Wednesday, September 10, 2014

Review of Fooling Some of the People All of the Time, A Long Short Story by David Einhorn

Allied Capital was a "business development company" - sort of like a bank except funded more with equity - that made "mezzanine" (that is, high loan to value) loans to corporations. It was mostly owned by retail investors who were hungry for the high dividend yield and couldn't really analyze the company much beyond that.

Poor David Einhorn shorted Allied Capital in 2002 and spent years talking it down and trying to get regulators to investigate its admittedly suspicious sounding accounting for loan impairments.

However, at the same time that Einhorn was shorting Allied, he had a significant long position in New Century Financial. Here was the rationale that he gave in a speech [pdf] at the Value Investing Congress on November 10, 2006:

"We have a company in our portfolio, New Century Financial (NEW), that turned a wonderful non-capital intensive business, the origination and sale of mortgages, and reinvested the cash flows into a mediocre capital intensive business of holding mortgage loans. Worse, they went into the capital markets to raise additional capital to focus on the capital intensive opportunity. I thought this was such a bad idea that I joined the Board with the goal of unwinding this decision and to free the valuable service business from the investment business. It is too soon to discuss my progress."
He was right that the company made a mistake by expanding into the business of owning/holding mortgage loans. However, it is also clear from his comment (and the fact that he owned a big stake in the company) that he completely missed what was going on in the mortgage market; both in the New Century portfolio and in the entire U.S. market. He did not resign from the board until March 2007.

Allied Capital did poorly in the financial crisis, but it lasted until 2010 when it was taken under at $5 per share. Much better performance than New Century which of course went to zero. This old Bloomberg article says that Einhorn's fund lost $140 million on New Century.

Note that the book came out in May 2008, which means he had probably been working on it in 2006 and 2007. Working on a book is very time consuming. It's also backward looking, which is why there are not very many great investment books. What if he had done real estate field research instead of working on this book? Greenlight lost 20 percent in 2008 [annual letter PDF]. 

I haven't read the new version of Fooling Some of the People All of the Time, A Long Short (and Now Complete) Story, Updated with New Epilogue, but the conclusion I draw from the original version is that life is too short to chase after the fraudulent stock shorts. Actually, the more crooked management, the harder it is to make money. Frauds can go on for years and years and years. As long as a fraud can attract investors fooled by some kind of batesian mimicry - in this case a high dividend yield - it can persist.

But if a company is unprofitable and it owes more money than it can repay, the creditors can be the catalyst for the short.



Unknown said...

I found FSOTPAOTT fascinating. Not so much for its description of Allied, which was a run-of-the-mill BDC Ponzi, but for Einhorn's rationale for sticking with a losing investment for years. He writes at the beginning of the book about the dangers of having an "evolving thesis" and then does exactly that with Allied.

I suspect he would have been quicker to cut his losses if he hadn't criticized the company publicly. When they responded to his presentation by blatantly lying, that set him off and made him obsessed with proving the company was a fraud. He says it's a cautionary tale about nefarious companies, lazy regulators, etc.--- I would say it's a cautionary tale about marrying your trades and feeling a need to be right.

Unknown said...

Allied doesn't seem to have performed worse during the credit crisis than other BDCs like ACAS. I looked up historical data for Sirrom, and it likewise doesn't seem to have done worse than other BDCs in 1998-- they were all down 50%+ during the LTCM drama.

bjdubbs said...

I picked this up and couldn't understand why anyone would read it. It does show one thing, that value investing requires a certain belief in justice, that the market rewards people who make the right decisions for the right reasons. That's also clear from Lowenstein's book on Buffett. Unfortunately that same deep conviction can also lead to this sort of thing.

CP said...

James, that's a great point about the evolving thesis.

And the public bashing is dangerous. Look at Ackman and Herbalife. (I think Hempton is right and Ackman is wrong, btw.) A gigantic, public position becomes something from which you can't back down.

Josh H said...

The updated version is the same version as before (at least I think) but has an extra 50-60 pages at the end with the ending.

I am curious on the perception of the thesis changing? Can you elaborate? My thinking is that the thesis is that Allied is a fraud and Einhorn kept uncovering more and more fraudulent loans.

I also found it incredible the amount of time and resources that were spent doing the research.