The (Real) Cautionary Tale Of David Einhorn
August 04, 2018
Edit
Greenlight Capital's David Einhorn was of late the dependent of a widely-circulated hitting slice yesteryear the Wall Street Journal, which came a few weeks inwards advance of Einhorn reporting a genuinely disastrous 18% loss inwards the starting fourth dimension one-half of 2018 (in rising U.S. markets). This termination capped a abysmal xxx calendar month stretch of performance, which has seen the quondam star's cumulative losses mountain to some 30% (during a bull market) - a autumn from grace that has attracted considerable media attention.
The WSJ article attempted to sketch a narrative of a quondam high-flyer felled yesteryear hubris as well as decadence, drawing attending to the famed value investor's penchant for afternoon naps; high-stakes poker tournaments; as well as the occasional glamorous all-nighter on the town, but I'm non convinced. I believe Einhorn has really been felled yesteryear much to a greater extent than prosaic factors - a combination of errors of judgement; the inherent dangers of brusque selling; as well as bad luck. The instant factor, inwards conjunction amongst the third, has resulted inwards misfortunate investment outcomes disproportionate to the failings of the starting fourth dimension factor, as well as they combine to enjoin a worthwhile cautionary tale (for those fond of learning vicariously).
So what went wrong?
I am non a fan of brusque selling, as well as although the mandate of the fund I run allows it, I conduct hold no naked brusque positions. The occupation I receive got amongst shorting is non a shortage of overvalued stocks, but the fact that in that location are every bit good many ways to lose a important amount of coin shorting even if you are ultimately correct on the fundamentals & valuation (which is hard plenty to acquire correct inwards as well as of itself).
Many hedge funds similar to emphasise their depression 'net exposure' to the marketplace seat (for instance, Einhorn is nearly 95% long as well as nearly 75% short, for a internet marketplace seat exposure of only 20%). However, this depression 'net' exposure radically understates the flat of peril involved for the fund's investors, because inwards for sure marketplace seat environments, it is only possible to lose on both your longs as well as your shorts at the same time. In Einhorn's case, the reality is that the fund really has gross active exposure of 170%, as well as so is thus to a greater extent than akin to a fund leveraged 1.7x, which volition magnify errors of sentence (or simply inopportune macro/style/factor positioning) profoundly.
The putative risk-reduction benefits of long-short positioning implicitly remainder on the supposition that stocks across sectors/factors/styles volition remain positively correlated at all times, but nosotros receive got seen both inwards yesteryear marketplace seat environments (notably the dot.com bubble), every bit good every bit inwards recent years, that it is only possible for whole segments of the marketplace seat to give-up the ghost downwards (especially value/cheap segments) spell other segments of the marketplace seat give-up the ghost upwards (especially growthy/hyped/bubbly sectors). If you're running a long/short mass amongst 170% gross exposure amongst important sectoral mismatches where correlations turn inverse, you're going to acquire yourself into a lot of problem quickly.
Furthermore, the potential emergence of this type of marketplace seat environs should non receive got been hard to envisage. As I've discussed inwards yesteryear weblog entries, the structural nature of value stocks is that the most probable upshot over the medium term is that the stocks volition maintain to give-up the ghost down/underperform, spell the most probable upshot for hyped growth stocks is that they maintain to give-up the ghost up/outperform. This is why value stocks give-up the ghost inexpensive inwards the starting fourth dimension identify as well as defy the dictates of marketplace seat efficiency, because the anomaly is hard for institutional investors to practically exploit.
The outperformance of value vs. growth over fourth dimension typically comes inwards small, concentrated doses, where real needlelike reversals hap (such every bit during 2000-02, when value stocks surged spell the NASDAQ plummeted almost 80%). Many of the best performing long-only value managers amongst the best long term rail records receive got spent important periods of fourth dimension underperforming the index. Consequently, a long value, brusque growth mass is almost for sure to drive y'all tremendous hurting from fourth dimension to fourth dimension (and especially belatedly cycle), as well as Einhorn should receive got anticipated this when formulating his strategy. Even if it worked a lot of the time, in that location were going to live occasional periods where the strategy was at serious peril of blowing upwards his fund.
