More On Corporate Governance: David Einhorn's Book

I finished Greenlight Capital founder David Einhorn's book, "Fooling Some of the People All of the Time," this afternoon, and wanted to record some reflections while they are still fresh.

By the end of the book, my sense of disgust for Lanny Davis, first mentioned in this post on my companion political blog, was even more pronounced.

Mr. Einhorn obviously is quite passionate about the events surrounding the Allied Capital matter. The latter half of the book contains more about his and Greenlight's activities beyond buying, or selling short, Allied's shares, than it does about the actual, simple investment position. He reproduces, at length, the SEC finding which effectively agreed with Greenlight's contentions over a number of years, but failed to punish Allied, it's management or board. Instead, the typical regulatory agency solution of a 'cease and desist' order, also popular at the FTC, ended the SEC's interest in the matter.

On the last few pages of the book, the author cites a conversation with Warren Buffett regarding short selling, as well as reviews the uneven justice dispensed to various corporate charlatans.

As I read those pages, I considered my own experience with short equity positions. About a decade ago, when I began rigorous application of my equity portfolio selection and management approach with a hedge fund based in New York, we paired longs and shorts in a fairly static strategy. After some lessons learned in 2001, and the fortunate collaboration with a private investor doing extensive research on variations of the strategies I had employed, the concept of a dynamically shifting long/short allocation arose and proved to be a much more robust approach than static hedging.

Thus, were my current partner and I running an equity fund, we'd have been short since last July, and have racked up very healthy, double-digit net performance for 2008, and a positive performance this year, to date.

But our shorts are selected quantitatively, in a manner similar to our longs. I use a blend of technical and fundamental factors. As such, I explicitly build in an expectation of market reaction to near-term future events.

In fact, though, we now eschew clients and focus, instead, on proprietary derivative implementations of my original equity strategy. It's simple, cost-effective and much more profitable, on a consistently-invested basis, with far less total risk, than the equity strategy would be.

Right now, we hold puts. But, as with the equity strategy, we expect performance due to the market's reaction to subsequent performance of the underlying equity, not due to a sudden change in awareness of something about the companies themselves.

In this, I believe, my own approach is radically different than that of some other well-publicized hedge fund investors who sometimes, or nearly always, are short-sellers. Mr. Einhorn emphasizes that the bulk of his fund's positions are not usually short, and certainly not on the basis of some short-only ideology. Noted successful investors such as James Chanos or Doug Kass are probably more consistently in short positions.

But since Mr. Einhorn's book was about his entanglement with Allied Capital as a result of both a short position, and a speech he made at a charity in which he offered that suggestion as an investment recommendation, I want to touch on his comments about short selling.

Specifically, one, or at least I, left his book, and, particularly, that last chapter, with the sense that Mr. Einhorn's, and his colleagues' careful, painstaking investigative analyses cause them to believe they see problems others have not yet observed. In this, their work can yield them early exit on an equity, via a short sale, which legitimately and fairly compensates their research.

But, in this sort of 'early awareness' short selling, one seems to depend upon a sea change in awareness by many others in the equity markets. Thus, it's almost impossible for someone with this approach to dodge the charges of manipulation, because they by definition hope that others change their perception of an equity which, heretofore, has not had its warts unveiled so publicly.

Since my own business background was from outside the investment community, I have an entirely different, and, perhaps, opposite approach. As a marketing strategist, then a business strategist, consultant and research director, I came naturally to a desire to understand how to quantify performance, and, then, attempt to discover the causes of differing corporate performances.

To skip a few decades of work and insight, let me just conclude that I settled on examining companies for signs of consistency. Consistency, I found, is its own reward. Find a consistently-superior performing equity, buy it, hold, and, depending upon your bases of analysis, you may well be rewarded without needing to change any other investors' perceptions.

And, no, it's not simply momentum investing. As I noted above, there are substantial and non-trivial fundamental factors involved in our strategy.

But, if you correctly anticipate enough consistent, but under-appreciated equity opportunities, the result is a consistently positive portfolio performance.

Mr. Einhorn's road is clearly a much rougher one to tread. Not only does Greenlight obviously apply careful and deep analysis by intelligent people. They seem, given what I read in his book, to seek out the lesser-known equities in which something will be discovered by other investors at a later date. I suppose that, anytime you buy, or sell, in advance of a major change in sentiment by other investors, you take a significant risk.

If you find yourself on the record about those positions, and they are short sales, it's inevitable that the targeted company is going to cry 'manipulation.'

Even my business partner attests to feeling uncomfortable when we are buying puts, as opposed to calls. He hates to hope for equity market declines, in which our put selections will typically outperform. He's much happier to experience gains in calls, although there's nothing particularly ethical at stake.

For me, it's just math. Puts, calls, I couldn't care less, if the signals are clear and strong. And since we count on continuation of existing patterns or trends, it's probably better that we don't call attention to our selections.

In closing, I wanted to write this post today, because it dovetails, in my opinion, so nicely with one of today's earlier posts. Mr. Einhorn's saga involving Allied Capital reads, from a distance, as yet another salvo in the ongoing war over appropriate corporate governance.

He states several times in the book that Allied was only one of many portfolio positions. His fund probably lost comparatively little on the position, judging from the Greenlight Capital performance numbers sprinkled throughout the book.

Thus, the book is probably a passionate catharsis for him for the time, energy, money spent, and reputational damage sustained, during the long-running matter.

I think it's also another good example which supports my contention that corporate governance, beyond simply buying, or selling equity positions, is a thankless and profitless task in almost every instance. There might be personal satisfaction in being 'right' after relentlessly pursuing a corporate governance agenda.

But Mr. Einhorn's own revelations of the lack of justice and effect of so many existing agencies, billions of dollars of regulatory budgets, staff, etc., reinforces my own belief that you're better off just sticking to either buying, selling, or avoiding an equity, than you are going after any management team.

Despite all the laws, courts, regulations and agencies created to change this reality, like it or not, the game is stacked in management's favor. Every time.

Thus, my own preference is to either pick a superior, inadequately-recognized equity, or the call thereon, to buy, or an inferior, but inadequately-recognized equity, or the put theron, and buy. But, unless you have substantial and uniquely superior detailed analytical prowess and firepower, which Mr. Einhorn and his firm evidently possess, avoid taking equity or derivative positions in which you expect massive change in either investor sentiment or senior management and/or board action.