David Einhorn is one of our favorite hedge fund managers. His fund, Greenlight Capital, has returned roughly 20% per year since its inception in 1996. Now, these returns aren’t in the ballpark of Jim Simons circa early nineties, but they’re impressive nonetheless. One of Einhorn’s most redeeming qualities is that he’s open to sharing his top stock picks with investors through keynote speeches and interviews (read our interview with Einhorn).
Interestingly, his most public stock picks – like those made at the annual Ira Sohn and Value Investing Congress conferences – have displayed a tendency to outperform both the market, and most of the other positions in his portfolio.
At the moment, we won’t go as far back as his bearish predictions about Lehman Brothers made in the summer of 2007, but we’ll take a closer look at his picks over the past two years.
In 2010, Einhorn publically challenged Bruce Berkowitz and his Fairholme fund, disclosing a short position in The St. Joe Company (NYSE:JOE), a Florida-based real estate developer. Berkowitz disagreed and upped his stake in the company by a significant amount. In the time since, shares of JOE underperformed the SPDR S&P 500 (NYSEARCA:SPY) by around 40 percentage points.
One year later, Einhorn presented his bullish thesis for Microsoft Corporation (NASDAQ:MSFT) at the Ira Sohn Conference in May; shares of the tech giant have gained about 16% since then (vs. 10.7% gain for the SPY). In the fall of that same year, Einhorn revealed perhaps his most noteworthy short position: Green Mountain Coffee Roasters Inc. (NASDAQ:GMCR). The stock has lost nearly 60% of its value since his disclosure. At the end of the third quarter Apple Inc. (NASDAQ:AAPL) and Seagate Technology PLC (NASDAQ:STX) are the two largest positions in Greenlight Capital’s 13F portfolio. Einhorn also made some bullish comments about Apple at the 2012 Ira Sohn Conference but the stock lost about 5% since then.
Taking these past successes into consideration, we can see that David Einhorn is a particularly skilled investor whose predictive capabilities outweigh those of most of his peers. This advantage allows him to generate alpha, both on the short side and the long side of his portfolio. Thus, it’s safe to say that Einhorn deserves the above-average hedge fund fees that have helped him to become a billionaire.
So far we’ve presented anecdotal evidence of this, but Greenlight Capital’s 13F filings since 1999 allow us to delve into the details a bit more. We can statistically analyze Einhorn’s long positions to estimate just how much alpha he’s generated on the long side, and whether it makes sense to imitate his stock picks.
David Einhorn’s Huge Secret Is Revealed Through 13F Disclosures
Imitating 13F filings, which most hedge fund managers file with the SEC on a quarterly basis, has some advantages and disadvantages. Unfortunately, these filings disclose holdings at only one point in time, there is a 45-day delay, and we don’t see the hedge funds’ short positions. On the positive side, we don’t have to pay 2% of our assets and 20% of our returns to the fund manager. We also don’t have to worry about other restrictions imposed by hedge funds, or risk investing in potential Ponzi schemes and other illegal activities.
Our calculations show that imitating David Einhorn’s 13F filings would have yielded a monthly alpha of 47 basis points between 1999 and 2011. The monthly alpha declines to 25 basis points between 2008 and 2011 (read how to calculate alpha and beta). It is obvious that imitating Einhorn’s entire 13F portfolio is a better alternative to index funds. However, the outperformance isn’t that big.
We aren’t out of luck though. Another advantage of imitating a hedge fund’s 13F filings is that we don’t have to imitate every single position. We can imitate only a subset of the disclosed holdings. One alternative is investing in Einhorn’s top 10 positions, while another option is investing in his small and mid-cap stock picks.
We actually prefer this second method better. Our analysis indicates that imitating Einhorn’s top 10 positions would have been a terrible idea since 2008. As indicated in his 13F filings, his top 10 holdings have underperformed the market by 29 basis points per month. The risk adjusted returns were even worse: a monthly alpha of -60 basis points.
Our analysis shows that imitating Einhorn’s small and mid-cap stock picks is indeed a pretty good idea. Einhorn’s long positions in small and mid-cap stocks (market cap < $5B) returned 1.34% per month between 1999 and 2011, versus the market’s 0.25% monthly return over this time period. Between 2008 and 2011, these stocks actually gained an average of 0.94% per month, versus 0.05% for the market.
These results reveal a huge secret about David Einhorn and Greenlight Capital. David Einhorn has a significant edge in picking small-cap stocks, and has been a rather pedestrian large-cap investor recently.
This isn’t the end of the story though. If Einhorn has an edge in small-cap investing, we can further restrict our universe to stocks with a market capitalization below $2 billion. Our analysis indicates that this is indeed a good move. Einhorn’s small-cap picks returned an average of 1.25% per month between 2008 and 2011. Recall that the market’s return was a miniscule 0.05% per month during the same period. The strategy’s alpha, 0.69% per month, was also significantly higher than what most hedge funds can generate on the average.
This is actually a very consistent pattern across all equity hedge funds. Their large-cap stock picks perform relatively poorly whereas their small-cap stock picks generate significant alpha. We developed an investment strategy that invests in some of the most popular small-cap stocks among hedge funds. Between 1999 and 2009 this strategy generated a monthly alpha of 120 basis points (51 basis points higher than Greenlight’s alpha). We started publishing a quarterly newsletter at the end of August and shared the stock picks of this strategy. Since then this strategy returned 14.3% (between September and December) vs. 2.1% for the S&P 500 index (read the details here). If investors want to piggyback hedge funds like Greenlight Capital, they should focus on their small-cap stock picks.
Disclosure: I have no positions in any of the stocks mentioned above