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) 📕

We ended 1997 up 57.9 percent with $75 million under management. We decided not to accept additional money until we were prepared to invest it. Why? Adding too much new capital to a portfolio too quickly is a problem. It creates undue pressure to find new investments or to add to existing positions. We do not deploy new capital into existing positions unless they are either fresh ideas or positions to which we really want to add. However, while professional money managers habitually put new money into existing ideas, we don’t feel comfortable doing that when an investment is already in the middle innings. If we buy something at $10 thinking it is worth $20, do we really want to add to it at $16 if we think the value hasn’t changed? It is better to wait for a fresh opportunity or to close the fund to new investment. On the other hand, when the portfolio is fully invested, adding new assets helps investment performance. It allows room for new opportunities without selling existing positions prematurely. We have accepted new capital from time to time under those circumstances.

Fifty people attended the 1997 partners’ dinner at the Penn Club. We expected it to be a celebration. It was not. After our presentation, we took questions. Several partners complained about how fast the assets under management had grown. They worried we would not be able to keep up the returns. I explained that we closed the fund and would not accept new money until we were fully invested and emphasized that we did not expect to make 57 percent ever again, under any circumstance. As we never expected the results to be so good, we did not believe them sustainable at any asset size. Our goal is to make 20 percent per year. This will not happen each year, but we hope to average that over time with demonstrably less risk than the market. This is a challenging goal, which we may not achieve. I believe in setting high goals rather than easily clearable low ones. However, the strong initial result was no reason to raise the bar. No matter, the dinner was a tough experience. I learned that if we were going to have question-and-answer sessions, I had to be prepared for anything.

We started 1998 well, as the fund returned 9.9 percent through April. Then, Computer Learning Centers (CLCX), our largest short position, became a problem. CLCX was a for-profit education company that took advantage of generous government student loans and ripped off both students and the government. The company charged $20,000 a year to teach computer skills to uneducated people on obsolete technology. They accepted anyone. Another short-seller sent someone to intentionally fail the admissions test at one of the schools. The admissions officer gave her the answer key and then asked her to take the test again. Because the company offered a poor product and engaged in misconduct, we took a large short position. A local TV station in Washington, D.C., ran a feature that interviewed a bunch of angry students complaining about the poor facilities and showed an admissions officer on hidden camera promising a prospective student an absurdly high expected starting salary upon graduation. The stock market reaction: yawn.

CLCX announced a strong first quarter. Reid Bechtle, the CEO, confronted the short-sellers, telling The Washington Post, “Every dollar the stock goes up is $4 million the shorts take out of their bank accounts.” The Post said he told an investor, “We’ve already gone through Hiroshima and it’s time for Nagasaki” for the shorts. Shortly thereafter, the shares began to decline when the Department of Education announced a program review to examine compliance and the Illinois attorney general filed a civil fraud complaint. The stock sank. Sensing that the end was near, we increased our short position.

A couple of months later, CLCX paid a $500,000 fine and promised better business practices to settle with the Illinois attorney general. The attorney general thought this was a big penalty, but the stock market judged it a trivial cost of putting their problems behind them. Bulls spread the word that the Department of Education completed its program reviews and would not take strong action. Three large mutual funds in Boston each added to already enormous positions. The stock doubled quickly. It looked as though CLCX might actually get away with it. I decided to swallow my medicine and covered the short in July. We lost about 2.5 percent of our capital on that position.

Covering the short was a poor decision because it turned out we were right about the company. The publicity from the regulatory action and more conservative behavior by the company caused enrollments and earnings to fall short of expectations, which killed the stock. This actually happens a lot in controversial short sales: Many times, the bulls win the battle on the core criticism (in this case, regulators didn’t immediately kill the company), but the bears win the war, as business or accounting reforms cause disappointing performance. It took the Department of Education two more years to complete its work. When it did, it demanded that CLCX return all the student loans it had ever advanced to the government. This put them out of business. (For a good summary, go to http://chronicle.com/free/v47/i23/23a03501.htm.)

A key problem for investors who short a company that is subject to government oversight is that the government, even when it acts, does not move at the same speed as the stock market. Two years might make a prompt government investigation, but it is an eternity for investors such as Greenlight reporting monthly results, even in a long-term strategy. Based on my decision to cover CLCX, I developed a stronger stomach and learned to become even more patient. CLCX is one of the more expensive of many examples that have taught me this lesson.

Unfortunately, as we covered CLCX, the stock market made a near-term top. Around that time, we also covered