Fooling Some of the People All of the Time


David Einhorn is one of the more respected hedge fund managers in the world and is the founder and president of Greenlight Capital. This book details his six year fight with Allied.

The Rabbit Hole is written by Blas Moros. To support, sign up for the newsletter, become a patron, and/or join The Latticework. Original Design by Thilo Konzok.

Key Takeaways
  1. Need to question everything. What management/analysts/investment banks/etc. say/do/write. Never accept anything as truth until you yourself have read it over and know it for a fact
  2. There were three basic questions to resolve: First, what are the true economics of the business? Second, how do the economics compare to the reported earnings? Third, how are the interests of the decision makers aligned with the investors?
  3. The trick is to avoid losers. Losers are terrible because it takes a success to offset them just to get back to even.
  4. 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
  5. Making a mistake on an actual investment is far more dire than missing a good opportunity
  6. The stock Einhorn discusses is Allied. Allied is a Business Development Company which is a public company which is hired by small businesses to help them grow during their early stages
  7. The stages Einhorn discusses and the amount of research invested into this holding is extraordinary
What I got out of it
  1.  Question absolutely everything and don't take something for granted until you prove it to yourself and it makes sense to you. There's often a very real, tangible reason people are successful. The amount of research done by Einhorn and his team is amazing
  • Blames not only Allied, but regulators, SEC, government, auditors, board of directors, etc.
  • Einhorn started off as a junior investment banking analyst and was miserable. then moved to a hedge fund where he learned a lot
  • A typical process to identify opportunities is through computer screens that identify statistical cheapness, such as low multiples of earnings, sales, or book value combined with rising earnings estimates. Then, they evaluate the identified companies as possible investments. Greenlight takes the opposite approach. 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.
  • The trick is to avoid losers. Losers are terrible because it takes a success to offset them just to get back to even. 
  • Another difference from SC is that we avoid “evolving hypotheses.” If our investment rationale proves false, we exit the position rather than create a new justification to hold.
  • Hedge funds tend to be absolute return investors as opposed to relative return. Einhorn believes this is what people pay extra for when investing in a hedge fund
  • Hedge funds have far less volatility than long only indices
  • "I decided to run a concentrated portfolio. As Joel Greenblatt pointed out in You Can Be a Stock Market Genius Even If You’re Not Too Smart: Uncover the Secret Hiding Places of Stock Market Profits, 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. Greenblatt concludes, “After purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small.”
  • Explains some of his early successes and what he learned from them. Takes a lot of guts when your short goes from $28 to $45 but he saw it through to eventually hit $6
  • AOL was a big Internet stock that analysts shorted. However, this proved a bad short and AOL soared. This caused the public to think that perhaps every Internet stock shouldn't be shorted and eventually led to the Internet bubble
  • Market extremes occur when it becomes too expensive in the short-term to hold for the long-term. John Maynard Keynes once said that the market can stay irrational longer than you can stay solvent.
  • Fraud can persist for a long time, and investors, analysts, and the SEC miss things. But, sooner or later, the truth wins. If you know you are right, all you need is patience, persistence, and discipline to stay the course.
  • Allied is the second largest business development company (BDC) in the US. A BDC is a public company which is hired by small businesses to help them grow during their early stages
  • Set up calls to talk with Allied and asked them accounting questions as well as how their business was structured and run. Came across some fishy answers but didn't argue at first until he had heard their side and finished his research
  • Figured out that write downs were only being conducted when they determined money would be permanently lost
  • Einhorn gives examples of Allied's conference call the next day to dispute what Einhorn had said - literally all lies and avoiding the questions
  • People who are willing to lie about small things have no problem lying about big things.
  • Merrill Lynch was their investment banker and tried to protect them
  • Spoke with the SEC to confirm their point of view and filed an official complaint about Allied's accounting practices
  • BLX, Allied's largest holding, lent money to people with very poor credit. They could charge high interests but a lot of the loans defaulted. Allied formed BLX to get itself out of a mess but BLX was an even bigger mess
  • Tried to convince the public that everything was fine by tweaking some accounting practices but saying it was consistent, paying out dividends, having insiders buy shares, etc.
  • Went to an Allied investor meeting and was surprised to find that the team actually looked and acted very charismatically, dressed well and presented themselves well. Sometimes the best crooks come off completely differently
  • Got some insider info that helped his belief that his short position was right
  • An independent analyst rated Allied as "sell" and the NYSE launched a full investigation and he later left Deutsche Bank
  • Einhorn did a case study at HBS to talk over his research of Allied
  • Had meeting with SEC lawyers to try to figure out if he was manipulating Allied stock by giving that speech at the charity event
  • The private investigator Einhorn hired digs up a lot of dirt on Allied and proves that they are lying in their financial statements
  • BLX had so many loans defaulted on that they became known as the last resort
  • Took great efforts to prove that BLX and Allied were committing fraud or at least lying to the SEC but found it very difficult to get the SBA, SEC or other government agencies to take any action
  • Allied smoothed its write ups and write downs to make profits seem smoother and less risky than they actually were

In the Latticework, we've distilled, curated, and interconnected the 750+book summaries from The Rabbit Hole. If you're looking to make the ideas from these books actionable in your day-to-day life and join a global tribe of lifelong learners, you'll love The Latticework. Join us today.