Legends of Fair Value Investing Part 5

Legends of Fair Value Investing – Part 5

As an investor, my job is to figure out what will happen rather than what should happen” – David Einhorn

Markets are a fickle being. The only constant is change. Strategies rise and fall with spectacular speed and efficiency and what worked yesterday may very well cause you to lose your money today. Very few investment styles have persisted throughout market cycles and the inventors of those styles have attained immortality, recording their names in the history of the financial markets forever. From Benjamin Graham with his Graham Number to Peter Lynch with his PEG ratio, the styles these investors practiced have come to be associated with their names forever.

Our latest living legend in the series of fair value investing is an activist investor like the vigilante we covered in the previous article. (If you have not read the article, please go ahead and read it. It also gives out an introduction to why activist investing is needed).

Activist investors arose to meet the need to protect small investors from fraudulent companies. Activist investors also often push company management into taking decisions that will benefit shareholders overall. For e.g. Benjamin Graham would often buy a sizeable stake in companies that were holding bonds and cash and would then force the management to either put the cash to use towards growing the company or distribute the free cash to shareholders in the form of dividends.

Our value investor, covered in this series, however, chose to focus only on fraudulent companies or companies whose value was highly inflated relative to their fair value. His success was so profound and his short bets so accurate that his name was associated with a resulting effect on the share price of companies effectively immortalizing him with the other legends. The namesake of the “Einhorn Effect”, our vigilante investor is a renowned Hedge Fund Manager, David Einhorn.

P.S. We once again encourage our readers who have not read the previous article part 4 to read it as we have also covered a brief on short selling which is what this legend does. So go ahead and read it, we are waiting for you right here.

The Einhorn Effect

The Einhorn effect often refers to the sharp movement, generally a drop in a company’s share price in response to comments and trading activity by David Einhorn or his hedge fund Greenlight Capital. His reputation for making bold and unlikely bets as we will see in the article has been consolidated on the back of strong successes leading to investors using his opinions or lack of as an indicator of company performance. Also unlike our previous vigilante, Einhorn is often subdued and measured with his declarations leading to an increased credibility whenever he does speak about the companies he is trading.

Investing Philosophy

Unlike our previous vigilante who has had pronounced success with both the long side and short side of activist investing, Einhorn’s biggest successes have all been on the short side.

In his own words, their long portfolio consists of the most boring, value-oriented companies which are currently mispriced. His long strategy is to first find reasons for why a company is mispriced and then undertake value analysis research to determine fair value and whether it is an attractive investment.

This is a fillip on the traditional value investing analysis method wherein a list of undervalued stocks is identified and then an analysis is undertaken on each security to determine those that are attractive for investment. Einhorn claims his method is more efficient but as we have seen before, there is no single road to success in the stock market and as investors, we have to decide what works for us the best and is in line with our mental makeup.

Also, as covered in our headline quote by the legend himself, investors must look at investing as a puzzle solution covering risk, uncertainty, and ignorance. Information is often incomplete and no one can predict the future with consistent accuracy. In such a scenario, you try to combine numbers, analysis, people’s motivations, and all available facts in a sort of a puzzle whose solution allows you to make a lot of money but failure to do so doesn’t lead to major losses.

His investing philosophy can be outlined in the following points:

