Fooling Some People All Of The Time by David Einhorn is an interesting read into one of the most famous and well known shorts in recent history. It certainly is a lucid account of the sometimes dramatic events. As a financial tutorial, it does not provide anywhere near the level of detail, or examples that a book such as One Up On Wall St, or the Intelligent Investor provides. Nonetheless there are some interesting takeaways from the book that are not normally found in other financial books.
I believe one of the best pieces of investing advice Einhorn provides is that a bad company may not be a good short. There are numerous reasons for this. The company you are shorting is doing everything they can to prove you wrong and can even resort to improper means to do so. The general market trend is positive so even if a company lags behind you could still lose money. A profitable short can often be one performing illicit activities; but these are inherently opaque and difficult to detect at times.
Although he did not touch on it as much, I am also a firm believer that a short can not depend upon valuation compression because valuation is inherently subjective and can be subject to bias induced by others. I think Einhorn made great points in saying that a great short can often be one with illicit activity or aggressive accounting fundamentals. These situations can be very difficult to find meaning they are not priced into the market. Additionally, they represent a total change in the nature of the business when revealed. Shorts of deteriorating businesses can work out; but they lack the catalyst that has made Einhorn's shorts do so well.
Einhorn's dogged persistence with Allied can show the importance of carefully reading financial statements. What can appear to be boilerplate can be extremely revealing. The prime example in the book came when Einhorn realized that Allied had changed 1 sentence in a year's 10K; namely, the sentence indicating that independent auditors agreed with Allied results was deleted. This is a huge read flag but is very easy to gloss over. Distinct changes or omissions from year to year can be very telling. Often management can try and slip in important things in areas where you least expect them to.
Along these same lines, reading financial statements requires a healthy amount of criticism. At first glance Allied's numbers appeared quite healthy. However, this was far from the case as one dug deeper. Not only did Allied use very aggressive accounting standards but it implemented shady executive compensation packages, improperly labeled the delinquencies on its loans, shifted resources back and forth between subsidiaries to fudge numbers, used improper valuation fundamentals for its assets, and changed the key figures that it reported constantly to illustrate the health of the company. In addition management avoided critical questions during Q&A sessions and were constantly spinning.
The story provides a great example of why one must do their own individual research to get an opinion on a company. Einhorn was not only smarter than analysts at bulge bracket banks, but put in more time and more original analysis than any of them. His figures were relatively speaking the most objective view of the company. Yet these analysts were quick to ignore him in their own write-ups and regurgitating the company line. This is definitely an extreme example. But at the end of the day, bulge bracket banks generate money through commissions generated through their reports and not from proprietary trading. There is an inherent conflict of interest that creates a bias. And even if the analyst does not have a bias and is insightful, they can be wrong. Avoiding these reports will allow you to independently analyze the company.
Another interesting personal philosophy of Einhorn is his preference for industry independent long short investing versus a market/industry neutral long short investing. Going long the strongest companies and shorting the weakest ones market wide will inherently generate a higher expected return than going long the strongest company and short the weakest company in an industry. Additionally, Einhorn's strategy allows you to invest in companies with no direct competitors such as Google. Pursuing the industry neutral policy can force you to invest in companies whose expected return is positive because of the strength of the industry. While the industry neutral policy may allow for slightly lower volatility, Einhorn's strategy should generate larger absolute returns.