Greenlight Capital is one of the most successful activist funds operating today. Founder David Einhorn described his process, how his team searches for new ideas as assets under management increase, and his views on monetary policy at the fifth annual investment conference on behalf of Make a Difference Wisconsin, a non-profit foundation that teaches financial skills to high school students (Einhorn is a Milwaukee-area native). IPE attended the 2014 conference, which afforded a rare view into the thinking of one of the most innovative – and successful – investors of recent times.
David Einhorn, President, Greenlight Capital
• 1996: Founded, Greenlight Capital
• 1993-95: Investment analyst, Siegler, Collery & Co
• 1991-93: Analyst, Donaldson, Lufkin & Jenrette
Einhorn has led Greenlight to an average return of just under 20% per annum since its inception in 1996. He first gained national stature in 2002 when he outlined problems at Allied Capital that served as the basis for his book Fooling Some of The People All of The Time.
Greenlight’s process is geared to not being fooled. Einhorn says his overall philosophy has not changed since the days when he operated from a few tables and faxed monthly results to investors himself. The anchor is independent qualitative research centred on a critical question: What is it that we think that is different from what other people think?
Despite the speed with which markets react to news that Greenlight is buying or selling a stock, the team looks for opportunities where the investment thesis will take between one and four years to resolve itself, says Einhorn.
Greenlight’s portfolio construction goal is to allocate “[the] most money in our best ideas,” Einhorn says. Half of the firm’s AUM sits in its top five ideas. As assets have grown to more than $10bn, the firm has adapted its opportunity set. “Our job is to figure out how to do a good job with the opportunities [that make sense at a given asset size],” he explains.
The disadvantage of managing a large block of assets is that it takes longer to get into and out of positions and, counter-intuitively, it can be hard to take large enough positions in some companies to have a meaningful impact on performance – because target companies have to be bigger. Early on, for example, Greenlight allocated 15% of assets to a company with an $18m market cap. Within a year, Einhorn says, the company had a market cap of $50m, giving Greenlight a return of nearly 400%. At current size, it’s not feasible to invest in such small companies. “[As assets increase], the bottom set of the opportunity set falls out,” Einhorn says.
That hasn’t kept Greenlight from finding opportunities. In fact, the firm has set its research skills to work on larger companies and major industry turnarounds, the kinds of situations where significant amounts of capital can be deployed. Greenlight took a major short position in Lehman Brothers before its 2008 collapse, and more recently bought Apple as part of a successful push for cash to be returned to shareholders.
At the conference, Einhorn highlighted Micron Technologies, which marks the first time Greenlight has gone long in a company that had previously been a material short position. The opportunity in Micron is a result of a “major misunderstanding” of the company and the DRAM microchip industry, Einhorn says. The company was a bad business in a declining industry for a long time – but that’s changed, he says, and investors haven’t recognised the structural changes.
Many Asian countries wanted to get in on the tech boom any way they could, and manufacturing computer memory was an easy business to enter – especially with government subsidies. The strategy enabled a few companies like Samsung to move up the tech food chain. But, overall, as Greenlight’s Q3 2013 investor letter put it, DRAM was “a lousy industry” in which tough competitors sold “an undifferentiated product, often below cost”. The firm was short Micron from January 2001 to February 2005.
August 2013 marked the end of a decade of consolidation from roughly a dozen major DRAM players down to just three, according to Einhorn’s current thesis. Technological advances and locked-up intellectual property have made new entries unlikely. Micron and its competitors are refraining from adding capacity and, instead, prioritise economic value-add – by using excess cash flow to buy back stock, for example.
Einhorn expects Micron to increase earnings and free cash flow during 2014. Micron was selling at 6.5 times earnings when he discussed the stock at the conference in May. By mid-July, the stock was trading above $33; Greenlight’s average acquisition price has been $16.49.
While well-researched value investments drive a major portion of Greenlight’s performance, Einhorn made headlines when his Q1 2014 investor letter revealed that the firm had shorted a basket of high-flying tech names that it believed had become disconnected from sensible valuations. Greenlight had avoided shorting momentum stocks during 2013, but concluded that a number of signs indicated tech flyers were due for a fall, such as huge first-day IPO pops for “cool kid” companies that “pretended compensation paid in equity isn’t an expense”.
Einhorn described a nuanced approach to shorting to conference attendees. Short positions, he says, provide protection to long positions; and when the market declines, profits from shorts provide fresh cash to invest in high-conviction ideas.
Greenlight Capital: some landmarks from 18 years of activist investing
2002: Allied Capital. Shorted the stock and announced the position in a speech; the following day the stock lost one-fifth of its value. Einhorn accused the firm of defrauding the Small Business Association through its lending practices. Allied Capital responded with accusations of market manipulation, leading to an SEC investigation. Eventually, in 2007, the SEC found that Allied Capital had broken securities law.
2007: Lehman Brothers. Took a short position in July 2007 based on analysis of the bank’s accounting for illiquid real estate investments.
2011: Green Mountain Coffee Roasters. As well as accounting questions, Einhorn doubted the size of the market for the company’s new single-cup coffee brewer, and the patents around the consumables for the machine, taking a short position. Weeks later, the company lost around half its value after earnings missed expectations.
2012: UK FSA. The UK regulator fined Einhorn and Greenlight Capital for insider trading linked to a position in Punch Taverns.
2013: Apple. Filed suit against the tech giant in order to pressure management to issue dividend-paying preferred stock to redistribute cash to shareholders.
Utilising shorts as part of an integrated portfolio management approach helps the firm maintain its concentration on top-five holdings, while also reducing performance volatility that can arise from moving into very high cash positions during periods of market weakness. “I only have to be one-third as good to get the same gain [as a hedge fund that might move to a 40% cash level],” he observes.
On the macro front, Einhorn expressed concern that former Federal Reserve chairman Ben Bernanke has sown the seeds of future inflation, while the Fed’s zero-interest rate policy is stifling the economy by creating a shortage of safe income. Consumers see interest income as a recurring item, Einhorn says, which fuels spending. Einhorn says he’s concerned monetary policy makers have so aggressively created liquidity that they’ve little wiggle room to address future crises. But he’s keeping an open mind that a wider range of policy outcomes could be possible under Fed chair Janet Yellen. “I’m more optimistic about her,” he says.
Einhorn’s key message to conference attendees was: “Do your homework, be very disciplined, and more often than not, things work out.” A key personal metric, he adds, is to avoid repeating errors: “Try to make new mistakes in the future.”
Looking back, he has no regrets. “I’ve been very fortunate,” he says. And it’s been a family affair. Einhorn founded Greenlight with seed capital from his parents, and the name was chosen after his wife “greenlighted” his plan to launch the hedge fund. Eighteen years on, the decision looks to have been a good one.