Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New by David Einhorn (tohfa e dulha read online TXT) 📕

CHAPTER 3

Greenlight’s Early Successes

We started 1997 strong and returned 13.1 percent in the first quarter. Then, I made my first costly mistake. There are two types of bad outcomes. Sometimes, after analyzing the risk and reward, an investment appears attractive, but the unfortunate or unlikely happens. Such is life. Other times, the analysis is simply flawed: The investment is poor and we deserve the eventual loss. This mistake was the latter. We invested 6 percent of capital into Reliance Acceptance, which charged 18 percent for car loans to people with tarnished credit. The key investment issue: Was that 18 percent enough to cover the losses from loan defaults, which were harder to estimate? I analyzed the car repossession data and determined that Reliance repossessed 20 percent of the cars and lost 40 percent of the loan each time. The loans lasted two years, so I calculated annual losses to be 20 percent × 40 percent ÷ 2, or 4 percent. The high interest rate appeared sufficient to cover the losses and the stock appeared cheap, at a discount to book value.

I erred by not framing the loss analysis properly. The repossession statistics did not include about 10 percent of the loans where the repossessor could not find the car. Obviously, these loans were 100 percent losses. This meant the real losses were more than twice what I’d calculated. The 18 percent interest did not cover the cost of funds, the true losses, and the operating expenses. We lost about half our investment before I realized my error. This led to our first down month in April, where we lost 0.3 percent.

The rest of the year was a cakewalk. The biggest winners: insurance company demutualizations, spin-offs, Pinnacle Systems, and some short sales. Demutualizations are good hunting grounds for our type of investing. Many insurance companies have been formed as customer cooperatives, or “mutuals.” In a mutual, there is no share ownership, but policyholders, who are considered the “owners,” do have some rights, such as electing directors. Management’s simple self-interest is to stay solvent. They tend to have conservative accounting policies because there is no stock price or even an organized ownership group to worry about. On the margin, large reported profits generate taxes and raise the possibility that the policyholders might demand some of the money back, either through lower premiums or surplus payments. Reporting profits actually could lead to eventual financial trouble—the one thing management needs to avoid.

From time to time, mutuals convert themselves to stock companies in a transaction called a demutualization. The most attractive deals are 100 percent sales of the stock in an initial public offering (IPO), with the proceeds going to the company. The new investors effectively get the company for free, as ownership of the post-IPO stock includes both the IPO proceeds held at the company and the company itself. Add in a nice dose of stock options for management set at the IPO price, and the incentives and the structure allow new shareholders and management to make a killing with little risk. In many cases, lackluster-performing companies begin to show remarkable profit improvements after the IPO.

Some spin-offs have similar dynamics, though they need to be assessed case by case. A spin-off is when a large company divests a subsidiary by distributing the subsidiary’s shares to the parent company’s shareholders. Over the years, we have found that carefully selected spin-offs are terrific opportunities.

Pinnacle Systems was a technology company that had reported a couple of disappointing quarters. Its stock traded down to book value, which was mostly cash. Many value investors eschew investing in technology companies because the products are complicated and the field changes rapidly. We take the view that technology companies that are not losing money, are trading at book value, and appear to have a viable product are good investments. It proved to be the case in this instance, and when Pinnacle reported better results, the shares tripled.

Finally, some of our short sales made nice contributions in 1997, including Boston Chicken and Samsonite. Boston Chicken’s accounting practices enabled it to recognize up-front revenue and profit when franchisees opened restaurants. Boston Chicken financed the openings and up-front fees and earned interest on loans to the franchisees. The underlying restaurants were not profitable enough to support the payments to the parent. Boston Chicken’s shareholders were not concerned, or perhaps were not even aware that franchisees lost money, because Boston Chicken did not consolidate the franchise operations in its financial statements. We believed that if the restaurant economics were not robust enough for the franchisees to satisfy their obligations to Boston Chicken and make a reasonable return for themselves, they would stop opening more restaurants and Boston Chicken’s price-to-earnings multiple would fall as it stopped growing. It turned out even worse because the franchisees defaulted on the loans. Eventually, Boston Chicken went bankrupt.

Samsonite also collapsed. We sold its shares short at $28 and watched them soar to $45. I checked and rechecked the thesis and decided to suck it up. Samsonite had raised prices and broadened its distribution network at the same time. It had opened many of its own stores, which aggressively competed against its own wholesale customers, the retailers. We saw a luggage store in Manhattan with a window display sign promoting “Samsonite 40% off.” We bought the sign to hang in our office. The clerk gave us a funny look. It turned out that wasn’t the only store working off excess Samsonite inventory. When Samsonite acknowledged that consumers didn’t accept the price increase and retailers were awash in excess inventory, the shares collapsed to $6.

We hired our first employees in the summer and moved into our own office in the Graybar Building, next to Grand Central Terminal. Our 1,300 square feet felt like a palace. I had my own office and could talk to my wife on the telephone without anyone knowing what