Circle of Competence

I finished David Einhorn’s investing “novel” Fooling Some of the People All of the Time this afternoon, and I have nothing but praise. I mentioned here that I’d write up a quick review, so I’d like to do just that.

The Story

In the early chapters, Einhorn does a great job introducing us to himself and the beginnings of his firm, Greenlight Capital. He talks of his early years working as a hedge fund analyst, the launch of Greenlight with a colleague, as well as some of their successful early investments. I have to say that I really enjoyed this part of the book, and if I had one complaint about the story, it’s that Einhorn mostly leaves behind the descriptions of Greenlight’s progress and investment performance once he launches into the story of Allied Capital, because it makes for terrific reading.

Once Einhorn gets us through the early years of Greenlight, he introduces the Allied Capital saga; it’s at this point that a story of greed, fear tactics, and misperception begins. Not only was the story engaging on its own merit, Einhorn and Greenlight were absolutely put through the ringer for the past 6 years, but the book was full of lessons in investing, accounting, and human misbehavior.

If you aren’t familiar with Allied (ALD), they are structured as a business development company (BDC). Generally they make mezzanine loans, senior to equity but subordinated to long-term debt, to small businesses private and public. Greenlight originally identified Allied as a short based on their shoddy valuation processes: often a company they invested in became nearly worthless but they carried their loans at full value because they claimed the company might recover in the future. They found over time that not only did Allied mis-value its investments, thus violating GAAP treatment of fair-value accounting, but a major portfolio company called Business Loan Express had engaged in SBA loan fraud for years.

What I found really interesting was the amount of time and effort the Greenlight team put into the investment, which never represented more than 8% of their portfolio to this day. From originally building an entire database of the company’s loans and investments, to digging into obscure regulatory filings, to talking with anyone who would give them the time of day, Greenlight put new meaning to the words “due diligence” in my mind. I’m reminded of the Bloomberg article about how Bill Ackman was charged $109,000 for photocopying and printing documents related to MBIA research.

Speaking of Ackman, the Greenlight story is all the more interesting in the context of Ackman’s recent battles with MBIA and Ambac. While Einhorn was bringing Allied’s shoddy accounting and poor regulatory oversight to light, Ackman was doing the same with the bond insurers. Unfortunately for Mr. Einhorn, Ackman’s investment has worked out great while Einhorn is still about even.

Poor Regulators Galore

Einhorn brought all of these fraudulent transactions, poor valuations, and shoddy accounting practices to several different regulators over a 6 year period, yet the company remains perfectly viable even today! It’s scary to think that SEC and SBA regulators could do so little with so much evidence in front of their faces. In fact, not only did these regulators not punish Allied with more than a slap on the hand, they investigated Greenlight on market manipulation!

Einhorn points out that in our culture, short sellers are often portrayed as villains; market manipulators out to bring down good people for profit. In reality, short sellers often do just as much in depth analysis as long only investors, sometimes more so, and are not manipulating the market any more than a long investor who presents his favorite stock idea with fervor. Going short doesn’t push a stock down any more than going long pushes a stock upwards. Why can’t short sellers accentuate their theses just as passionately as long investors?

The real story of the book, though, is the gutless regulatory system and the absolutely clueless Wall St. analysts who cover Allied. The regulators have backed down time and time again, incentivizing Allied to continue its horrendous accounting practices, and incentivizing their subsidiary BLX to continue its fraudulent loan practices. The Wall St. analysts haven’t been willing to do the necessary work to uncover the fraud behind management’s comments, and I believe the shareholders will eventually suffer.

OK, but what about those investing lessons?

From purely an investing standpoint, there was much to be learned from the book. Not only does he outline Greenlight’s approach to value investing, Einhorn takes us step by step through Allied’s misleading accounting practices, and I learned an amazing amount about proper accounting and how to detect when accounting practices are poor.

The key here for investors is that one must read SEC filings and management discussions with a very skeptical eye on differences between the true economics of the business and the numbers presented. Not only does this give you a much better sense of the business itself, it can help you spot fraudulent accounting or bad business practices while they occur. Reading the book, one gets a sense the Einhorn and his team aren’t merely investors, but forensic accountants looking to spot gaps and inconsistencies that can be used to gain insight that the market is missing; long or short.

Conclusion

I’d highly recommend any investor or business person pick up Fooling Some of the People All of the Time and read it cover to cover. Like any great investment idea, this story is a real no brainer. Einhorn uncovered some bad, bad things, and the people doing them were willing to spare no cost preventing the truth from surfacing. He stuck with it for years, and now the whole story is out there for anyone interested.

I hope the shareholders and regulators of Allied Capital eventually do the right thing; but until then, we can only revel in the power of incentive-caused bias and its ability to sway people down some dark, dusty roads.

See Einhorn’s site dedicated to the story
See Einhorn’s speech “Private Profits and Socialized Risk”
Buy the book