Value Investing

Learning From David Einhorn

David Einhorn, the President of Greenlight Capital, has one of the best long term investment track records on the street. From inception in May 1996 to the end of 2016, Greenlight Capital compounded at 16.1% pa net, significantly outperforming the S&P500.

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David is a value investor, but unlike your typical value investor, David takes the traditional value investor’s process and inverts it ... "The traditional value investor asks “Is this cheap?” and then “Why is it cheap?” We start by identifying a reason something might be mis-priced, and then if we find a reason why something is likely mis-priced, then we make a determination whether it’s cheap." Oftentimes there will be a short term structural reason for the cheapness - a special situation such as a merger, a spin-off, a debt issue or significant complexity or uncertainty etc - that is creating an opportunity.

I enjoyed a recent rare interview with David at the Oxford Union Society. In a similar fashion to inverting the typical value investor's process, David also inverts the natural tendency for investors to think they're right when a position moves against them. I enjoyed hearing David articulate how his natural presumption when a stock goes against him is not that 'he's right', but that 'he's missed something'.  A useful mindset to help overcome confirmation bias.

David discusses the similarities between poker and investing, why he's maintained his short basket despite his reticence to short stocks solely on valuation and the cultural and behavioural keys to successful investing.

I've included some of my favourite quotes below [Please click on the links to see the Investment Masters insights into those topics]

Love

“I love it. I love trying to solve puzzles. I love trying to find investments. I love trying to figure out what it is that is motivating a situation where we have a difference of opinion”

Thinking

“If I had to pick one reason [for Greenlight's success] it’s critical thinking skills. It’s the ability to look at a situation and see it for what it is, which isn’t necessarily what is presented to you. When something doesn’t make sense, question it, challenge it, look at from a different way and you often come to the opposite conclusion. You don’t have to do that very often. Most of the time when someone tells you something, it makes sense, but sometimes it really doesn’t make sense and there is another side to it. When you can come to a view, maybe just a few times a year, where you have an important difference of opinion with what everybody else is thinking about a particular situation and you can figure it out and it’s important, we’ve been able to make a small number of large investments that the vast majority of the time have worked out very well. [It’s] because we really have had an important difference of opinion between what we think and whoever is on the other side of the transaction ”

CultureHumility & Change

“The culture of the firm is a lot of smart nice people.  I think we interact well, there is a lot of humility. People respect one another, they respect one another’s views. People respect me, I respect them. I respect their time which is an unusual management culture for senior management people to truly respect the time of junior people.  You wind up with a group of people who are critical thinkers, that think and reason things out before they speak, that can adjust to new facts, that can adjust to feedback and work well within a culture”

Humility, Constant Re-assessment & Patience

“It’s not about sticking to our guns [in contrarian positions]. It’s about re-assessing constantly. When positions don’t work and go against you the presumption is not “we’re right, the presumption is “we might have missed something here”. Then you have to go back and think about it again and again and again. You have to understand the other side and see if anything has changed, see if your view has changed and if it has changed to modify the position. You might eliminate it, or you might reduce it or you might sometimes increase it, but very rarely. Generally speaking my inclination is, when the position is not going well, it’s more likely we’ve missed something so the choice is generally either reduce or eliminate or simply keep it if we think its right. On the other hand if we continue to think we’re right, I find patience is the way to go. We have to wait and let the story play out, while we continue to re-asses it to see in fact we were wrong”

What you Know, Can Infer and the Range of Outcomes

“Investing in a poker game and investing in stocks, at least the way I do it, is a very similar skillset. You have certain facts you know, in stock investing it’s whatever objective information you know about a company or a situation - what is the stock price, what the company does, what are their sales etc. Then there are things you can surmise, but you don’t really know. That would be – what is the motivation of the CEO, what is the strategy, what are the interests, what does the competition look like. These aren’t objective but through work you can make educated guesses about, but you don’t really know. And then you have a range of things that you don’t know that are going to come in the future.  These are future events that are fundamentally unpredictable but they live within a range of possible future events. So you combine what you know, with what you think you can surmise, combined with understanding the range of outcome related to the uncertain things and say “is this a good place to commit a fraction of my capital"

And you can translate that to poker. What is it you know; you know how many chips you have, you know what cards you're holding, you know the cards displayed face up on the table as you can see those. Then you can surmise what you opponents cards are likely to be; I can get information from how he is betting the hand or by sitting at the table playing with him for a while I can see his personality, his style, his skill and I can make inferences about the present hand based upon his past behaviours. Those are things you are trying to deduce. Then there is the uncertainty; the range of future cards concealed in the deck that are yet to be displayed that are important and there is a range of those possible outcomes. You take a look at all those things and you say "do I want to play this hand?", do I want to bet chips into this hand”

Understand

“The most exciting part is when you think you’ve figured out the joke. When you get the joke and you understand what it is that you’re doing and why it is you have an opportunity now. You’re going to be able to deploy capital and its very likely to work out. Those situations come up few and far between when you really have it”

Mistakes

“We are wrong often and we have to constantly question whether we are wrong. There are lots of times when you buy a stock and after a certain amount of time a certain event happens and you have to look at it a different way, and say nope that’s not it, we should have done the opposite. Then you change course

Risk Management

“We take a layer by layer approach [to risk management]. What is our risk on this investment, that investment and the next investment. We tend to think about risk as how much can we lose in our worse case. If it’s a $10 stock the downside is $10. That’s how I think about it”

Developed Markets

“We are invested in developed markets. I have no aspirations to get further away [from developed markets] because I find that once you get into places further away you’re subject to what’s going on with the insiders and there are local rules and customs, and local knowledge. It’s very hard to compete with that sitting in NY even if you get on an aeroplane and go visit once in a while”

Process

“We re-evaluate all of our investments [whether they have worked out good or bad]. Ones that have worked we sell or reduce because they have worked and we are not interested in them anymore. Some that haven’t worked we exit or reduce because we decide that whatever it was we were thinking is no longer true or is unlikely to be born out. We modify the positions accordingly and we do that on a position by position basis and we do that whether things are going well for us or not going well for us. It’s part of our ongoing process.”

