David Einhorn Spots Financial-Reform Problems and Blue-Chip Bargains
Thanks to his astute calls on the failings of Allied Capital and Lehman Brothers, David Einhorn has gained a reputation as one of the nation’s shrewdest hedge-fund managers. Profits from the short sales of those stocks have helped his $7 billion fund, Greenlight Capital, achieve scintillating results. From its inception in 1996 through November 30, the fund returned an annualized 21%, net of fees (over the same period Standard & Poor’s 500-stock index gained 6% annualized).
Although Einhorn attracted more attention in October when he suggested that the stock of St. Joe, a real estate development company in Florida, was greatly overvalued, he clearly wants to be known for more than his investing acumen. In 2008, he published a book, called Fooling Some of the People All of the Time, about his battle against Allied, a business-development company, and his lengthy campaign to get federal regulators to act on his assertions that Allied engaged in deceptive accounting practices. At one point, the Securities and Exchange Commission investigated Einhorn for allegedly manipulating Allied’s stock. He was eventually cleared of wrongdoing.
Now, Einhorn has issued an updated version of his book. The new edition completes the Allied saga and connects it with Lehman Brothers, whose demise in September 2008 nearly resulted in the collapse of the global financial system.
Einhorn, who considers himself a value investor, isn’t just a short seller. He says some of the best bargains today are in large, blue-chip companies. Here is an edited version of our conversation with him:
KIPLINGER: What are the main points you’re trying to get across in your book?
EINHORN: I wanted to tell a story about my actual experience that surprised me greatly. I also learned a lot about how our system works and doesn’t work. I wrote the book because the system is much more dysfunctional than we might expect. Our government’s lack of accountability is one of the themes that permeate the book.
What are the key things you’ve added to the new edition? The first edition was published in 2008, and the story wasn’t complete at that point. Since then, shares of Allied Capital have collapsed (Ares Capital recently acquired Allied for $3.47 per share; Einhorn shorted Allied at an average price of $26.25 a share). The Securities and Exchange Commission determined that it should never have investigated us, but rather focused on investigating Allied. I also had a similar experience with Lehman Brothers -- though Lehman was much larger and its problems resolved themselves much faster. So I got to discuss how that occurred and why the problems still persist.
Does the new financial-reform law make it less likely that banks can grow so large that Uncle Sam will feel compelled to rescue them when they get into trouble? Not at all. In fact we’ve institutionalized the concept of “too big to fail.” The lesson that the regulators would like to draw from Lehman Brothers is that something like that should never be allowed to fail again. And if that’s the lesson, then it institutionalizes “too big to fail” and makes it an even more embedded concept than before the crisis.
Where is the next crisis? There’s no way to know for sure, but we’ve transferred a lot of risk from the private sector to the public sector, and we’re incurring large deficits and engaging in aggressive monetary policy both inside and outside the U.S. It’s possible that the next crisis will come as a result of those risky policies.
So you’re against the Federal Reserve’s current policies? I’m not in favor of the Fed’s policies. I would do the opposite of the Fed. I would not monetize the debt, or print money to buy government bonds. I would raise interest rates, and I would act tougher toward the banking sector and make the banks realize losses on their bad loans faster so that we can get on with things.
What about the health of the U.S. government’s balance sheet? Is it time for Uncle Sam to embrace the kinds of austerity measures being imposed on some European nations? It’s important for the U.S. to demonstrate its ability to move toward long-term solvency. What happens to the deficit in the next 12 months is not the most important thing. But the inability of our leaders to seriously address the long-term fiscal situation is very worrisome.
Where -- if anywhere -- are you seeing bubbles now? I don’t know for certain. “Story stocks” -- such as those involved in so-called cloud computing -- have started to gain momentum characteristics that remind me of how similar story stocks traded more than a decade ago during the Internet bubble.
Do you see any bubbles in commodities? Eventually commodities could become bubbles. We’re not there yet, but they seem to be feeding off easy-money monetary policies.
How do you find investment candidates? One idea at a time. Usually we start by identifying a reason why a security is mispriced and test it to see if it is indeed misunderstood and mispriced.
Where are you finding value now? We’re finding value in high-quality blue-chip companies. We’re long Vodafone (symbol VOD), Sprint Nextel (S), Apple (AAPL), Pfizer (PFE) and CareFusion (CFN). Vodafone doesn’t seem to be getting credit for its 45% ownership of Verizon Wireless, which is an extremely valuable company. Vodafone is well positioned for growth in Europe because it holds a large amount of spectrum space. That should become more valuable as more people use fancy devices, such as iPads and 4G phones, that require more bandwidth.
What about the others? Sprint has dramatically improved its customer service and appears to have stabilized its business. The company also has a strong spectrum position, which gives it an advantage compared with poorly positioned competitors, such as T-Mobile. AT&T charges its customers on a per-gigabyte basis, while Sprint can offer unlimited service because of its strong spectrum position. Apple offers nice synergy among its devices, so that when you buy one, you also want to buy another. Apple is also winning more acceptance among corporations. As for the stock, if you net out the cash per share from the share price, it’s trading at about the same price-earnings multiple as the market, which is very cheap for a company performing this well. Pfizer trades at a low multiple because Lipitor’s patent will expire soon. We believe that Pfizer will preserve its earnings through expense cuts and growth in other areas. Once our view is borne out, the multiple is likely to expand.
Amidst all these well-known blue chips, CareFusion stands out. The company makes infusion pumps, respiratory care ventilators and other devices. It is well positioned to generate revenue growth through a favorable wave of product cycle upgrades and to gain market share in infusion pumps as a result of Baxter having to recall its pumps. CareFusion has good opportunities to expand its profit margins, and it has no net debt. And the shares are inexpensive relative to analysts’ estimates, which we believe are too conservative.
On the short side, you were dead on about Lehman and have been in the news recently with St. Joe. How do you pick your shorts? We like to short things that are misunderstood and usually deteriorating.
Are you still short the rating agencies, Moody’s and McGraw Hill, which owns Standard & Poor’s? Yes.
Is it correct that gold is the largest position in your portfolio? Yes.
What’s the case for gold? Is it in bubble territory? I don’t think gold is in a bubble at all. As long as monetary and fiscal policies don’t make sense, gold should perform well. Pension funds have less than 1% of their assets in gold. More investors will have to participate in gold for it to take on the characteristic of a bubble.
Some hedge funds have moved into the mutual fund business. Do you have any plans to launch a mutual fund? No.