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David Einhorn: Fooling Some of the People…

April 28th, 2009 · 3 Comments · Uncategorized

I finally had time over the weekend to read something outside of the 1000s of pages of cases that we’re assigned each week.  Fooling Some of the People All of the Time by Greenlight Capital’s founder, David Einhorn, has been sitting in my (growing) pile of unread books collecting dust for a while now.  I think I purchased it based on a recommendation by Paul Kedrosky months ago.

Anyway, it’s a great, easy read — I highly recommend it!  The first half of the book provides an excellent summary of his hedge fund’s philosophy.  (For those who don’t follow this industry — a hedge fund is different from typical mutual funds in that 1) it’s private and 2) has less rules.  This gives the fund much more flexibility — chiefly, allowing it to “sell short”, that is, bet on a stock declining.)

Here’s a classic example: Let’s say that you think Pepsi’s stock price is a great deal.  You weighed your aluminum can the other day and discovered that it’s 25% lighter!  You think the material savings will be huge, and you don’t think anyone else has noticed the change yet.  If you were a mutual fund, you’d buy 10 MM shares of Pepsi stock and hope that it would go up as Pepsi started to realize the cost savings.  But… what happens if the economy goes into a recession and people stop spending money on soda?  Or what if China decides that soda rots your teeth and decides to ban all imports?  In both of these cases — you might be 100% correct about the new cans, but the stock would drop and you’d lose money.

A hedge fund, on the other hand, could buy Pepsi stock and “short” Coke stock.  That is, they would make money if Coke stock falls.  Why would they do that?  Well, it might have nothing whatsoever to do with any expectations they have about Coke… but it would help “hedge” their risk against market and industry uncertanties.  Consider what would happen in the scenario above if you were a hedge fund.  Both stocks would fall 30% based on economic news, but then Pepsi would rise by 10% based on their new cans.  For a hedge fund, the fall in Coke (by 30%) cancels out the fall in Pepsi (by 30%), which leaves them with the 10% gain from the new cans.  A much better outcome than the mutual fund could obtain!

So, back to Einhorn… Einhorn’s approach has less to do with “classic” hedging above, but is more along the lines of acting as a financial detective of sorts.  He (and his staff) spend time studying all sorts of firms looking for fraud and mismanagement.  I think what’s so interesting about this is that there’s a huge profit motive to uncover firms that are lying to the market…  This is a pretty amazing “self-correcting” market mechanism.  When you ask the question: “Why don’t corporations blatantly deceive investors and fabricate their financial statements?”, there are two answers: 1) the SEC and government or 2) market incentives.  This book makes a strong case for #2.

Anyway, that’s enough finance for one post.  I guess I find it particularly interesting because I’ve always viewed finance in a somewhat demeaning light…  after all, shouldn’t these people be making “real things” instead of just “shifting money around”?  The type of role described here (as detective / judge / advocate) makes me feel like there might be more here than just traders bleeding out miniscule value gains from efficiency by trading stocks.

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3 Comments so far ↓

  • Lin

    Interesting blog you got here, but should you really be knocking finance for not doing anything “real” when you’re into consulting?? Hahaha

    By the way, I once attended a lecture by Harry Markopolos, the guy who devoted almost a decade of his life to investigating Bernie Madoff, only to send a very compelling report to the SEC and have it ignored. His main motive for exposing Madoff was to level the playing field. I forget what asset-management firm he was working at but they were losing assets to Madoff. Just another case of free market competition regulating itself (though by no means sufficient for a less regulation argument)

  • rob

    Excellent point…! It would be interesting face-off to place a bunch of consultants vs. finance types and see who could best justify their value. (Although… from the last few VCs I’ve heard speak, it sounds like that sector of private equity is trending back towards (or below) average market returns.)

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