The following appeared in the May 30, 2008 edition of Value Investor Insight.
Greenlight Capital's David Einhorn has broken from this tradition with his new book, Fooling Some of the People All of the Time, an account of his ongoing six-year odyssey holding a short position in small-business lender Allied Capital (ALD). In it, Einhorn details a mind-numbing litany of what he considers malfeasance and prevarication by Allied in misrepresenting its performance and making ad hominem attacks on him, but he also pulls no punches in his criticism of regulators, analysts, journalists and other investors, who in almost all cases turned an indifferent or cold eye to the hard evidence he presented to them.
We should point out that we have the highest personal and professional respect for David Einhorn and that funds Whitney Tilson manages have long held a short position in Allied Capital stock, for many of the reasons articulated in Fooling Some of the People All of the Time. But the book's broader lessons go beyond whether Allied is a good short or not, with important implications for investors and the proper functioning of capital markets. The first eye-opener is the intensity and depth of Einhorn's analysis. This is no cursory look at the financials leading to a quick conclusion, but rather a meticulous, exhaustive and proprietary investigation into nearly every aspect of Allied's business. The book provides a unique look at the type of work undertaken by highly successful investors like Einhorn.
In one particularly telling scene, he describes meeting with the lead analyst at a mutual fund firm that owned more than $100 million of Allied’s stock. Minutes into the meeting, it became clear the analyst had read none of Einhorn's widely published work and that his primary reason for holding the stock was because it fit into a “basket approach” to owning high-yielding stocks. Can this possibly be representative of the lack of due diligence sometimes performed by large institutional investors? Sadly, we suspect it is.
Also troubling is the success Allied has had in deflecting Einhorn's claims by casting his motives as “long-running attempts to manipulate the price of Allied Capital's stock to increase the value of Greenlight Capital's short position.” This characterization seems to have hit home with regulators, at least early on. Einhorn describes an uncomfortable grilling by SEC attorneys about his “intentions” when he presented his Allied short thesis at a charity event.
Einhorn rightly wonders whether other speakers at the same event, who shared long ideas, got the same treatment. As he explained: “We are not critical of this company because we are short; we are short because we are critical of this company.” This is not a semantic debate. Well-functioning markets depend on the transparent flow of information, which can be greatly hindered when critics are attacked not for the quality of their analysis, but simply for being skeptics. “The vilification of critics, be they short-sellers, journalists or regulators, chills the free flow of ideas and analysis – indeed, chills free speech – by making it so darn expensive,” writes Einhorn. “If posting an analysis on a Web site or making a speech gets you an SEC investigation, why bother?”
Equally dangerous, says Einhorn, is the thinking currently in vogue among regulators that penalties for violating securities laws should not unduly harm shareholders, considered to be the victims of the wrongdoing in the first place. While this may seem fair, he warns of unintended consequences: “If regulators insulate shareholders from the penalties of investing in corrupt companies, then investors have no incentive to demand honest behavior and worse, no need to avoid investing in dishonest companies.” As an investment, Einhorn's bet against Allied has been no homerun.
Since first shorting Allied at $26.25 in early 2002, the share price has fluctuated between $33 and $18 per share, most recently trading around $19.50. Yet many of Einhorn's warnings have proved prescient, leading to eventual changes in the company's accounting, the shuttering of the local office of a subsidiary after a top officer there was indicted for defrauding the Small Business Administration, and a series of government investigations, many still ongoing. We suspect the final chapters of this story have yet to be written.
One final footnote: The above, only slightly modified, was originally written as a review for one of the most respected and widely read financial publications in the world. Upon legal review, the item was killed, due to concerns over litigation exposure. So much for the free flow of ideas and analysis.