What it means
Einhorn founded Greenlight Capital in the 1990s, and the firm follows a value approach. This means it looks for shares trading below what the managers believe the business is worth, buys them and waits for the market to catch up.
The firm also sells short, which means borrowing shares and selling them in the hope of buying them back at a lower price. His public profile grew when he challenged companies in speeches and presentations.
He questioned the accounting at Allied Capital, a lender to small businesses, and argued that its valuations were not credible. The company disputed his claims, and the episode became a well-known example of the conflict between short sellers and the firms they target.
He also spoke at an investor conference in 2008 about Lehman Brothers, questioning its asset valuations and its disclosures just months before it failed. After the collapse, many observers saw his comments as an early warning, which gave him wide credibility among analysts.
The episode is a standard case of how careful reading of financial statements can reveal risks. The lessons for non-finance readers are practical.
Footnotes to the accounts, changes in accounting policy, gaps between profit and cash flow, and aggressive valuation assumptions are all places where trouble shows up first. A short seller must do thorough research, because the loss on a short position has no upper limit if the price rises.
The nuance is that a famous investor is not always right, and long-term performance has varied across periods. Value investing can be out of favour for years, and short positions can lose heavily when markets rise.
Use his work as a lesson in analysis, and form your own view from the facts. Short sellers also play a role in the market.
By betting against companies they think are overvalued, they can bring attention to weak disclosure and lead to earlier correction of prices, although companies often resent the scrutiny. Reading both the critique and the company's reply is the best way to judge the argument.
In practice
Real-world examples.
Example
An analyst reading a company's annual report notices that profit is rising but operating cash flow is falling. Inspired by the approach associated with Einhorn, she reads the notes on revenue recognition and finds that more sales are being booked on credit terms. She flags the issue to her portfolio manager.
Example
A business school lecturer uses Einhorn's public critique of a lender's valuation methods as a case study. Students must read the company's response and decide which side makes the stronger argument. The class concludes that disclosure quality is a key warning sign.
Example
A fund manager considering a short position reads the target company's filings for months and speaks with its suppliers and customers. She sizes the position small because a short loss can grow without limit. She sets rules for when she will exit if the share price rises.
Case study
Seen in the real world.
Marlborough Instruments is an illustrative, fictional listed manufacturer whose profits had risen for six years. An analyst at a value-focused fund noticed that receivables were growing twice as fast as sales and that the company had lengthened its customer payment terms.
Following the research approach associated with investors such as David Einhorn, the analyst read the footnotes, compared the numbers with competitors and found that the company had changed how it recognised revenue on long-term contracts. Adjusted for the change, profit would have been about 20% lower.
The fund took a modest short position and published its reasoning. In this illustrative story, the company's share price fell by a third when it later restated its results, but the analyst noted that the position could have gone badly wrong if the market had ignored the issue for longer.
Watch out
Common mistakes.
- Assuming a famous investor's public view is always correct, when even the best investors are wrong regularly and their positions may change.
- Treating short selling as simply the opposite of buying, when losses on a short position are unlimited and the position can be forced to close at a bad time.
- Reading only headline profit and ignoring cash flow and footnotes, which is where accounting warning signs often appear.
Questions
People also ask.
Who is David Einhorn?
He is the founder of Greenlight Capital, a hedge fund known for value investing and for public research questioning the accounting of companies such as Lehman Brothers and Allied Capital.
What is value investing?
It is an approach that buys shares when the price is below the investor's estimate of the business's underlying worth and waits for the price to rise.
What is short selling?
It is borrowing shares, selling them and aiming to buy them back later at a lower price, which makes a profit if the price falls and a loss if it rises.
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