Furthermore, shorting actively forgoes some of the most of import contributors to the long term success of a well-implemented, long term value strategy: the ability to wait, as well as at select times, average down. If I purchase a 2% long seat inwards a value stock (at say $100), as well as it later falls 50%, I tin maintain to conduct hold as well as wait. While I am 'wrong' as well as the stock is falling, the seat size is shrinking, so the seat becomes a steadily smaller portion of the overall portfolio, as well as hence the pressure level to sell recedes, rather than increases. I tin wait. Furthermore, I receive got the powerfulness to average down. If I invest a farther 2% of the portfolio after the stock has fallen 50% (at say $50), I at nowadays receive got a 3% seat (4% yesteryear cost) at an average cost of precisely $66.67. If the stock rallies dorsum to precisely $100 - my master entry - I at nowadays receive got a 50% profit, equal to 2% of the overall fund.
The dynamics of shorting are fundamentally different. If I set a 2% brusque seat on a stock at $100, which I think is worth only $50, as well as the stock doubles on me to $200,* then I at nowadays receive got a 4% portfolio brusque seat (not a 1% position, every bit inwards the instance of the long). My seat size has doubled rather than halved. This is a serious problem, because dissimilar amongst the long position, I cannot slumber comfortably as well as wait, because peril management considerations volition at some dot forcefulness me into covering, converting what would otherwise live a temporary newspaper loss (assuming my thesis is ultimately vindicated) into a permanent loss of capital.
Furthermore, I cannot meaningfully average downwards (or perhaps I should say, 'average up'). If I were to set some other 2% portfolio brusque on at $200, I would at nowadays receive got a 6% brusque seat at an average cost of $133.33. A farther doubling inwards the portion cost would bring this to a 12% brusque seat (vs. a farther 50% autumn reducing my long seat from 3.0% to 1.5%). Risk management considerations would preclude such an action, as well as create an unacceptable peril of a total blow up.
To succeed every bit a value investor, it is absolutely essential that y'all are investing from a seat of strength non weakness, as well as receive got the powerfulness to 'stay the course' when markets motion against you, but the peril of beingness a forced buyer every bit a brusque seller is real real. The to a higher identify dynamics receive got probable been a important contributor to Einhorn's horrific recent returns. Notable is that Einhorn covered his disastrous Netflix brusque only during early-mid 2018, as well as has doubtless had to cut down his other 'bubble basket' shorts inwards recent times every bit well, every bit they threatened to barbarous the fund.
This sense betrays a structural occupation of a long/short fund focused on valuation. If you're long inexpensive stocks but receive got no shorts, y'all volition underperform for a spell as well as it volition live painful, but you'll probable alive to acquire by some other hateful solar daytime as well as volition eventually brand dorsum all of your underperformance (and more) when the cycle turns. However, if you're long those stocks, which are going down, spell also beingness brusque expensive stocks which are going up, amongst gross leverage of 1.7x, the affect on your returns tin live ruinous and permanent - even if y'all ultimately halt upwards beingness right.
Einhorn appears to receive got overlooked this risk, but has been punished disproportionately for this oversight on occupation organization human relationship of bad luck. During the post-GFC upcycle, as well as especially during the lastly 3-4 years or so, U.S. markets receive got witnessed tape outperformance of growth over value. Einhorn noted inwards his recent alphabetic character that value's underperformance of growth is currently inwards the 1st percentile of historical experience! By definition, the adventure of something this extreme happening was thus only 1 inwards a 100!
Some of this departure has been due to belatedly cycle excesses, but some of it has also been fundamentally justified. The yesteryear decade has witnessed a tape flat of 'disruption' (or perceived disruption) of traditional industries at the hands of Amazon, Netflix, Tesla (perceived), as well as numerous other technology/software/online businesses, including both listed as well as VC-funded 'Unicorns'. Many of these companies receive got raised tape amounts of funding, which is beingness used to run fast-growing, but loss-making businesses that receive got been taking marketplace seat portion off incumbents.
In to a greater extent than traditional funding markets, they would non receive got been able to practise this to the flat they receive got for the duration they receive got (as the lack of earnings would receive got deprived them of the working capital alphabetic character needed to acquire economies of scale), but real permissible tech funding markets receive got reduced entry barriers to an unprecedented flat as well as allowed them to plough billions of dollars of losses into rapid growth (aided yesteryear the fact that rising tech valuations receive got meant tech investors receive got non felt the burden of such operating losses).
