David Einhorn: The Irony of It All

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.

Comments

[pochovilla:]

Transparency, eh? Possibly not in our lifetime. What makes a good analyst is the ability to dig beyond the annual report, 10k and public information and reconstruct the "quality" of the balance sheet. That's were winners and losers are. It's a great deal of homework combined with experience, knowledge and staying power to be best in class.
Too much financial guidance today results from drawing conclusion by connecting two dots (gimme a chart) and declaring victory, not to mention massive conflicts of interest and lack of independent thinking. Just look at the majority of Seeking Alpha "scribings" or for that matter most "journalistic" efforts. The state of journalism is on par with GWB's Presidential ratings.
Good article. Remember "pioneers" are the guys who get arrows in their back, but they are the true leaders.
Aren't attorneys just wonderful?

2008 Jun 29 07:08 AM

[wallawallab...:]

Shorts are responsible for damaging companies important to the country's economy. They have colluded in an orchestrated effort to defame CEO's, products, and services to drive stocks down. They have hired bashers to pollute and render useless message boards, such as the Apple board on Yahoo. These bashers lie and deceive in an effort to scare retail investors out of their stocks. They increase volatility and create unrealistically low and damaging valuations based on, say, unsubstantiated health rumors regarding Steve Jobs, etc. Meantime, the SEC does absolutely nothing about the material misrepresentations being hurled by these sociopaths and their hired goons. I fully expect organized guff for posting this, but I'm beyond caring what the bashers say. They can screw off.

2008 Jun 29 07:08 AM

[Gollum:]

Einhorn is willing to penalize companies for violating securities laws so that investors will have an incentive to demand honest management and avoid investing in dishonest companies.

I think a heavy financial penalty on the executive officer who authorized the illegal behavior would punish the real wrongdoers and change behavior.

2008 Jun 29 07:45 AM

[Yodaorange:]

"Yet many of Einhorn's warnings have proved prescient" is correct." He was correct about the problems at the Detroit office of Business Loan Express (BLX). However, he was 100% wrong that ALD was systematically over valuing its holdings. During Einhorn's holding period, ALD sold many of their holding. Many if not all, were sold for more that what ALD carried them on their books at.

Also, there was no mention of the ALD dividends that Einhorn has paid out on his short position. From Q1 2002 through today, the cumulative dividend paid out is $15.38. So Einhorn has net lost money on ALD.

I have no position in ALD.

2008 Jun 29 10:48 AM

[chagrinned1:]

This is complete horsepucky!! Einhorn shorted Ald and has spent all the time since he took this position bad mouthing the company with the help of dorks who publish his analysis. If all who shorted stocks spent their career trashing the companies and had media assistance(as with ol' Herb Greenberg of CNBC(a Marketwatch flunkie), there would be NO RISK in shorting securities. And, yes, I also have shorted securities and licked my wounds, thought I was correct in the first place and then I MOVED ON!! Einhorn is not satisfied with moving on even though he has made big $$ I assure you. This San Fran cheap trick never moves on and you need to beware of that type. I am sure most investors have had their fill of Einhorn and his tirades. His minions say he is a flaming success. If this is how he suceeds, he needs to be banned from Wall Street. Seriously!! This has gone on for 6 years. It is now an Einhorn vendetta...Big C

2008 Jun 29 04:48 PM

[Leonard the...:]

Amazing how much heat you have to take when you point out something that is bad about a company.

People who pump up stocks for good reasons as well as those who put down companies for good reasons are performing an important service.

It's the lazy, less intelligent people who have poorly researched analysis that investors should criticize.

I have found David's work to be well thought out.

2008 Jun 29 09:06 PM

[IPAYMYTAXES:]

Eihnhorn being a big poker player is a known lier , he has to be to be a great poker player. Didn't he get whacked in the middle of a subprime financial company ? Wasn't he insisting what a great company that was as its share price dived to the cellar ? Can you really trust a stock manipulator and a professional lier who bluffs his opponents out their money ?

