The Mystery Of Einhorn

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The Journal has a nice article about David Einhorn today, making the point that he can move stocks with the sheer power of his disapproval. Not even disapproval, really; a raised eyebrow will suffice, as it did for HerbaLife. Imagine his parenting skills.

Here is a chart from the Journal and I guess you win a cookie if you can tell me how it's calculated:

But you get the gist: on average (er, median), an Einhorn seal of disapproval lops 4.9% off a company's market cap in one day, and 13% in a month. You can argue that he is just excellent at picking stocks that are about to drop precipitously, but the repeated one-day success seems like pretty clear evidence that the market is reacting to, rather than independently fulfilling, his predictions.

So, first off: this is a great skill to have! I think that in part because I am very lazy and have always imagined a hedge fund manager's job as being to come into the office, point at a stock, say "that one," and go home for the year while the stock he picked makes him rich. I don't think it works that way, though; stocks tend to move for reasons in the external world unrelated to your simple desire to make yourself rich, so you have to spend your days, like, doing research and stuff. But when your desire to get rich off a stock pick makes it so, that is metaphysically delightful.

It's particularly delightful for a short seller. (Though also: sort of puzzling for a short seller.) We've talked before about a paradox of short selling where:

  • if you have a good idea for improving a company, you buy the stock and say so, and maybe they'll do it and you'll get rich, but
  • if you have a good idea for making a company worse, you can't short the stock and say so, since no one will do it, and
  • more broadly, if you think a company is doing a fine job of getting worse all on its own, you can't short its stock and be like "look at how terrible this company is," because then they'll fix the terrible things and the stock will go up and you'll lose money.

This should in theory confine short selling to outright frauds and hopeless cases, though that theory is confounded by enough persistent mismanagement and/or irrational market valuations so that you can grind out a living. But it's hard work, and lacking in the natural feedback mechanisms that make, say, a Warren Buffett seal of approval intrinsically valuable on the long side. So self-fulfillingness is quite a shortcut.

It's such a great skill that if I were David Einhorn I'd be sorely tempted to monetize it. Of course he does - he tends to short stocks before saying mean things about them, though not always, as in the case of HerbaLife, where he destroyed 30% of shareholder value in a month and doesn't seem to have made a dime off of it. But he limits himself to economically rational short positions on stocks that he's actually, y'know, researched and found wanting.

Aren't there better strategies? Here's one: instead of shorting and saying nasty things about X stocks per year, short and say nasty things about, say, X*Y stocks per year. X of these are researched and found wanting; the other X*(Y-1) are half-assed. (Hire a half-assed analyst to plagiarize research and write up some nasty comments.) I think this works thusly:

  • Markets figure out that you've lost a bit of your touch and so its effect dissipates somewhat;
  • But markets can't easily figure out which calls are right and which are half-assed, since if they could prices would have already adjusted to reflect that;1
  • So the near-term effect is, say, reduced from a ~5% to ~5%/Y one-day drop, proportional to the increase in number of calls; but
  • You still get out of your half-assed positions at a profit on that drop, while keeping the "real" shorts until prices adjust to your (hypothetically correct) fundamental call. (Maybe you even add to the "real" shorts, which will be less expensive given the smaller near-term drop.)

If you have faith in your short calls, this shouldn't cost you anything on those, while adding free value on your half-assed picks. Picking Y is then a creepy optimization problem.

Here's another one: sell advance notice of your disapproval. The order of operations is like (1) short company's stock, (2) tell a few subscribers that you're planning to say mean things about company, (3) say mean things about company. Oh also (0) sell subscriptions for zillions of dollars, where the subscriber comes after you but before the public. These subscriptions would obviously be valuable; the Einhorn effect seems to be about 50% bigger than the effect of earnings surprises, and people have gone to jail for years for trying to get those surprises.

Of course the natural reaction is that you'd go to jail for buying or selling the Einhorn subscription, but why? Is it insider trading? Put aside whether Einhorn's disapproval is "inside information" - it's not, he's not an insider, but the prohibition is really on trading on "material nonpublic information," and before he announces his disapproval it is arguably both material and nonpublic. But the rule - at least in America - forbids trading on material nonpublic information "in breach of a fiduciary duty or other relationship of trust and confidence," and it's hard to figure out where that duty would come from in this case.2 My guess is that the Greenlight Newsletter would be perfectly legal, much like the Felix Salmon Scoops Service would be.

