When David Einhorn speaks, markets listen. Since Einhorn first joined the spotlight with his now famous speech regarding Allied Capital in 2002, Einhorn has been a catalyst for huge declines in the share prices of Lehman Brothers, Green Mountain (GMCR), and Herbalife (HLF). Behind the scenes, Einhorn has done exceptionally well on shorts in US Steel (X), First Solar (FSLR) and Diamond Foods (DMND).
While many high profile fund managers have the ability to move the prices of stocks for a short duration, Einhorn has a unique ability to deliver uncovered information to the marketplace for investors to start discounting into individual equities.
The information Einhorn brings to the marketplace often has to do with classic signs of shady management or accounting practices. Einhorn's best shorts have come from his superior ability and will to dig into a company's financials and various disclosures, and decide if the story makes sense.
The Allied Capital Story
For those who want a nice background on Einhorn, and a fascinating business story, I highly recommend Einhorn's Fooling Some of the People All of the Time.
Allied Capital managed to get itself right in Einhorn's crosshairs after its management said they only wrote down loans when they believed they had permanent impairment of the asset. Einhorn's extensive knowledge of accounting regulations led him to realize that since Allied was formed as a Business Development Company, or BDC, it had to use fair-value accounting, or value the asset to the actual marketable price.
Einhorn and his team of analysts continued to dig, and found several more improprieties. They went so far as to compile a database of all of Allied's outstanding investments, and found a particularly odd valuation on its investment in a company callled Loewen. The firm was in bankruptcy, and had bonds that traded in a fairly liquid market with fair bid-ask spreads. Allied's management claimed that it carried its Loewen bond investment well above market cost, because the bonds weren't trading; this was clearly not true.
At this point, it became clear to Einhorn that at best, the company had exceptionally undisciplined accounting practices and hardly marked anything to market, and at worst, the company had a gigantic pool of overvalued investments and was misleading shareholders.
Though far less complex, Einhorn's recent recommendation to short US Steel has worked out quite well. The thesis is that with poor earnings, weakening iron ore demand from China, and exceptionally high pension costs, US steel is in weak shape and at major risk. He also noted that the company's demographics put it at a major disadvantage, since there are three retirees for every employee.
The US Federal Reserve
Seen here, Einhorn uses some sober analysis to explain that the Fed is suppressing equity prices and economic growth by keeping interest rates at record low levels. The key dynamic that few think of is that by endlessly supporting bond prices, few actually sell bonds and move into equities. Instead, the so-called Bernanke Put is actually in the bond market itself, since prices have been in a multi-decade uptrend.
The short play here, of course, is gold (GLD). Endless printing and negative real interest rates will keep gold prices in a bull market until interest rates reflect economic reality and the Fed keeps balance sheet expansion on the table.
The Actual Method
To find good shorts, Einhorn doesn't search for the most richly valued companies on the planet. He actually advises against this method thanks to an experience he had with Chemdex during the internet bubble.
With the stock richly valued at $26, Greenlight Capital shorted it. Well, the stock got even more richly valued at $164, and finally $243. They were all ridiculous prices and valuations, but nothing stopped investors from finding stupidly high prices to invest at.
Einhorn doesn't even search for companies to short, or even invest in from the long side. Rather,
We start by asking why a security is likely to be misvalued in the market. Once we have a thoery, we analyze the security to determine if it is, in fact, cheap or overvalued." (Page 14, Fooling Some of the People All of the Time)
In other words, Greenlight looks for securities that have underlying dynamics that are difficult to understand, and therefore, are likely to be mispriced by the market. They'll often come across a business where the revenues and growth trends don't match up with the structure or nature of the business. From there, the fund uses its superior knowledge of accounting to find why the story doesn't add up, and this is where the most profitable shorts have come from.
The same was true with Green Mountain; years of excellent earnings growth, but essentially, no free cash flow to show for it. It made no sense, but it made a great short.
As nimble investors, we shouldn't actively search for companies to short; the goal is to find the best risk-adjusted returns, short or long. However, If you can gain extensive knowledge of accounting practices, have a good sense for when top line growth doesn't translate to the bottom line, and have the will to dig through quarterlies, annuals, proxies, and every other filing, then you can gain the "analytical edge" that Einhorn believes Greenlight finds over the marketplace. In this case, you may find a very unique and profitable short opportunity.