Einhorn: “None Of The Problems From The Crisis Have Been Solved” – Full Q&A
By Tyler Durden – Zero Hedge
Two months ago, a downbeat David Einhorn mused rhetorically “will this market cycle never turn?”
Despite solid Q3 performance, Einhorn admitted that “the market remains very challenging for value investing strategies, as growth stocks have continued to outperform value stocks. The persistence of this dynamic leads to questions regarding whether value investing is a viable strategy. The knee-jerk instinct is to respond that when a proven strategy is so exceedingly out of favor that its viability is questioned, the cycle must be about to turn around. Unfortunately, we lack such clarity. After years of running into the wind, we are left with no sense stronger than, ‘it will turn when it turns’.”
Such an open-ended answer, however, is a problem for a fund which famously opened a basket of “internet shorts” several years prior, and which have continued to rip ever higher, detracting from Greenlight’s overall performance.
This, in turn, has prompted Einhorn to consider the unthinkable alternative: “Might the cycle never turn?” In other words, is the market now permanently broken.
While the Greenlight founder did not explicitly answer the question, in a recent speech at The Oxford Union in England, Einhorn made it clear how farcical he believes this market has become, pointing out that the problems that caused the global financial crisis a decade ago still haven’t been resolved.
“Do I think we’ve learned a lesson from the global financial crisis? It depends on what one thinks that the lesson was, unfortunately” Einhorn says 9’40” into the speech.
Famous for his value investing style and bet against Lehman Brothers that paid off in the crisis, Einhorn said he identified several issues at the time of the crisis, including the fact that institutions that could have gone under were deemed too big to fail. The scarcity of major credit-rating agencies was and remains a factor, Einhorn said, while problems in the derivatives market “could have been dealt with differently,” and in the “so-called structured-credit market, risk was transferred, but not really being transferred, and not properly valued.”
“if you look at all the obvious problems from the financial crisis, we really kind of solved none of them. And we went on a different way, and we basically, went the bailout route. And said we are going to create a whole lot of moral hazard, and we’re going to sweep as much of this stuff as in the rough under the rug as we can, and we are going to move on as quickly as we can. And so, that solved some things in some ways, but I think it is left the basic structure, more or less, as it was. And I think that it is susceptible to the same type of events or series of events sometime in the future.”
Einhorn didn’t avoid discussing his underperformance, citing several failed bets that companies’ stocks would decline. He didn’t name the stocks he was shorting, but insisted that none of the companies are “viable businesses.”
“What I was basically saying was look value investing over time has worked, we think this is the best and right way to invest, it’s not going to be true every day, in every environment, but we are in an environment right now, where it doesn’t seem to be working at all, and in fact the opposite seems to be working, because people are looking at things and saying, the ownership of a company is something other than the risk adjusted future profits of the company, maybe it’s the social disruption, maybe it’s the social desirability, maybe is the charismatic value of the CEO.”
Einhorn, an avid poker player, also shared the following insight into the similarities between gambling and investing:
Host: You are an avid poker player and say, what is your approach to risk, both when dealing with cards and chips and then dealing with stocks.
David: Yeah. Investing in a poker game, and investing in stocks at least the way I do it, it’s a very similar skillset. You have certain facts that you know, and in stock investing, it is whatever objective information you know about a company or a situation, you know, what is the stock price is a good one. But also, what the company does, what their sales are, so forth. These objective things that you know. And then, there are things that you can surmise, but you don’t really know, you are making an implication, so that would be, you know, what is the motivation of the CEO, what is the strategy, what are the various interests that are there, what does the competition looks like. These are not objective, these are things that through work, you can make an educated guess about, but you don’t really know. And then you have a range of things that you don’t know that are going to come in the future, which are future events, that are fundamentally unpredictable, but they live within a range of possible future events. So, you combine what you know, with what you think you can surmise, combined with understanding the range of outcomes related to the uncertain things, and say is this a good place to commit a fraction of my capital.