  1. Avoid losses – Identify securities with a margin of safety. If you are right, you will do well. If you are wrong, you stand a good chance of breaking even.
  1. Have Patience – It often requires a long time for the market to realize the fair value of companies and as an investor, you must acquire these companies at bargain prices and then wait patiently for the market to realize its true worth. This also ties in with the philosophy of Warren Buffett covered in Part 2 wherein he would often wait for years in cash before an investment opportunity passed by.
  1. Avoid investments that are exceptionally difficult – This is one of the most important tenets that we as investors must follow. Why invest in something you don’t understand? Especially when there are others, far more knowledgeable than you that might be taking the other side of the best. Stick to investments that you can understand and evaluate correctly or stick to point 2 and wait.
  1. Have a sound process -Any random investment can be a success or a failure. The importance of luck in investment is often incorrectly stated. It is perfectly fine to have a poor investment decision make money while a sound investment decision can lose money. As long as one is following the right process, the outcome of the process will win over luck in the long run.
  1. Choose wisely –Einhorn believes that if you ever have the chance to make the best choice at a later point in time, you should take it. He is a believer in not making decisions before they need to be made due to changes in people’s behavior, circumstances, facts, and opinions.
  1. Avoid Leverage – There is not much to be said in this and ties in with risk management. Do not borrow money for investments. Invest what you have and size appropriately to protect against bankruptcy in case of extreme movement.
  1. Re-evaluate investments from time to time – Complacency is the bane of investors and as value investors, it is a must to evaluate your portfolio at periodic intervals to ensure that the securities you are holding are still undervalued and that any change in fundamentals has not impacted the value. Any security that is no longer undervalued must be removed from the portfolio and replaced by others and this has to be an ongoing process.
  1. Take advantage of market extremes – This tenet ties in with Buffett’s policy, buy when there is blood on the streets, and buy when others are fearful. Investment returns are often lumpy and if one can accept that, one can wait patiently for the market extreme wherein one can then clean up their portfolio and lock in gains in the most efficient manner.
  1. Let your investment strategy be challenged – This is the most difficult thing for any human being to do. Human beings are averse to criticism. We do not take criticism very kindly. However, criticism is the only way we will be able to find out our weak points and improve upon them. Have your friends, family, and peers challenge your investment strategy, and ask you questions about your decisions and successes and failures which will help you identify the missing elements that will then help you improve your investment decisions.

The short side of activist investing

Einhorn is most known for his massive short bets and he catapulted to the limelight with his 2002 short of Allied Capital. Allied capital was a private equity and mezzanine capital lender (subordinated debt i.e. below standard debt like banks and bonds in priority).

Allied capital held a lot of illiquid securities as private equity and mezzanine capital lenders often do. Private equity firms by their nature hold unlisted shares and bonds of private companies and earn a return when these companies finally go public. This is a common occurrence and is generally not a cause of concern.

Einhorn’s tirade against Allied capital began with their incorrect valuation of those illiquid securities. The major problem with holding unlisted securities is that there is no defined way to value them. Companies usually hire a third-party valuation agency to undertake this exercise to keep it fair for their investors. Einhorn undertook a major short position in Allied Capital and then made a public announcement calling out their incorrect and fraudulent valuation of illiquid securities.

This began a lengthy 5-year battle and investigation, one in which Allied Capital even illegally accessed Einhorn’s phone records. At the end of the investigation by the U.S. Securities Exchange Commission (SEC, regulator of US financial markets), Allied Capital was found guilty of fraud and Einhorn made a lot of money on the short position. He also published a book about his experience titled “Fooling some of the people all of the time” and it is a good read for those interested in his method of investigation.

Einhorn followed up on this success by shorting Lehman Brothers in 2007 with a similar claim on the improper valuation of illiquid real estate securities and dubious accounting practices. Unlike Allied, however, he did not have to wait too much as the markets responded to this much faster and Lehman declared bankruptcy in 2008.

Throughout his investing journey, Einhorn has called out improper decisions by large and small companies, often by directly asking the CEOs of those companies in public media. He called out Steve Ballmer, CEO of Microsoft to step down in 2011 after Google and Apple surpassed Microsoft in market value.

He undertook a similar exercise in 2013 with Apple Inc. to get them to distribute their idle cash. Apple holds a lot of cash, often more than the market value of several S&P 500 companies. In 2013, it held $137 billion in cash. Einhorn filed a lawsuit against the company to issue dividend-paying perpetual preferred stock as a means of distributing some of that cash to its shareholders and to everybody’s surprise set a legal precedent by winning that suit. Apple however has since then done well for its investors by instituting frequent stock buybacks as a way of returning that surplus cash to its shareholders.

Einhorn’s failures

Einhorn’s stellar path to success has also been marked with failures, albeit fewer in number. 2018-19 was a particularly bad period for his hedge fund. He lost money on both the long side as well as the short side. His investments in MetLife spinoff Brighthouse Financial, General Motors, and rig manufacturer Ensco turned out to be value traps.

He bet on the crypto bubble being burst and represented that bet by taking a short position in graphical processing unit manufacturing companies Advanced Micro Devices (AMD) which rose +60% for the year and was the biggest loss in his portfolio. He further faced a series of losses by going short tech stocks, namely Netflix and Tesla both of which rose sharply and continued to rise throughout the pandemic. These instances show that even legendary investors are not immune from making incorrect decisions or simply bad luck. Despite being right on the crypto bubble and betting on the weaker company (AMD vs. NVIDIA), he still lost money. Sometimes, it is just luck and you have no option but to grind it out.