Here's a third strategy: sell protection. You only have so much capital you want to risk on shorting stock, and only so many stocks you want to short. But there are so many other stocks! I mean, there are 19 publicly traded multilevel marketing companies3 alone; surely none of them want David Einhorn poking around their conference calls. And perhaps he's not planning to poke around their conference calls but you never - well, hang on, this is delicate. Let me put it this way: I have a feeling that if David Einhorn were to offer his services as a board consultant - one who was forbidden by virtue of that consulting position from buying or selling stock - to multilevel marketing, say, or real-estate-development or coffee-making companies, there would be a lot of demand for those services. Those high-priced, not very labor-intensive services.

I'm not entirely serious about any of these things - I think they'd stand a good chance of dissipating the Einhorn effect, and I'm not sure they really lever his skills more than just shorting bad stocks does. But there's a concept in the law of "the mystery of blackmail": it's legal to reveal negative information about someone, it's legal not to, and it's legal to ask someone for money, but it's not legal to ask someone for money in exchange for not revealing negative information about them. Unless it is - in the context of settling a threatened lawsuit, for instance: the mystery of blackmail is one that can often be cleared up by hiring a good lawyer. The David-Einhorn-as-board-consultant scheme partakes, I think, of the mystery of blackmail: offering his services as a consultant with a wink is legal; offering them with a threat is not.

The subscription service partakes of the mystery of insider trading: information about Einhorn's intentions is secret and arguably more material than information about earnings surprises, but disclosing it selectively probably isn't illegal insider trading. Even the strategy of shorting stocks you haven't actually researched touches on some deep mysteries: people of course do it all the time, but if you laid it out as a business plan like I did above - explicitly taking advantage of copycats who trade on your announcements - you'd surely be guilty of (the rather nebulous offense of) market manipulation. That would be true even if your half-assed research was more thorough than what most people put into their best-thought-out stock picks.

All of these things would, I think, be legal and profitable in a certain light, and illegal in another, with the call being closer than you might expect. Which is probably a good enough reason not to do them. Especially if you can make so much money just by saying negative things and being right about them.

A Mighty Wind: Sizing Up Fund Manager's Sway [WSJ]

1.In other words, the Einhorn effect can't simply consist of Einhorn pointing out what everyone would have figured out on their own, because then they would have figured it out. Instead it has to have some real (herd-following) content, of people selling stock because Einhorn did rather than because they instantaneously knew he was right. Instructive on this point is this article, claiming that not only are copycats incapable of evaluating Einhorn's underlying reasoning, they are sometimes incapable of evaluating whether he actually bought the stock.

2.His fiduciary duties to Greenlight investors? I don't see it - if subscribers get the information after Einhorn puts on a position, that helps Greenlight LPs rather than hurting them - but in any case could be fixed by explicitly allowing this in the LP agreement.

3.I don't exactly vouch for that list, which amusingly includes Berkshire Hathaway (not counted in my 19).

Related

David Einhorn Said No To A Capital Raise, Kept The Door Open For A Pub Crawl

Remember how David Einhorn got in trouble in England for insider trading on Punch Taverns stock and he was all "what?" and we were all "what?"? Well, you can judge it for yourself because now the entire disputed call with Punch is available online (at the back of this). So go read it, or read the highlights here. The FSA still thinks it's insider trading, but the count of people confused by the whole thing is rising, and now includes the Merrill banker on the call. There's lots of insider traderiness on this side of the pond today too so we should talk about that in a bit. For now, though, two other things. One is quick - no one can resist one part of the call and I can't either so here it is: DAVID EINHORN: Hi, I’m sorry I didn’t get to see you when you were in New York. PUNCH CEO: No, no, we -- well, we’ve -- we’ve only had the chance to speak once, although we have seen [reference to Greenlight Analyst] a few times since then. DAVID EINHORN: Oh, you’re -- you’re -- you’re getting more than -- than I could help with anyway. So, this is good. PUNCH CEO: Okay. That’s fair enough. Well, one day we’ll get you around on a pub crawl around some English pubs. DAVID EINHORN: Oh, that sounds fun. PUNCH CEO: It is. You’re right. English readers: Is it? I just assumed that Punch Taverns are rather grim places, like TGI Friday's but with more ... punching? ... but maybe I'm totally off base here. Also, here is a hypothesis: vice investments do well because, for the same level of profitability, they get more analyst/investor coverage and enthusiasm. Wouldn't you rather go on a pub crawl instead of like a tour of an auto parts factory in Queens? Would that influence your stock recommendations / money allocations? Someone should do a study.