'Value' stocks - companies amongst actual earnings as well as cash flows - receive got been on the receiving halt of the growth as well as disruption wrought yesteryear these businesses (e.g. traditional retail as well as media). Some of them receive got indeed seen their revenues as well as earnings reject (especially for sure traditional retailers as well as PayTV companies - especially satellite providers), so disruption fears hither are real much real, spell others (e.g. traditional auto) receive got continued to post tape earnings, as well as fears of disruption receive got so far proven simply hypothetical. Multiples receive got nevertheless fallen precipitously across these industries. General Motors is a clear illustration - the fellowship keeps producing tape profits as well as cash flows, but the stock continues to languish on disruption fears, spell loss-making 'disruptor' as well as marketplace seat darling Tesla continues to scale novel heights (until of late at least). Einhorn's long GM brusque Telsa positioning has thus wound him badly, fifty-fifty though he volition likely ultimately live right.
This has made the investing environs especially hard for Einhorn's style. However, spell the failure to anticipate the flat to which the cycle would play out inwards this management tin live somewhat excused, Einhorn has compounded the harm amongst unforced errors yesteryear shorting scalable, potentially category-killing, as well as good run-businesses similar Netflix as well as Amazon using inappropriate valuation metrics. As I discussed inwards my recent Spotify weblog post, using nigh term earnings multiples was a wholly inappropriate way to aspect at these businesses. I am non criticising his determination to avoid them on the long side (I receive got avoided them also, although I receive got been tempted to purchase Amazon all the way from $250, but receive got of late ceased to give-up the ghost tempted), but shorting them was a demonstration of a profound lack of imagination as well as appreciation for some of the fat-tail upside risks to these stocks, and fatty tail peril matters tremendously when shorting.**
Assured Guaranty
More generally, Einhorn's sense amongst his Amazon as well as Netflix shorts highlight a to a greater extent than systemic occupation amongst Einhorn's approach where he oftentimes appears to acquire overly caught upwards inwards the details (particularly accounting arcania), as well as oftentimes misses the big picture. Einhorn is undeniably an incredibly smart investor, but in markets, it is meliorate to live wise than smart, as well as for a really smart guy, Einhorn seems to recurrently practise some pretty dumb things.
An illustration is his brusque thesis for bond insurer Assured Guaranty (AGO US), which he presented at this year's Sohn Conference when the stock was trading nearly US$35. I was long the stock at the fourth dimension (and remain long). The stock barbarous to $33 inwards early-morning trading post the presentation, but speedily rallied as well as ended the hateful solar daytime up, on a hateful solar daytime where the S&P500 traded down. It was a stunning rebuke of Einhorn's analysis. The stock has since traded upwards to $39.
Einhorn's thesis was that AGO had insured Puerto Rico municipal bonds, which had of late defaulted, as well as the fellowship had only reserved for 20% of its par exposure (about $1bn vs. $5bn of par exposure), yet the bonds were trading inwards the secondary marketplace seat at 25c. AGO was under-reserving its PR exposure, Einhorn argued, as well as when the marketplace seat woke upwards to that fact and/or the fellowship was forced to significantly increment loss reserves, the stock would tank.
The thesis, however, failed to address a fairly obvious point: AGO's mass value is currently $60 per share, as well as the stock was trading at precisely $35 - a $25 discount. The fellowship has 112m shares outstanding. $25 x 112m shares outstanding = $2.8bn, as well as these losses would live tax-deductible, so grossed upwards for 25% tax, that equals $3.7bn inwards pre-tax losses. In other words, the marketplace seat had already taken an additional $3.7bn pre-tax 'reserve' inwards excess of what was on AGO's books. Add that to its existing reserves of nearly $1.0bn as well as y'all acquire $4.7bn - i.e. roughly inwards line amongst the company's total PR par exposure. The marketplace seat was already pricing inwards the worst instance scenario as well as was already good aware of the peril of farther PR reserving, as well as Einhorn didn't enjoin the marketplace seat anything it didn't already know - hence why the stock reacted amongst nonchalance.
Furthermore, in that location were already clear signs that the PR economic scheme was starting to dramatically outperform expectations (and PR bonds receive got rallied real significantly since Einhorn's presentation). PR's economic scheme was hitting hard yesteryear Hurricane Maria inwards 2017, but insurance as well as federal authorities reconstruction funds are at nowadays starting to flow, boosting reconstruction activity. I am from NZ, as well as I tin shout back NZ's economic scheme booming inwards the years next the Christchurch earthquake, which destroyed many homes as well as necessitated a reconstruction boom. Both of these factors - the markets assuming the worst (PR was all over the media as well as people were universally negative), as well as the potentially overlooked stimulus reconstruction activity was going to generate, coupled amongst AGO's long rail tape as well as character management (the fellowship was 1 of the few bond insurers to hold upwards as well as thrive during as well as inwards the aftermath of the global fiscal crisis), were the reasons I was long.
