David Einhorn grew up in Milwaukee and graduated from Cornell. He learned the hedge fund business from Gary Siegler and Peter Collery, who managed the SC Fundamental Value Fund. He learned to answer three basic concepts before investing in a company: how competitive the business is, how the company performs relative to competitors, and whether the management’s interests are aligned with shareholders.
“We start by asking why a security is likely to be misvalued in the market. Once we have a theory, we analyze the security to determine if it is, in fact, cheap or overvalued. In order to invest, we need to understand why the opportunity exists and believe we have a sizable analytical edge over the person on the other side of the trade.
… We accept more industry risk, but assemble a portfolio where we believe our longs are ones and twos and our shorts are nines and tens. We do not short to hedge. If we are uncomfortable with the risk in a position, we simply reduce or eliminate it. By having a portfolio of worthwhile longs and worthwhile shorts, we achieve a partial market hedge without having to spend capital on negative – expected – return propositions.”
Like Bill Ackman, Einhorn doesn’t shy away from having a concentrated portfolio in his fund. A single long idea can have up to 20% weight in the portfolio. The top five positions usually are 30 to 60 percent of the portfolio. The reason is pretty simple. The stocks he picks have the best prospects and there aren’t a lot of them. Investing in 8 to 10 stocks that are in different industries usually give a fund enough diversification. So, it’s not really necessary to have dozens of stocks in a portfolio. Einhorn gives a lot of examples on how he made money investing conservatively. In one very interesting example, he criticizes Jim Chanos without mentioning his name:
“America Online traded at a high multiple of what many short – sellers believed to be low – quality earnings. America Online spent heavily on marketing or “ customer acquisition costs ” to generate monthly fee – paying subscribers. Short – sellers believed America Online inflated its income statement by capitalizing these costs and writing them off over the expected life of the subscriber relationship. America Online ’ s accounting did not comply with GAAP, which required the costs to be expensed as incurred. I evaluated shorting America Online and determined that even if the accounting were wrong, it was a lousy short because the true economics of the business were incredibly compelling. The stock was inexpensive considering the company ’ s economic profits. I calculated the net present value of a subscriber by comparing the up – front cash customer acquisition costs to the subscription payments over the expected life of the customer relationship. America Online was adding so many new customers that it would not take long to justify its seemingly lofty stock price. Add in the possibility of new revenue streams, including advertising, and I saw it was a really bad short idea. Perhaps this is what “ value investor ” Bill Miller saw that convinced him to step out of the box and take a large long position. I did not have the guts to buy America Online, but contented myself by not shorting it and arguing with those who did.”
Greenlight Capital didn’t have a spectacular 2010, achieving only a 6.9% return after fees through the first 9 months. However, David Einhorn achieved an average annual return of 21% since 1996, beating the market by a huge margin. Considering his net exposure is usually less than 100%, this accomplishment looks even better. Insider Monkey, your source for free insider trading data, likes David Einhorn a lot and he’s one of the “insiders” we occasionally monkey. Earlier this year we imitated Einhorn and bought Vodafone (VOD) shares. The position returned 27% in less than a year. If you want to learn more about David Einhorn’s investment style, we strongly urge you to read Fooling Some of the People All of the Time.