That is what our legend did. Investors who stuck by Greenlight and Einhorn were rewarded in 2022 as his fund returned 37% against a loss of 20% in the S&P 500. That is an outperformance of 57%, displaying genius-level investment skills. As an investor, this is the validation of the faith and trust you place in your processes. Bad luck may ruin a few bets, but your process will see you through to success, provided it is sound and followed consistently.

Philosophy Caveat

Einhorn’s strategy is often a function of scale as well as the influence he wields on social media and traditional media. You might be able to find a good trade or a bad company, but there is no guarantee that it will work out for you unless the big players notice. This is especially brutal if you are short as a small investor. Hence for all practical purposes, we should simply be on the lookout for undervalued companies whose shares we can buy and then raise the issues in shareholder meetings in order to persuade the management to unlock value.

As small investors, we are best suited to ignore bad companies and let the big boys deal with the mess. Other than that, the philosophy is pretty straightforward and easily applied in the real world. How you unlock value is up to you and we at Fairvalue can help you out in that matter

Application in the real world with Fair Value Investing

At Fairvalue Calculator, we have data on 30,000+ stocks listed across the world with automatic financial analysis. As our premium user, all you have to do is search for the listed company and you will find all the information you need. Alternatively, you can visit our sector analysis stock screener and check out the hot sector currently driving the economy. Here we take a look at broadcasting.

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Let us look at local television broadcasting and digital media company, Nexstar Media Group Inc.

Legends of Fair Value Investing – Part 5
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The initial snapshot tells us it is 84% undervalued.

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Diving deeper, we discover that it is trading below fair value on a lot of parameters. This warrants further digging into company financials, management discussions, and analyst calls to figure out what is causing this undervaluation and then acquiring shares and raising this issue in the next shareholder meeting wherein the management is obligated to provide a response.

In the case of Nexstar, it is fighting a battle against streaming giants like Netflix, Disney, and Amazon Prime. However, Nexstar offers something which is unique and unachievable at the moment for the streaming giants; local content. People are beginning to turn away from streaming services, are dissatisfied with the content currently available, and are turning to providers like Nexstar for local, community-oriented content. This is probably where the value lies. This is not an investment recommendation but simply an observation that we are encouraging our readers and premium users to pursue and analyze for themselves.

We at Fairvalue Calculator have done most of the heavy lifting. All that remains is for you, dear investor to dig a bit deeper and then ask some strong questions to the management of the company in question.

Last Words

We all love a vigilante. The plethora of books, comics, movies, and TV shows dedicated to vigilantes are testament to audiences’ obsession with them. Investors are no different. All of us have at one point in time or another, held fraudulent and expensive companies which could have been avoided had we known there was some issue in them. We would have rallied around that person who called out the issues, like our savior.

Einhorn represents that breed of activist investors. The Einhorn effect is a testament to his ability to call out such bullshit and his performance speaks for itself. Everybody has losses and no one is immune. However, trust and faith in one’s process and the ability to stick by it in tough times are what distinguish successful investors from average and failed investors. Remember, there is a vigilante in all of us, and in investing; it is far easier to act upon it. Simply go to a shareholder meeting of a company you feel is doing wrong or right and gather like-minded peers simply by voicing your grievances in the public forum. We are in no way advocating that you do something illegal or disrupt a peaceful meeting but as a shareholder, you have every right to question the management and ask them to take decisions in the favor of all shareholders. The key to unlocking value is in your hand, you just have to use it.

In the concluding part of the series, we look at an investor who managed to turn value investing into art. His book on “Dhandho”, a Gujarati word for Business, highlights an investment style that has taken inspiration from immigrants, specifically Gujarati immigrants to the United States of America. Our investor is highly influenced by Warren Buffett and even bid for upwards of $650,000 for lunch with the legend. This inspiration also extended to charitable activities and he founded the “Dakshana Foundation” with the goal of recycling most of their wealth back to society. Stay tuned as we cover this grounded investor in the concluding part of the series. Until then, become our premium member and embark on your own vigilante activities.

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