Furthermore, AGO has a huge amount of liquidity as well as cannot live accelerated on its PR guarantees. Instead, involvement as well as principal would receive got to live paid out slow over 20-30 years. Consequently, 'event risk' was negligible, rendering a brusque seat that much to a greater extent than hard to justify (a brusque that plays out over many years is commonly every bit good costly - inwards terms of the cost of borrow - to carry). Einhorn appears to receive got missed the wood for the trees here, having been completely caught upwards inwards accounting arcania, as well as having failed to properly consider what was already priced in.
No broken thesis rule
A lastly gripe I receive got amongst Einhorn's approach is his famed 'no broken thesis' rule. This policy insists that each investment seat receive got a clearly articulated rationale (e.g. for AGO, it volition live forced to upwards its PR reserves, which should cut down the portion price). If that rationale ceases to live applicable, the seat demand live unopen immediately. The dominion is designed to forbid 'thesis drift', where novel reasons are invented to justify holding a seat when the old ones receive got ceased to apply. It is seen every bit synonymous amongst a disciplined investment process.
The occupation is this: Like whatever flawed methodology inwards stock markets, it is a dominion that pays no brain to price. Steve Johnson of Forager Funds has said that a clear score of a flawed investment thesis is that it makes no reference to cost (and hence the same declaration could live made at twice the electrical flow price; e.g. contestation that Sydney belongings is a purchase 'because of population growth; express land; as well as negative gearing taxation benefits', without whatever reference made to price). I couldn't concur motion as well as believe that to live an fantabulous way of putting it.
The occupation amongst the no broken thesis dominion is that it requires the seat live sold regardless of price if the master rationale for holding the stock no longer applies. The approach is problematic because the marketplace seat nearly e'er overreacts to nigh term events - if word comes out that suggests the stock is likely worth 10% less than previously thought, the stock volition invariably really reject 20-30%. It is a recipe for selling out of many positions at extremely disadvantageous times as well as prices. Personally, I've made a fortune off broken theses stocks inwards the past, every bit portion prices react disproportionately to negative developments, allowing me to average downwards at unusually attractive prices. In markets, in that location is no such thing every bit a mechanical dominion which e'er industrial plant - judgment as well as rationality inwards each private province of affairs are what matter.
In short, Einhorn has also demonstrated misfortunate sentence on several occasions amongst many of his positions (both long as well as short, but especially short), as well as this has combined amongst bad luck (market environment) as well as the inherent dangers of brusque selling to create genuinely atrocious outcomes.
Conclusion
All told, it's a much less exciting read than the WSJ, but I believe these to live the existent reasons for Einhorn's spectacular autumn from grace.
Will Einhorn live back? Quite possibly. Einhorn is still, without doubt, a significantly above-average investor inwards my perception, despite the to a higher identify failings, as well as I believe it is quite probable his functioning volition rebound nicely at some dot - provided his shorts don't set him out of occupation organization earlier then.
What Einhorn should practise is begin a long only fund. If he does, I would non live surprised to run into it perform reasonably good over time. On the long side, Einhorn's functioning has also been mediocre of belatedly but non disastrous. I concur amongst several of his longs (I also ain General Motors as well as Aircap), but yesteryear no agency all. I've been unenthused yesteryear physical golden for some fourth dimension (see my recent weblog entry on gold), which Einhorn has owned a sizable seat inwards for many years. I was also initially unimpressed amongst his Brighthouse Financial choice (which I blogged nearly early on this year), every bit the assumptions underpinning the company's valuation of its liabilities appeared aggressive to me. The stock was trading at $65 at the time. It has since declined to $40-45, as well as I've changed my melody at this much reduced valuation, as well as receive got started to accumulate inwards the depression $40s. Einhorn's long-side tape is far from unblemished, but overall I believe him to live a decent long-style value investor.
It is the shorts that receive got done him in, where some of import mistakes receive got disproportionately cost him. If tech all of a abrupt crashes, his existing long/short fund mightiness also phase a dramatic turnaround, but many of the losses he has already taken on his shorts volition probable nevertheless evidence permanent. Time volition tell, but Einhorn's experiences inwards recent years are nevertheless a worthwhile cautionary tale.
LT3000
*The 2 are inversely equivalent, geometrically. A 50% reject from $100 to $50 requires a 100% gain to acquire dorsum to $100; as well as a 100% gain from $100 to $200 requires a 50% reject to acquire dorsum to $100.
