filing cabinet to my desk. We shared a photocopier with the five other small trading outfits in our “suite.”
In February 1996, I wrote a brochure outlining our investment program and illustrating sample investments. Though the hedge fund industry is generally known for its secrecy, I saw no reason to be secretive. I felt that if we explained our investment program, how individual investments fit into the program and what happened and why, our investors would have greater confidence in us. They would also understand that even our failures came from reasoned, disciplined decisions.
Either way, I believed this would lead to a more informed, confident, and stable partner base. We refer to our investors as “partners” because that is how we view them.
Part of the reputation hedge funds have for secrecy comes from the SEC’s prohibitions against advertising. As a result, many hedge funds make fewer public disclosures than they otherwise would. SEC Commissioner Paul Atkins noted the problem in a speech in January 2007: “We need to stop scaring ourselves and others with rhetoric about hedge funds. Rather than talking about how hedge funds ‘operate in the shadows,’ let us take a look at the regulatory constraints on hedge fund advisers that stop them from saying anything about their funds publicly. One irony of the SEC’s complaints about the secretive nature of the hedge fund industry is that advertising restrictions on hedge funds have been interpreted broadly so that hedge fund advisers do not dare to say anything publicly.” Though the outside world may view hedge funds as secretive because the updates are not public, Greenlight communicates openly with our partners except regarding what we are about to buy or sell.
Our investment program employs the skills I learned at SC 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.
Many traditional long-only managers design their portfolios to perform over the next six to twelve months. Hedge funds attack the resulting inefficiency from both sides. Some believe that horizon is too long. They do not care whether a stock is going to do well in a year. They want to do well today or this week or, at worst, this month. These funds usually hold positions for a short time. Many of them are “black box” funds, where computer programs tell them what to buy. Others are news driven and want to know whether the next piece of news, or “data point,” will be positive or negative. Some of these short-term-oriented funds rely on technical analysis, the study of security trading patterns, to decipher the likely near-term future direction, while others rely on the manager’s trading instinct, feel, and experience. Many use a combination of insights, and some have been quite successful. These types of funds, though, tend to have little to no transparency. Nobody on the outside really knows much about the portfolio. Even if they were willing to disclose a lot, it would not be so informative because the holdings change so frequently. When the investing is computer driven, the managers of the fund are not interested in sharing the program, because the program
is
the business.
Greenlight believes the traditional investment horizon is too short because equities are long, if not indefinite-duration, assets. When we make an investment, we usually don’t have any idea how long we will be invested. 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. In practice, some “dead money” opportunities work out more quickly than we expect. A portfolio where some investments work quickly, some work slowly, and the rest retain their value generates exciting results. The trick is to avoid losers. Losers are terrible because it takes a success to offset them just to get back to even. We strive to preserve capital on each investment. It does not always work out that way, but that is the goal.
As we generally have long holding periods, there is no reason not to disclose key positions. Some of our peers disclose little because they worry people will gossip over their inevitable errors. Journalists seem increasingly joyful to report stories about hedge fund mistakes. Greenlight experienced that when we were large holders in (and I was a director of) New Century Financial, a subprime mortgage originator, which imploded in early 2007. My view is that actually losing money is much worse than the mere embarrassment of others’ seeing we were wrong.
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.
Another difference from SC is that we avoid “evolving hypotheses.” If our investment rationale proves false, we exit the position rather than create a new justification to hold. We exit when our analysis is wrong or we just can’t stand the pain, rather than when the market simply disagrees longer than we had imagined. Everyone is wrong some of the time. At SC, the principals were smart and believed the firm was smart. It is hard for smart people to admit a mistake. As a research analyst at SC, if I recommended a long idea at $10 and the stock fell to $7, there was an enormous institutional bias toward my recommending additional purchase, even if that required inventing a new rationale for the position. If the shares hit $5, it could become one of the largest positions in the fund. This created the risk that SC would put the most money into the ideas where SC was the most wrong.
We consider ourselves to be “absolute-return” investors and do not compare our results to long-only indices. That means that our goal is to try to achieve positive results over time regardless of the environment. I believe the enormous attraction of hedge funds comes from their absolute-return orientation. Most long-only investors, including mutual funds, are relative-return investors; their goal is to outperform a benchmark, generally the S&P 500. 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. As a result, both investors might look at the same situation and come to opposite investment conclusions.
The popular misperception is that investors are attracted to hedge funds for the status, the secrecy, the leverage, and, according to one preposterous magazine account, the high fees. The truth is simpler: Asking the better question of risk-versus-reward gives hedge funds an enormous opportunity to create superior risk-adjusted returns compared to relative-return strategies. While the media do not understand this, hedge fund investors do.
There are other misconceptions about hedge fund performance. It is easy to measure performance, but difficult to assess underlying risks. As a result, it is easy to highlight performance comparisons between hedge funds and the S&P 500. To some, if the S&P is up 20 percent and hedge funds are up 15 percent, then hedge funds have not earned their keep and investors have wasted a lot of money on high fees. 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). It is important to judge a strategy compared to its goals and contexts. If the Yankees’ goal is to win the World Series and they do, what is the point of comparing their record to the Cowboys’ record? Likewise, if a hedge fund seeks to achieve an attractive, risk-adjusted, positive absolute return and does that, then it has accomplished what it set out to do.
Similarly, the media misunderstand the risks in hedge funds. Academic research demonstrates that hedge funds have far less volatility or risk than long-only indices. However, once in a while a hedge fund fails spectacularly. Either the manager made poor or unlucky decisions or, worse, stole the money. Obviously, fraud needs to be prosecuted aggressively.
As a whole, these spectacular blow-ups grab so many headlines that it throws the popular perception of hedge funds out of whack. Just as individual companies implode from time to time due to poor strategy, bad luck, or fraud, so do hedge funds. Even considering the occasional meltdowns and the higher fees, hedge funds generally provide attractive risk-adjusted returns.
I decided to run a concentrated portfolio. As Joel Greenblatt pointed out in
You Can Be a Stock Market Genius Even If You’re Not Too Smart: Uncover the Secret Hiding Places of Stock Market Profits
, holding eight stocks eliminates 81 percent of the risk in owning just one stock, and holding thirty-two stocks eliminates 96 percent of the risk. Greenblatt concludes, “After purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small.” This insight struck me as incredibly important. 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. Based on this concept, we decided that Greenlight would have a concentrated portfolio with up to 20 percent of capital in a single long idea (so it had better be a good one!) and generally would have 30 percent to 60 percent of capital in our five largest longs. We would size the shorts half as large as we would longs of the same quality, because when shorts move against us, they become a bigger portion of the portfolio and to give us the ability to endure initial losses and maintain or even increase the investment. In most successful short sales, we lose money gradually for a period of time until we suddenly make a large gain—often in a single day.