Value investor David Einhorn has received a lot of negative press in recent years thanks to a few years of underperformance. The criticism levied against Einhorn, and Bill Ackman is an example of how the hedge fund world’s short-term focus is damaging to both managers and investors alike.
Value Investor David Einhorn started his fund Greenlight Capital in 1996 with $900,000 and has since gone on to produce 16.5% annualized returns for investors by the end of 2016. Similarly, while Ackman and his team might have had a rough few years, since inception in 2004, Pershing Square Holdings has produced a return of more than 500% net for investors (through the end of 2016) compared to a return of 163% for the S&P 500 over the same period.
Following a few years of underperformance, these investors have lost the star status they once had, but that does not mean their advice is any less relevant.
Investor David Einhorn Interview
I recently stumbled across an old issue of Value Investor Insight containing a great interview with Einhorn in which he explained his process for assessing potential investment opportunities. For example, when asked about how he conducts his valuation assessment, Einhorn replied that he starts by identifying why the asset is cheap in the first place:
"We take the traditional value investor’s process and just flip it around a little bit. The traditional value investor asks “Is this cheap?” and then “Why is it cheap?” We start by identifying a reason something might be mispriced, and then if we find a reason why something is likely mispriced, then we make a determination whether it’s cheap."
Using this approach, the team at Greenlight appear to hunt for bargains in an entirely different way to many other market participants:
"If you’re looking for something that’s cheap, you’ll probably do a variety of screens – on price-to-sales, price-to earnings, price-to-book, whatever – to identify stocks that appear to be inexpensive. Once you have that list, then you start to research if there are good reasons the stocks deserve to be cheap, or if maybe there’s an investment opportunity because they’re cheap without a good reason. We think that’s the way most value investors approach it.
We never do screens like that. We start by identifying situations in which there is a reason why something might be misunderstood or mispriced, why 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."
This approach hasn't been rewarded in the current market. Last year, sticking with winners was the best approach for investors, not finding the most undervalued equities. Facebook, Apple, Amazon Microsoft and Alphabet posted average gains of 47.3% last year. These five companies alone accounted for 5.2 percentage points of the S&P 500's total gain of 23.7%. According to Bloomberg, just being long momentum returned 38% in 2017. In such an environment, a strategy of buying the market's laggards is never going to outperform.
Riding Out The Underperformance
Still, having been in the business through both the dot-com bubble, and pre-crisis boom, Einhorn has been through this environment before. In his year-end 2015 letter to Greenlight's investors, Einhorn gave a frank description of these periods:
"It has been a difficult environment for value stocks. This is the fourth time in our history where we’ve had a period of outsized losses, and in each of the prior periods, the macro environment was unfavorable to value investing:
- In 1998, the market was led by large capitalization growth stocks like Coca-Cola and Gillette, and value suffered. After losing 11.7% over the prior six months, we entered November down 3.2% while the S&P 500 was up 14.6%.
- From February 1 through March 10, 2000, the Nasdaq rose 28%, the S&P 500 was flat, and we were down over 10% as investors sold value stocks in order to pour every dollar they could find into the top of the tech bubble.
- In July through October 2008, we lost 26.5% despite very conservative long-short positioning. During that environment, where nearly everything fell, our problems were amplified by short squeezes in the most overvalued industrial company in the market (Volkswagen) and in overvalued financials after the regulators temporarily banned short selling."
This time around, the period of underperformance has been longer and more challenging. Long periods of underperformance are just part of the value investing business and Einhorn continues to believe that, despite all of the criticism Greenlight and value investing has taken since 2015, over the long-term patience will prevail.
Value Investing Is Not Dead
Einhorn tried to make this point clear in a letter to investors sent out in October, but several outlets believed that rather than defending value investing, Einhorn was questioning it. He later came out with the following statement to clear the air:
"I'm actually saying the exact opposite of the way the letter is being interpreted. The letter is actually a defense of value investing. What we're saying is, is that the value of a company has to do with the current and future profits discounted back at an appropriate rate and then with a tone of irony, we are saying hypothetically what would it take for that theory to be wrong and advancing the way that we think some investors are investing today; and we think ultimately this is a temporary phenomenon time to time when value investing gets out of focus, people question, hey, is this ever going to work again...I think over time, this is going to revert and value investing which historically has been a terrific strategy is due at some point for a significant recovery".
There's a lot that can be learned from Einhorn's insights. Even though David Einhorn has underperformed since 2015, his long-term performance cannot be overlooked. Unlike many other hedge funds, Greenlight has managed to compound investors' capital for more than two decades at a steady rate after deducting fees; this makes Einhorn's advice on long-term and value investing worth paying attention to.