**To live clear, this does non hateful I believe Netflix as well as Amazon to live attractive longs at introduce (indeed, I tin envisage scenarios where Netflix could implode, as well as although Amazon appears invincible today, it volition probable eventually live broken up, as well as its valuation is currently at nose-bleed levels). It agency that I believe them to live unsafe shorts - a belief I receive got held for many years.
The WSJ article attempted to sketch a narrative of a quondam high-flyer felled yesteryear hubris as well as decadence, drawing attending to the famed value investor's penchant for afternoon naps; high-stakes poker tournaments; as well as the occasional glamorous all-nighter on the town, but I'm non convinced. I believe Einhorn has really been felled yesteryear much to a greater extent than prosaic factors - a combination of errors of judgement; the inherent dangers of brusque selling; as well as bad luck. The instant factor, inwards conjunction amongst the third, has resulted inwards misfortunate investment outcomes disproportionate to the failings of the starting fourth dimension factor, as well as they combine to enjoin a worthwhile cautionary tale (for those fond of learning vicariously).
So what went wrong?
I am non a fan of brusque selling, as well as although the mandate of the fund I run allows it, I conduct hold no naked brusque positions. The occupation I receive got amongst shorting is non a shortage of overvalued stocks, but the fact that in that location are every bit good many ways to lose a important amount of coin shorting even if you are ultimately correct on the fundamentals & valuation (which is hard plenty to acquire correct inwards as well as of itself).
Many hedge funds similar to emphasise their depression 'net exposure' to the marketplace seat (for instance, Einhorn is nearly 95% long as well as nearly 75% short, for a internet marketplace seat exposure of only 20%). However, this depression 'net' exposure radically understates the flat of peril involved for the fund's investors, because inwards for sure marketplace seat environments, it is only possible to lose on both your longs as well as your shorts at the same time. In Einhorn's case, the reality is that the fund really has gross active exposure of 170%, as well as so is thus to a greater extent than akin to a fund leveraged 1.7x, which volition magnify errors of sentence (or simply inopportune macro/style/factor positioning) profoundly.
The putative risk-reduction benefits of long-short positioning implicitly remainder on the supposition that stocks across sectors/factors/styles volition remain positively correlated at all times, but nosotros receive got seen both inwards yesteryear marketplace seat environments (notably the dot.com bubble), every bit good every bit inwards recent years, that it is only possible for whole segments of the marketplace seat to give-up the ghost downwards (especially value/cheap segments) spell other segments of the marketplace seat give-up the ghost upwards (especially growthy/hyped/bubbly sectors). If you're running a long/short mass amongst 170% gross exposure amongst important sectoral mismatches where correlations turn inverse, you're going to acquire yourself into a lot of problem quickly.
Furthermore, the potential emergence of this type of marketplace seat environs should non receive got been hard to envisage. As I've discussed inwards yesteryear weblog entries, the structural nature of value stocks is that the most probable upshot over the medium term is that the stocks volition maintain to give-up the ghost down/underperform, spell the most probable upshot for hyped growth stocks is that they maintain to give-up the ghost up/outperform. This is why value stocks give-up the ghost inexpensive inwards the starting fourth dimension identify as well as defy the dictates of marketplace seat efficiency, because the anomaly is hard for institutional investors to practically exploit.
The outperformance of value vs. growth over fourth dimension typically comes inwards small, concentrated doses, where real needlelike reversals hap (such every bit during 2000-02, when value stocks surged spell the NASDAQ plummeted almost 80%). Many of the best performing long-only value managers amongst the best long term rail records receive got spent important periods of fourth dimension underperforming the index. Consequently, a long value, brusque growth mass is almost for sure to drive y'all tremendous hurting from fourth dimension to fourth dimension (and especially belatedly cycle), as well as Einhorn should receive got anticipated this when formulating his strategy. Even if it worked a lot of the time, in that location were going to live occasional periods where the strategy was at serious peril of blowing upwards his fund.
Furthermore, shorting actively forgoes some of the most of import contributors to the long term success of a well-implemented, long term value strategy: the ability to wait, as well as at select times, average down. If I purchase a 2% long seat inwards a value stock (at say $100), as well as it later falls 50%, I tin maintain to conduct hold as well as wait. While I am 'wrong' as well as the stock is falling, the seat size is shrinking, so the seat becomes a steadily smaller portion of the overall portfolio, as well as hence the pressure level to sell recedes, rather than increases. I tin wait. Furthermore, I receive got the powerfulness to average down. If I invest a farther 2% of the portfolio after the stock has fallen 50% (at say $50), I at nowadays receive got a 3% seat (4% yesteryear cost) at an average cost of precisely $66.67. If the stock rallies dorsum to precisely $100 - my master entry - I at nowadays receive got a 50% profit, equal to 2% of the overall fund.
