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) 📕

Just as the Elán bulls had argued that Elán was a lousy short, because it would never miss its earnings forecast, the Allied bulls argue that Allied’s dividend is unlikely to be cut regardless of whether it deserves to be cut. They raise the same question: “How are you ever going to get paid on your short if Allied never cuts the dividend?” Of course, when Elán was ultimately revealed to be a fraud, it did miss the earnings forecast, and the short worked out well.

As bizarre as this sounds, Allied’s “dividend” is not really a dividend. Traditionally, a dividend represents excess profit that a company pays to shareholders because it does not need to retain the capital in its business. Though Allied’s “dividend” of about 8 percent is about three times the average yield in the S&P 500, it isn’t a “dividend” in the traditional sense. Traditional companies that pay large dividends do not generally issue fresh equity because the dividends reflect an unneeded surplus of capital. However, Allied does not have excess capital. So, its “dividend” is not paid from surplus it doesn’t need to retain in order to maintain or grow its business. In fact, Allied routinely sells freshly issued stock to satisfy its ongoing need for additional equity.

Technically, Allied’s “dividend” is a tax distribution. As an investment company, as long as it distributes its taxable earnings to its shareholders, Allied does not pay corporate taxes. This is the same tax regime practiced by mutual funds and every other type of U.S. investment company. When mutual funds pay large annual tax distributions, its investors are unhappy. In fact, a good mutual fund seeks to minimize its tax distribution by keeping its winners and selling its losers. No mutual fund strives to smooth and grow its tax distribution. No one would value a mutual fund based on the yield implied by its tax distribution.

As a stroke of investor-relations genius, Allied breaks its tax distribution into four quarterly pieces and calls them “dividends.” Wherever I refer to Allied’s “dividend,” “tax distribution,” or just “distribution,” I am referring to the tax distribution Allied calls its “dividend.” Unlike almost every other investment company, Allied principally judges itself by how well it maximizes its taxable income rather than by its investment results. As a result, it sells its winners and keeps (and often supports) its losers. In the money management industry, this is known as “picking your flowers and watering your weeds,” and it’s a recipe for disaster. The maximize taxes strategy, of course, increases Uncle Sam’s take. Allied has taught its shareholders to pay taxes and like it!

Later, Walton said: “We’re a dividend company that wants to grow the dividend 10 percent a year.” Then Walton addressed me. “I’d like to just point out to Mr. Einhorn that he’s so generous by giving up half his profits,” he said. “We’ve got 85,000 retail shareholders that depend on the dividend. We really operate the business for dividends. I think that’s a pretty good social purpose, too. . . . We find it unusual that somebody gets up and gives a speech about a company who never bothers to talk to management. I think most informed investors would appreciate some time spent with us so they can talk these things through unless you’re simply trying to develop the short thesis to scare people and make a quick buck and move on. I don’t find that a very high social purpose. Maybe other people do.”

Walton and others at Allied knew we had talked to management and gone through the issues with them at length. Their responses on the conference call weren’t different from what Sparrow and Roll told us. They knew there wasn’t any misunderstanding, and they had no interest in calling us to work through the issues to try to show us we were wrong. Instead, they desperately needed people to question our motives and to think we didn’t do our homework.

Walton responded to a question about how much of the distribution is covered by ordinary income. “For the last four years, our exclusive strategy is to build the interest and fee income from the portfolio to provide more ordinary income to cover the dividends.” He continued, “Last year, our ordinary taxable income was about 90 percent of income, which we think provides a lot of stability for the dividends. We think capital gains are great, but they’re less predictable, and so, therefore, we try not to build that into the dividend growth model.”

Beginning with that quarter, Allied has been unable to sustain the 10 percent distribution growth it projected, and ordinary income never again came close to covering the distributions. Instead, Allied shifted to a capital gains strategy. All it had to do was make shareholders forget Walton’s words and convince them that capital gains are actually predictable.

Then Walton finished with an Orwellian wrap-up. “We’re delighted to talk about our business and we’re committed to transparency and full disclosure,” he said.

Allied’s entire strategy is extensive disclosure on some things, but little disclosure on what a skeptical investor might really wish to know. For example, Allied provides terrific detail of its industry and geographic investment diversification, but barely a word about the business results, prospects or valuations of its individual investments.

It occurred to me that people who are willing to lie about small things have no problem lying about big things.

CHAPTER 7

Wall Street Analysts

Coming out of the conference call, I felt great. Allied management did not make any points that seriously challenged our analysis and continued to repeat what they had told us previously. Their comments were convoluted, their tactics desperate. When a reporter for Dow Jones Newswire called, I told her, “They talked around all my issues without really addressing any of them.” I decided to sell more shares short.

Starting that day, a number of law firms began filing class-action suits, repeating