Over the weekend, I was reading David Einhorn's book Fooling Some of the People All of the Time. I've had it on my bookshelf for some time, and it has always taken a back seat to other books until I decided to pick it up recently.
It's an entertaining read, basically recounting his short thesis on Allied Capital in great detail. It is a good book because it provides a glimpse into the significant amount of research and due diligence that a great investor like Einhorn performs in his investment approach.
Source: Columbia Business School
Don't Count Einhorn Out
Einhorn - like many well-known value investors - has had a very tough year. But we have not seen the end of Einhorn's run as a top-quality investor.
To borrow an analogy I used in a post last year - just as so many were so quick to write off Tom Brady after an early season loss to Kansas City last year that left the struggling Patriots at 2-2 and looking like a shell of their former dominant selves, I think far too many people are writing off Einhorn (as well as others) who have had a bad year. As I said last year, if the Patriots were a publicly traded equity, the stock would have been beaten down after the Chiefs blowout and it would have been one of those rare opportunities to load up. Lo and behold (and as painful as it is for me to say as a Bills fan), the Pats rattled off a long string of consecutive wins on their way to their 4th Super Bowl title, and continued that winning streak until a surprising upset loss last night to the Denver Broncos (coincidentally led by a young QB who is temporarily replacing another legend that many are also writing off-perhaps prematurely).
Back to the book - there is one chapter where Einhorn describes a meeting he had with a well-known mutual fund manager. To put this meeting in context: Einhorn was in the midst of doing significant due diligence on a company called Allied Capital, a business development company (BDC) that used aggressive accounting practices, questionable reporting of their financial results, and very liberal valuations of the illiquid equity and debt securities that they held for investment. Einhorn had been short the stock for some time, and although it slowly was becoming apparent that Einhorn's thesis was largely correct, the stock hadn't fallen much and continued to trade in the same general range that it had prior to Einhorn's famous speech where he announced his short thesis.
So Einhorn was introduced to this fund manager through his broker, who thought that it would be good for both sides to hear each other's thesis on the stock (Einhorn was short and this mutual fund manager had a large long position).
Einhorn showed up to the meeting fully prepared with a briefcase full of his research, and the mutual fund manager came in with nothing but a notepad and a pen.
As it turned out, this fund manager hadn't even read Einhorn's research - this is despite being long a stock that was very publicly criticized by Einhorn and others who had published significant and detailed research laying out their thesis for everyone to see.
Einhorn couldn't believe that this fund manager owned a large block of stock and not only did he not do his own primary research, but he didn't even read the secondary research that was easily and freely available for him to read regarding the potential problems at Allied.
What's the point here?
I've always thought that there are two main reasons that stocks generally get mispriced:
Large-cap stocks that get mispriced are almost always due to disgust. These stocks are large companies that are widely followed by investors and analysts. There is very little information that is not widely known by all market participants. However, sometimes these large companies run into a temporary problem and investors sell the stock because the outlook for the next next quarter or the next year is poor. Investors can take advantage of this situation by: a) accurately analyzing the situation and determining that the nature of the problem is in fact temporary and fixable, and b) be willing to hold the stock for 2 or 3 years - a timeframe that most individual and institutional investors are not willing to participate in.
Some investors refer to this concept as "time arbitrage". It just means that you're willing to look out further than most investors and willing to deal with near-term volatility and negative (but temporary) short-term business results.
In addition to a company specific "disgust", these large caps can also get beaten down when the general market environment is pessimistic. In bear markets, companies with no problems at all often see their stock prices get beaten down because of macroeconomic worries or general market pessimism.
So although many value investors look at small caps because they feel this is where they can gain an informational advantage, I think taking advantage of this "disgust" factor is just as effective and is an important arrow to have in the quiver.
Often times, the most mispriced stocks in the market are small-cap stocks that are underfollowed and neglected. The obvious advantage here is to locate a situation that no one else has discovered by looking under a lot of rocks and in the nooks and crannies of the market. Sometimes things slip through the cracks. I would also put special situations in this category. Sometimes companies are misunderstood as well-but this is usually because they are neglected to a certain extent. The market has collectively not been willing to put the effort into understanding these situations sufficiently, and this creates potential mispricings.
Einhorn talks a lot about "the guy on the other side of his trade". In other words, each stock trade has a buyer and a seller and both think that they are getting the better deal (or they wouldn't be engaged in the transaction).
I don't really spend a lot of time thinking about this angle, but it is interesting to consider who might be selling you shares that you are buying, and the reasons why. In this case, Einhorn thought he might be selling (shorting) shares to sophisticated institutional investors who disagreed with Einhorn and believed Allied was undervalued.
However, as Einhorn learned, this wasn't the case. The institutional investor was "too lazy or too busy", as Einhorn put it, to put the time and effort into understanding what he owned.
So, I'm not sure which category this type of situation would fall into, or maybe ignorance deserves its own category. But the experience with the mutual fund manager that Einhorn describes is certainly evidence of how sometimes even widely followed stocks get mispriced. If an investor is buying millions of shares for reasons that don't have anything to do with the intrinsic value of the company, then there is the potential for a mispricing to occur.
To Sum It Up
I think most investors intuitively understand that it's occasionally possible to find a bargain in an underfollowed stock, but I think just as often, large caps (or more widely followed) companies get mispriced for these reasons (disgust, ignorance, short-term thinking, or irrational behavior).
Here is the passage of the book I referenced above where Einhorn met the mutual fund manager:
"…so James Lin and I walked over with a briefcase full of our research. We met with Painter and Stewart in the conference room. Stewart brought nothing but a legal pad and pen. "Okay," he said, "go ahead."
I thought this was supposed to be a two-way dialogue. "First, what did you think of our analysis?" I asked him. "Do you see anything wrong with it?" He said he hadn't read it.
While I could believe that Allied's shareholders might generally be too busy to have read the lengthy analysis we put on our website, it was hard to imagine a professional, who was the second largest Allied holder, would come to a meeting with us and acknowledge such lack of preparation.
So I asked him why he held the stock. Stewart said that in the tough market he felt it was a good time to own a lot of high-yielding stocks and his Allied holding was really part of a "basket approach"…
"I left with a new understanding of what we were up against. It wasn't an issue of investors understanding our views and disagreeing. In addition to the small investors, Allied's other investors were big funds managing lots of other people's money-too busy or too lazy to worry about the details, other than the tax distribution."