The dynamics of shorting are fundamentally different. If I set a 2% brusque seat on a stock at $100, which I think is worth only $50, as well as the stock doubles on me to $200,* then I at nowadays receive got a 4% portfolio brusque seat (not a 1% position, every bit inwards the instance of the long). My seat size has doubled rather than halved. This is a serious problem, because dissimilar amongst the long position, I cannot slumber comfortably as well as wait, because peril management considerations volition at some dot forcefulness me into covering, converting what would otherwise live a temporary newspaper loss (assuming my thesis is ultimately vindicated) into a permanent loss of capital.
Furthermore, I cannot meaningfully average downwards (or perhaps I should say, 'average up'). If I were to set some other 2% portfolio brusque on at $200, I would at nowadays receive got a 6% brusque seat at an average cost of $133.33. A farther doubling inwards the portion cost would bring this to a 12% brusque seat (vs. a farther 50% autumn reducing my long seat from 3.0% to 1.5%). Risk management considerations would preclude such an action, as well as create an unacceptable peril of a total blow up.
To succeed every bit a value investor, it is absolutely essential that y'all are investing from a seat of strength non weakness, as well as receive got the powerfulness to 'stay the course' when markets motion against you, but the peril of beingness a forced buyer every bit a brusque seller is real real. The to a higher identify dynamics receive got probable been a important contributor to Einhorn's horrific recent returns. Notable is that Einhorn covered his disastrous Netflix brusque only during early-mid 2018, as well as has doubtless had to cut down his other 'bubble basket' shorts inwards recent times every bit well, every bit they threatened to barbarous the fund.
This sense betrays a structural occupation of a long/short fund focused on valuation. If you're long inexpensive stocks but receive got no shorts, y'all volition underperform for a spell as well as it volition live painful, but you'll probable alive to acquire by some other hateful solar daytime as well as volition eventually brand dorsum all of your underperformance (and more) when the cycle turns. However, if you're long those stocks, which are going down, spell also beingness brusque expensive stocks which are going up, amongst gross leverage of 1.7x, the affect on your returns tin live ruinous and permanent - even if y'all ultimately halt upwards beingness right.
Einhorn appears to receive got overlooked this risk, but has been punished disproportionately for this oversight on occupation organization human relationship of bad luck. During the post-GFC upcycle, as well as especially during the lastly 3-4 years or so, U.S. markets receive got witnessed tape outperformance of growth over value. Einhorn noted inwards his recent alphabetic character that value's underperformance of growth is currently inwards the 1st percentile of historical experience! By definition, the adventure of something this extreme happening was thus only 1 inwards a 100!
Some of this departure has been due to belatedly cycle excesses, but some of it has also been fundamentally justified. The yesteryear decade has witnessed a tape flat of 'disruption' (or perceived disruption) of traditional industries at the hands of Amazon, Netflix, Tesla (perceived), as well as numerous other technology/software/online businesses, including both listed as well as VC-funded 'Unicorns'. Many of these companies receive got raised tape amounts of funding, which is beingness used to run fast-growing, but loss-making businesses that receive got been taking marketplace seat portion off incumbents.
In to a greater extent than traditional funding markets, they would non receive got been able to practise this to the flat they receive got for the duration they receive got (as the lack of earnings would receive got deprived them of the working capital alphabetic character needed to acquire economies of scale), but real permissible tech funding markets receive got reduced entry barriers to an unprecedented flat as well as allowed them to plough billions of dollars of losses into rapid growth (aided yesteryear the fact that rising tech valuations receive got meant tech investors receive got non felt the burden of such operating losses).
'Value' stocks - companies amongst actual earnings as well as cash flows - receive got been on the receiving halt of the growth as well as disruption wrought yesteryear these businesses (e.g. traditional retail as well as media). Some of them receive got indeed seen their revenues as well as earnings reject (especially for sure traditional retailers as well as PayTV companies - especially satellite providers), so disruption fears hither are real much real, spell others (e.g. traditional auto) receive got continued to post tape earnings, as well as fears of disruption receive got so far proven simply hypothetical. Multiples receive got nevertheless fallen precipitously across these industries. General Motors is a clear illustration - the fellowship keeps producing tape profits as well as cash flows, but the stock continues to languish on disruption fears, spell loss-making 'disruptor' as well as marketplace seat darling Tesla continues to scale novel heights (until of late at least). Einhorn's long GM brusque Telsa positioning has thus wound him badly, fifty-fifty though he volition likely ultimately live right.