2008 Jun 29 11:53 PM

[MCHEAL:]

Not sure about all the Mr. Ehnhorn says, am sure, however, that ALD has changed either directly or indirectly because of his output.

2008 Jun 30 04:33 AM

[fxtrader07:]

I don't see any irony here - and honestly, I don't see what the authoractually wants to tell the reader other than praising his buddy David Einhorn.

2008 Jun 30 05:03 AM

[sumguytang'...:]

Einhorn has been shorting ALD for about 6 years.

Any idiot can predict disaster and after it happens gloat with smug satisfaction.

A truly gifted financial analyst will not only predict the price, but when that price will occur. When did Einhorn predict the sub prime debacle which has affected ALD's ability to raise capital?

Einhorn fails this test.

2008 Jun 30 09:00 AM

[Randall Arnold:]

More fawning publicity for Einhorn and his twisted personal vendetta. It's a shame that shorts are still allowed to do so much damage to the US economy.

If ALD is so guilty, then regulators need to do their jobs and handle this through legal channels. So far Einhorn's evidence hasn't held up well in that regard.

2008 Jun 30 11:10 AM

[Bonzo:]

Einhorn talks about the loss of freedom of information, and yet his fund is almost entirely unregulated and doesn't have to diclose anything to anyone. Callers to his company won't be spoken to, much less have any questions answered unless the caller has at least $1 million to invenst. For the counterpoint to Mr. Einhorn's book and this review, read deepcapture.com blog.

2008 Jun 30 12:20 PM

[leviticus1935:]

One helpful move toward transparency would be to force all short sellers to file Form 13F with the SEC disclosing their short positions exceeding an aggregate of $100 million. This would be the mirror image of what money managers are required to do when they disclose their long equity positions exceeding $100 million. This makes total sense and would give market participants much better information about concentrated positions in a stock. However, this rule will never be adopted by the SEC because the hedge funds have too much political influence.

2008 Jun 30 12:56 PM

[paso11:]

Bonzo:

"Einhorn talks about the loss of freedom of information, and yet his fund is almost entirely unregulated and doesn't have to diclose anything to anyone. Callers to his company won't be spoken to, much less have any questions answered unless the caller has at least $1 million to invenst. For the counterpoint to Mr. Einhorn's book and this review, read deepcapture.com blog."

Einhorn has to answer to his investors regarding performance not to you, why should he have to disclose positions to anyone else? His fund is not something that exists for the general public to invest in, they target high net worth individuals so why would they waste time talking to anyone with less?

Allied on the other hand is a publicly traded company and is required to follow GAAP and SEC rules regarding disclosure.

I also find the accusations against him prove the point he makes regarding the bias that exists within Wall st and the financial media.

Furthermore he and other short sellers are not idiots, they dont just pick on any Company unless they suspect accounting fraud, mispreprentations by management, or simply that the stock is overvalued.

There is nothing wrong in bringing these reasons to light as they benefit the investment community in general, i see no diffference between this and the talking heads on Bloomberg who big up certain stocks and explain their reasoning for going long.

2008 Jul 01 05:34 AM

[fxtrader07:]

@raj24: you are a bit naive, to put it mildly. there are -legitimate- short positions utilizing borrowed shares. And there are illegal naked short positions where millions of shares are sold but never borrowed or delivered. talk about selling stuff and never delivering it! Impossible anywhere - except at the world#s premier stock exchanges and capital markets. And possible only because the big IBs run the Clearing coproration and conbtrol the SEC which truned a blind eye towards it. recently, they admitted the problem, though. But said it cannot be fixed because essentially, it is 'too large'! Think about that! The SEC refuses to fix the naked shorting crime because it fears explosions in stock prices for those companies that have been the major victims! Rather let companies die than naked short sellers (hedgefunds, IBs etc) welcome to the rigged reality of u.s. stock markets.
read the deepcapture.com blog for a contrarian viewpoint.

and, btw: to disclose short positions similar to the disclosure requirements for long positions is so legitimate and obvious, it should make you think why this hasn't been implemented?

