Sunday, July 26, 2009

Einhorn, Fooling Some of the People All of the Time

David Einhorn is perhaps best known to the investing community for challenging the transparency of Lehman Brothers’ balance sheet in May 2008. In Fooling Some of the People All of the Time: A Long Short Story (Wiley, 2008) he recounts his losing battle to unmask Allied Capital, a company he accused of fraud. The book is a scathing indictment of the regulatory system in this country. In the wake of the Madoff scandal and Harry Markopolos’ testimony that the SEC turned a deaf ear to his evidence Einhorn’s book speaks even more loudly.

But for today’s abbreviated--and admittedly intellectually lazy--post I want to highlight the way Einhorn’s hedge fund, Greenlight Capital, structures its portfolio because it offers an interesting twist on some accepted norms. Greenlight is a long short fund, but it does not practice pairs trading. The problem with pair trades, Einhorn argues, is that often “the second half of the pair trade is not a worthwhile investment other than as an industry and/or market hedge.” (p. 16) Greenlight looks for worthwhile longs and worthwhile shorts. In this way the fund achieves “a partial market hedge without having to spend capital on negative-expected-return propositions” (p. 16) such as an index hedge. “Selling short individual names offers two ways to win—either the market declines or the company-specific analysis proves correct. In practice, we have more long exposure than short exposure because our shorts tend to have greater market sensitivity and volatility than our longs. Also, the market tends to rise over time and we wish to participate.” (p. 17)

Greenlight Capital is a concentrated portfolio. Einhorn cites Joel Greenblatt’s observation that “holding eight stocks eliminates 81 percent of the risk in owning just one stock, and holding thirty-two stocks eliminates 96 percent of the risk.” (p. 18) Once an investor has a diversified portfolio of eight stocks or so, the law of diminishing returns starts to kick in when he adds additional stocks in an effort to decrease risk.

Just some food for thought.

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