This has made the investing environs especially hard for Einhorn's style. However, spell the failure to anticipate the flat to which the cycle would play out inwards this management tin live somewhat excused, Einhorn has compounded the harm amongst unforced errors yesteryear shorting scalable, potentially category-killing, as well as good run-businesses similar Netflix as well as Amazon using inappropriate valuation metrics. As I discussed inwards my recent Spotify weblog post, using nigh term earnings multiples was a wholly inappropriate way to aspect at these businesses. I am non criticising his determination to avoid them on the long side (I receive got avoided them also, although I receive got been tempted to purchase Amazon all the way from $250, but receive got of late ceased to give-up the ghost tempted), but shorting them was a demonstration of a profound lack of imagination as well as appreciation for some of the fat-tail upside risks to these stocks, and fatty tail peril matters tremendously when shorting.**
Assured Guaranty
More generally, Einhorn's sense amongst his Amazon as well as Netflix shorts highlight a to a greater extent than systemic occupation amongst Einhorn's approach where he oftentimes appears to acquire overly caught upwards inwards the details (particularly accounting arcania), as well as oftentimes misses the big picture. Einhorn is undeniably an incredibly smart investor, but in markets, it is meliorate to live wise than smart, as well as for a really smart guy, Einhorn seems to recurrently practise some pretty dumb things.
An illustration is his brusque thesis for bond insurer Assured Guaranty (AGO US), which he presented at this year's Sohn Conference when the stock was trading nearly US$35. I was long the stock at the fourth dimension (and remain long). The stock barbarous to $33 inwards early-morning trading post the presentation, but speedily rallied as well as ended the hateful solar daytime up, on a hateful solar daytime where the S&P500 traded down. It was a stunning rebuke of Einhorn's analysis. The stock has since traded upwards to $39.
Einhorn's thesis was that AGO had insured Puerto Rico municipal bonds, which had of late defaulted, as well as the fellowship had only reserved for 20% of its par exposure (about $1bn vs. $5bn of par exposure), yet the bonds were trading inwards the secondary marketplace seat at 25c. AGO was under-reserving its PR exposure, Einhorn argued, as well as when the marketplace seat woke upwards to that fact and/or the fellowship was forced to significantly increment loss reserves, the stock would tank.
The thesis, however, failed to address a fairly obvious point: AGO's mass value is currently $60 per share, as well as the stock was trading at precisely $35 - a $25 discount. The fellowship has 112m shares outstanding. $25 x 112m shares outstanding = $2.8bn, as well as these losses would live tax-deductible, so grossed upwards for 25% tax, that equals $3.7bn inwards pre-tax losses. In other words, the marketplace seat had already taken an additional $3.7bn pre-tax 'reserve' inwards excess of what was on AGO's books. Add that to its existing reserves of nearly $1.0bn as well as y'all acquire $4.7bn - i.e. roughly inwards line amongst the company's total PR par exposure. The marketplace seat was already pricing inwards the worst instance scenario as well as was already good aware of the peril of farther PR reserving, as well as Einhorn didn't enjoin the marketplace seat anything it didn't already know - hence why the stock reacted amongst nonchalance.
Furthermore, in that location were already clear signs that the PR economic scheme was starting to dramatically outperform expectations (and PR bonds receive got rallied real significantly since Einhorn's presentation). PR's economic scheme was hitting hard yesteryear Hurricane Maria inwards 2017, but insurance as well as federal authorities reconstruction funds are at nowadays starting to flow, boosting reconstruction activity. I am from NZ, as well as I tin shout back NZ's economic scheme booming inwards the years next the Christchurch earthquake, which destroyed many homes as well as necessitated a reconstruction boom. Both of these factors - the markets assuming the worst (PR was all over the media as well as people were universally negative), as well as the potentially overlooked stimulus reconstruction activity was going to generate, coupled amongst AGO's long rail tape as well as character management (the fellowship was 1 of the few bond insurers to hold upwards as well as thrive during as well as inwards the aftermath of the global fiscal crisis), were the reasons I was long.
Furthermore, AGO has a huge amount of liquidity as well as cannot live accelerated on its PR guarantees. Instead, involvement as well as principal would receive got to live paid out slow over 20-30 years. Consequently, 'event risk' was negligible, rendering a brusque seat that much to a greater extent than hard to justify (a brusque that plays out over many years is commonly every bit good costly - inwards terms of the cost of borrow - to carry). Einhorn appears to receive got missed the wood for the trees here, having been completely caught upwards inwards accounting arcania, as well as having failed to properly consider what was already priced in.
