Update: Fooling Some of the People

A bit over a year ago I pointed to my review of David Einhorn's book Fooling Some of the People All the Time, saying that you could read the opening paragraphs online. Since that time, Einhorn has linked to that review from the book's website and the editor of The Objective Standard has allowed the review to be read in full online. Enjoy!

Review of Einhorn's Book

In preparation for writing a review of Fooling Some of the People All the Time, I read all 16 reviews (from mostly major publications) listed at its site, and others besides.

With a few exceptions, most did not actually review the book--showing what it said and why what it says is important. I set out to write a review that did do these things. And I did. You can read the opening paragraphs of it here, at The Objective Standard.

Note, for the curious, this is partly why my posts here are going to be few and far between. I decided to focus on doing a few in-depth, quality articles or reviews rather than the many posts I've been putting up here these past few months.

Einhorn (and Buffett) on Position Size

Here, from page 19 of Fooling Some of the People All the Time, is Einhorn sharing how he sizes both longs and shorts within Greenlight's portfolio--and why:

It is hard to find long ideas that are ones and twos or shorts that are nines and tens, so when we find them, it is important to invest enough to be rewarded.

Based on this concept, we decided that Greenlight would have a concentrated portfolio with up to 20 percent of capital in a single long idea (so it had better be a [good] one!) and generally would have 30 percent to 60 percent of capital in our five largest longs.

We would size the shorts half as long as we would longs of the same quality, because when shorts move against us, they become a bigger portion of the portfolio and to give us the ability to endure initial losses and maintain or even increase the investment.

Like reading about a company he's invested in, knowing why Einhorn has done something is as (if not more) important than following it without further thought.

Here, he takes big bets on the best ideas he can find. And, as the book from which this quote is taken shows, he knows these companies inside out.

Do you know the companies in your portfolio well enough to write more than a one page introductory statement on them? How about a book? Can you name their top five suppliers, salespeople, or customers with ease?

If not, you may well choose to size your bets differently. And you should. Warren Buffett states both points here better than I, so I'll give him the rest of the post to do so:

We think diversification, as practiced generally, makes very little sense for anyone who knows what they're doing. Diversification serves as protection against ignorance. If you want to make sure that nothing bad happens to you relative to the market, you should own everything. There's nothing wrong with that. It's a perfectly sound approach for somebody who doesn't know how to analyze businesses.

But if you know how to value businesses, it's crazy to own 50 stocks or 40 stocks or 30 stocks, probably because there aren't that many wonderful businesses understandable to a single human being in all likelihood. To forego buying more of some super-wonderful business and instead put your money into #30 or #35 on your list of attractiveness just strikes Charlie and me as madness.

Einhorn Still Short Allied

I am close to completing an in-depth review of Einhorn's Fooling Some of the People All the Time--which, though it won't be published here, I'll be sure and send a link to. Here's some updated news on the long short story:

Shares of Allied Capital Corp have been wiped out over the past year, but David Einhorn, the hedge fund manager who has famously shorted the business lender's stock, feels more vexed than vindicated.

That's because the past year's financial markets collapse has produced even more serious fall-out. From the demise of Lehman Brothers to Bernard Madoff's massive Ponzi scheme, the questionable accounting practices of a small lender was just one product of sleepy regulatory oversight, Einhorn told Reuters in an interview.

"What we've seen a year later is that Allied was the tip of an iceberg; that this kind of questionable ethic, philosophy and business practice was far more widespread than I recognized at the time," he said. "Our country, our economy, is paying a huge price for that."

Einhorn, head of the $5 billion hedge fund firm Greenlight Capital, made headlines in May 2002 when he told an audience he believed Allied's stock was overvalued. He argued Allied was slow to mark down depressed assets -- often equity stakes in small private companies -- and stretched accounting rules.

Greenlight shorted the stock, meaning it would profit if Allied's price fell. Einhorn also submitted what he considered red flags to the Securities and Exchange Commission, expecting that the agency would investigate.

Instead, what followed was a long public battle between Einhorn and Allied, which denied and continues to deny wrongdoing, as well as SEC scrutiny of the hedge fund manager's short-selling activities.

Allied stock is now around 97 percent lower from where Einhorn sold it short. Einhorn's comment above about how far more widespread the problem was than he realized is exactly correct. My review will show why--on a fundamental level--and, in doing so, show the fuller, true value of Fooling Some of the People.

It was and is far more than simply a book about a single short case in a single company--telling what went wrong and why. For a more exact identification, stay tuned

Einhorn on Insider Buying

I recently re-read Fooling Some of the People All the Time, and will be sharing some quotes from it directly related to how Einhorn views different aspects of investing.

Speaking of insider purchases, Allied management made several small insider purchases between my speech on May 15, 2002, and the end of the year. As one shareholder asked me, "Allied insiders have been buying shares and not selling. In fact, I think the last insider sell was more than a year ago. This does not seem like the behavior of a management that is hiding something. If, as you suggest, they are privy to negative information that likely would be detrimental to the stock price, it's inexplicable to me that they would put more of their own money at risk."

This, of course, is a straightforward and logical analysis. I agree that insider purchases are generally bullish. However, in this case, the insider purchases were so small relative to the financial wherewithal of the participants and to their existing stakes in the company that they appeared to be simply an effort to "signal the market" with news of insider purchases, thus reassuring retail investors like this fellow. In context, this was not a serious effort to increase their stakes by taking advantage of discounted prices.

...If insider purchases are indiscriminately believed to be a bullish indicator, bad actors can use them as false indicators at desparate times. Dennis Kozlowski and Mark Swartz of Tyco each spent about $15 million to signal the market with insider purchases in January 2002. In June 2005, Kozlowski and Swartz were found guilty on twenty-two of twenty-three counts of grand larceny and conspiracy, falsifying business records and violating business law. They were ordered to pay fines and restitution of over $200 million and given lengthy prison sentences.

The above is from page 131 of the book. It shows that Einhorn does not limit himself to rules, such as insider purchases are good, but looks at any one action by management in the context of everything else he knows and only then reaches a conclusion.