What You Know, Concentration & Portfolio Construction

“The way you deal with unknown unknowns is through portfolio construction. We like to run a concentrated portfolio but even our best idea we are not going to put all our money in. You have to set some kind of a limit, have some kind of risk management, some level of diversification. We have some amount of longs and some amount of shorts and have some amount of market risk we are willing to take on a knowing basis. Then you have the idiosyncratic risk relating to the individual investment. When people say there is a stock at $10 with $1 of downside and $10 of upside, I say NO, it has $10 of downside because you can lose your whole investment when you make it.  We manage risk further by the level of investment we make"

Leverage

"We are not levered, we don’t borrow more money to make even more investments. That’s one way you avoid risk. If you don’t have to ever repay anybody you're not subject to lending terms and conditions”

Value at Risk

“One of the things that was most exposed in the financial crisis is the flaw in the mathematical modelling of tail risk. So called Value-At-Risk. It is a method used by all of the large banks  and institutions. What VAR basically does, it basically says, if the risk is something that is going to happen beyond a certain level of frequency, you don’t have to put any capital aside. They put capital aside to cover 95% of all possible outcomes, but not for really remote things beyond the tail”

Short A Bubble Basket - Lots of Small Positions

“We decided if we could look at company[s], none of the companies were profitable or materially profitable, and we didn’t know what the business was, but we knew what the financial statements were and we knew the projected financial statements, and we thought a little bit about the business, but we didn’t even know what the business was - if it was an office supply company, a paper-maker or Netflix - and we closed our eyes and said what would you pay for the stock.  If the answer was 90% less than where it was trading, we created a basket of about 40 or 50 of these and shorted a small amount of a large number of them. Over time, at least until the beginning of this year that basically worked out.  Even though we had 2 or 3 or 4 that really worked against us in a pretty big way, a big number of those 40 or 50 ultimately failed or de-rated and the stocks went down a lot. The gains were roughly enough to offset the ones that appreciated. This year that has not been the case. Pretty much everything that has remained or we put into the basket has continued to go up. But the thesis on all of them is that none of them are actual, viable businesses. And the market might disagree with us on this, but when they start showing real profits then we’ll take a different point of view on particular names”

"We generally don't short stocks just on valuation. But when we came to a point with certain stocks that the valuation was so extremely out of whack it wasn't really a debate about whether the stock was in a range of fair value, in other words it was 90% or so overvalued. You don't need a computer to help you figure that out. Even if you are wrong by 100% instead of it being 90% overvalued its 80% overvalued.

Seeking Perfection

"We do not sit around all day and try and figure out the precise value of individual stocks. Because those are not relevant to our actual ability to make decisions. So if we have a stock and its $10 the goal is not to figure out if its worth $11 or $11.50 or $12. The goal is to figure out is it worth a lot more than $10 and not being precise about that. If we buy at $10 it doesn't really matter whether its worth $18 or $20 or $25 and there is no point in us trying to figure that out right now. The only decision we have is - do we want to own the stock at $10, and if we think its undervalued by a lot that's good enough for us to decide to own it now. By the time it starts approaching higher values we can re-asses and fine-tuning on an ongoing basis. We do our assessments in a very imprecise way"

Investments as Puzzles

"We view investments as puzzles. There are a few things you can know but they are not the most important things as everybody knows them. The most important thing is what is it you can infer and how good are you at assessing a possible range of outcomes, either the known unknowns and the unknowns unknowns and how can you construct that into a portfolio"

Margin of Safety

"Our goal is to find things that are widely misunderstood by a large margin"

Time Arbitrage

"I think one of the inefficiencies in the market is investors are generically too short-term oriented and time arbitrage is one of the best inefficiencies in the market."

Activism

"When we get involved in pushing an agenda, which is very rare, our view invariably is if it doesn't help in the short term, intermediate term and long term, then its not a good solution to what the problem is"

Structural Problems

“As I looked at the global financial crisis as it happened I thought there were three or four or five really obvious structural problems that were exposed. Institutions that were thought to be able to fail, in fact were deemed to be too big to fail. You had structured credit where risk was being transferred but it wasn’t really being transferred or properly evaluated. You had the problem of credit rating agencies, only two or three major ones, so you wound up with a centralised decision maker as to who is creditworthy and who isn’t – that’s a really bad way to allocate credit. You really want a large number of people evaluating each credit to determine the creditworthiness. If you have one or two you create crisis of confidence when the one or two change their mind and you lose the opportunity to go into the market and find other people who might look at it differently from the credit rating agencies. That was separate to the corruption relating to the triple-A ratings. I think there was a lesson learnt about derivatives. They could have been dealt with differently, but instead we’ve created a clearing house for derivatives which has essentially created another too big to fail institution where all the credit is on an undercapitalised entity that everyone assumes will perform under all circumstances which of course it can’t as counter-parties begin to have problems. So from my perspective if you took all of the obvious problems from the financial crisis, we really kind of solved none of them.. I think it has the left basic structure more or less as it was and I think it is susceptible to the same type of event or series of events sometime in the future.”

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