No broken thesis rule
A lastly gripe I receive got amongst Einhorn's approach is his famed 'no broken thesis' rule. This policy insists that each investment seat receive got a clearly articulated rationale (e.g. for AGO, it volition live forced to upwards its PR reserves, which should cut down the portion price). If that rationale ceases to live applicable, the seat demand live unopen immediately. The dominion is designed to forbid 'thesis drift', where novel reasons are invented to justify holding a seat when the old ones receive got ceased to apply. It is seen every bit synonymous amongst a disciplined investment process.
The occupation is this: Like whatever flawed methodology inwards stock markets, it is a dominion that pays no brain to price. Steve Johnson of Forager Funds has said that a clear score of a flawed investment thesis is that it makes no reference to cost (and hence the same declaration could live made at twice the electrical flow price; e.g. contestation that Sydney belongings is a purchase 'because of population growth; express land; as well as negative gearing taxation benefits', without whatever reference made to price). I couldn't concur motion as well as believe that to live an fantabulous way of putting it.
The occupation amongst the no broken thesis dominion is that it requires the seat live sold regardless of price if the master rationale for holding the stock no longer applies. The approach is problematic because the marketplace seat nearly e'er overreacts to nigh term events - if word comes out that suggests the stock is likely worth 10% less than previously thought, the stock volition invariably really reject 20-30%. It is a recipe for selling out of many positions at extremely disadvantageous times as well as prices. Personally, I've made a fortune off broken theses stocks inwards the past, every bit portion prices react disproportionately to negative developments, allowing me to average downwards at unusually attractive prices. In markets, in that location is no such thing every bit a mechanical dominion which e'er industrial plant - judgment as well as rationality inwards each private province of affairs are what matter.
In short, Einhorn has also demonstrated misfortunate sentence on several occasions amongst many of his positions (both long as well as short, but especially short), as well as this has combined amongst bad luck (market environment) as well as the inherent dangers of brusque selling to create genuinely atrocious outcomes.
Conclusion
All told, it's a much less exciting read than the WSJ, but I believe these to live the existent reasons for Einhorn's spectacular autumn from grace.
Will Einhorn live back? Quite possibly. Einhorn is still, without doubt, a significantly above-average investor inwards my perception, despite the to a higher identify failings, as well as I believe it is quite probable his functioning volition rebound nicely at some dot - provided his shorts don't set him out of occupation organization earlier then.
What Einhorn should practise is begin a long only fund. If he does, I would non live surprised to run into it perform reasonably good over time. On the long side, Einhorn's functioning has also been mediocre of belatedly but non disastrous. I concur amongst several of his longs (I also ain General Motors as well as Aircap), but yesteryear no agency all. I've been unenthused yesteryear physical golden for some fourth dimension (see my recent weblog entry on gold), which Einhorn has owned a sizable seat inwards for many years. I was also initially unimpressed amongst his Brighthouse Financial choice (which I blogged nearly early on this year), every bit the assumptions underpinning the company's valuation of its liabilities appeared aggressive to me. The stock was trading at $65 at the time. It has since declined to $40-45, as well as I've changed my melody at this much reduced valuation, as well as receive got started to accumulate inwards the depression $40s. Einhorn's long-side tape is far from unblemished, but overall I believe him to live a decent long-style value investor.
It is the shorts that receive got done him in, where some of import mistakes receive got disproportionately cost him. If tech all of a abrupt crashes, his existing long/short fund mightiness also phase a dramatic turnaround, but many of the losses he has already taken on his shorts volition probable nevertheless evidence permanent. Time volition tell, but Einhorn's experiences inwards recent years are nevertheless a worthwhile cautionary tale.
LT3000
*The 2 are inversely equivalent, geometrically. A 50% reject from $100 to $50 requires a 100% gain to acquire dorsum to $100; as well as a 100% gain from $100 to $200 requires a 50% reject to acquire dorsum to $100.
**To live clear, this does non hateful I believe Netflix as well as Amazon to live attractive longs at introduce (indeed, I tin envisage scenarios where Netflix could implode, as well as although Amazon appears invincible today, it volition probable eventually live broken up, as well as its valuation is currently at nose-bleed levels). It agency that I believe them to live unsafe shorts - a belief I receive got held for many years.