2008 Jul 01 06:23 AM

[Bonzo:]

I wasn't going to bother to respond to raj24 since he basically spewed, almost verbatim, the argument that Einhorn, Cramer and Greenberg have all made in Einhorn's defense. However, he is dead wrong on one point that seldom seems to be recognized. If you look at the general media coverage going back over the past couple years, it has been either balanced, telling both sides of the story, or heavily tilted in Einhorn's favor. The idea that the media has been out to get short-sellers or Einhorn is pure fiction.

I agree that short-sellers are a necessary part of the market, but they should play by the same rules everybody else does. ALD makes regular appearances on the Regulation-SHO list for high failures to deliver. This is prime evidence that there is naked (illegal) short-selling in their stock.

As for regulation, all holders of more than 1% of a company's stock are required to file with the SEC. However, one can be short any amount of a company's stock without having to file anything with the SEC. I really don't see any difference between a "private-equity" fund and a mutual fund other than the selection criteria for investors and that mutual funds elect in their charter to not short stock. They should be subject to the same rules.

Einhorn is a poker player. What he wants is to have everyone else play with their hole cards exposed and not have to show his except to collect the pot.

2008 Jul 01 12:38 PM

[Bonzo:]

One further thought. The accusations don't come from the media. They come from the companies that are being attacked and people who follow those companies' stock.

2008 Jul 01 12:45 PM

[User 220692:]

Einhorn's book, though tedious at times and overly long, makes a somewhat scary case against Allied. His attacks are mainly against what certainly appears to be reckless lending from it's subsidiary, BLX.

I've noticed that since the book came out, the share price of ALD has plummeted from about $20 a share to about $13. I don't know how much of this is due to his book -- and short interviews he has given -- but whether he is right or not, the timing of this precipitous decline seems to be more or less directly related to his damning book about ALD.

2008 Jul 02 04:32 AM

[johnhaskell:]

ALD now on the dark side of $13. Was an unlucky share price anyway. Who will buy ALD's next share issuance? They need to issue more shares to pay out their "dividends." Please? Anyone?

2008 Jul 03 02:40 PM

[sk4543:]

If ALD is playing us for fools as Einhorn alleges, they have been doing it for 46 years AND paying huge dividends AND financing,building and selling companies.

Is this is wrong or illegal, please give us more such companies.

ON ALD, Einhorn has lost money and that is not including the time value of money ( A dollar of dividend he paid in 2002 is worth a lot more today)

Most importantly, how many shares did Einhorn short naked. We will find out Monday 7/21/08 when the SEC mandates a written agreement on borrowing shares to short. ( currently you only have to show an intent to borrow, creating LIAR NAKED SHORTS, similar to Liar Loans for homes ( and you know where the no doc loans got us )
The mother of short squeezes, (thankyou SEC) could take ALD back to 30 in a few weeks if the shorts are bare naked.

2008 Jul 17 05:51 PM

[Tulls19:]

LOL I just finished reading Einhorns book and am researching his assumptions. Nothing I've read so far has lead me to believe his is wrong about anything. Most of the people who criticize him don't seem to have read the book. FYI he doesn't criticize ALDs entire existence the way a lot of the people who continue to hold this stock proclaim he only points out is faults going back to the late 1990's. If you have received dividends before and after Einhorn shed light upon the inner workings of this company then the better for you. At this point you are probably holding an unrealized loss and are a little nervous after this Madoff affair to know that you are essentially invested in a legal ponzi scheme. You can always cut your losses now and be thankful for the dividends you have received all of those years. I invested in Bank of America pre-countrywide and pre-Meryll the dividends I received wouldn't cover the cost of John Thains office toilet much less the loss of capital I suffered before selling. I could site the long history of dividends but I won't. Suffice it to say that BAC changed for the worse just as Allied apparently did at some point in its 46 year history. If you want to go on trusting managers who paid themselves so well wile diluting their shareholders than by all means double down. I would point out however that their are plenty of beaten down stocks right now that the last remaining shred of your principal would probably be better invested with at a maintainable dividend.

Jan 26 07:47 AM