And then you could translate that to poker, what is it that you know, you know how many chips you have, you know what cards you are holding in your hand, if there are cards that are displayed face up on the table, you can what those are, right? And there are things you can surmise, what are my opponent’s cards likely to be, how he is betting the hand, I can get information that way or by sitting in a table and playing with him for a while, I can see what his personality is, what his style is, what his skills and I can make inferences about the present hand based on upon his past behavior. So those are things you are trying to deduce.
And then there is the uncertainty which is the range of future cards that are concealed in the deck that is yet to be displayed, that is important, right, and there is a range of those possible outcomes. And you take a look at all of those things, what you know and what you can surmise, and the range of outcomes and say do I want to, you know, play this hand? Do I want to bet chips into this hand and so forth?
Finally, in the context of Einhorn’s generally downbeat mood, we remind us of his exasperated conclusion from the latest Greenlight letter to investors:
Given the performance of certain stocks, we wonder if the market has adopted an alternative paradigm for calculating equity value. What if equity value has nothing to do with current or future profits and instead is derived from a company’s ability to be disruptive, to provide social change, or to advance new beneficial technologies, even when doing so results in current and future economic loss?
It’s clear that a number of companies provide products and services to customers that come with a subsidy from equity holders. And yet, on a mark-to-market basis, the equity holders are doing just fine.
Ah yes, the Fed-funded “deflation trade” which lowers prices for goods and services courtesy of ravenous investors who will throw money at any “growth” idea, without considerations for return or profit, because – well – more such investors will emerge tomorrow. After all, in this day and age of ZIRP, what else will they do with their money?
Transcript of Interview at Oxford Union
Host: So, thank you so much for joining us here this evening. Packed room. Everyone is very excited to see you.
David: I’m excited to see everyone. This is fantastic. Thank you.
Host: Great. No worries. So, the Oxford Union is as you know, the speaking and debating society here at the University of Oxford. And when it was initially founded, it was a platform for free speech and debate. And to this day, we host weekly show debates, as I mentioned earlier, on a range of topics. And your college Dan, tipped me off earlier this week that you’re in fact a huge fan of debates. When does this passion stand for?
David: Yeah, I’ve spent most of my high school doing debate. It was the team that I was on. And I started freshman year and spent an incredible amount of time preparing for the annual topic and competing throughout the state, and sometimes throughout the country. And it was just my main activity in high school, outside of my academics.
Host: And do you ever use that in your career today? Do you find that skill useful?
David: It is. It is a skill that is useful because the fundamental skill of debate is critical thinking and analysis. And it’s to hear something and to react to it, relatively quickly, and to access the truthfulness of it, and to question the validity on it, and to be able to sometimes argue both sides of it, because a lot of the debates you go to tournament, and there will be 8 rounds and 4 times you’d be arguing one side, and the other 4 times you’d be arguing the other side. So, you’d have to see both sides and be able to advance an argument. And that translates through to just so many things that you do. You need to know. In my business investing, you are buying a stock, and someone else is selling the stock. Right there, that’s like a debate. It’s the stock going up or is it going to go down? So being able to have a skill that you’ve honed, and be able to argue on both sides of that proposition, allows you sometimes to be able to look at something and say: Okay, this is the side that I’m picking on this particular argument.
Host: Have you ever had that instance, when you are picking a stock, and you’ve had a complete change of mind and a reversal in the approach that you initially took?
David: Yeah. We are wrong all the time. I shouldn’t say we are wrong all the time, but we are wrong often. And we have to question whether we are wrong constantly. And so, there are lots of times that come along where you buy a stock, and then a certain amount of time happens, or additional events happen, and you have to look at it a different way and say, no, sorry that was it. We should have done the opposite of what we did, and then you change course.
Host: Okay. So, slightly different question. But you studied Government as you mentioned earlier, and then you went into the Finance Industry. Did you ever consider another career path?
David: Yeah. After my undergraduate, I’ve written a thesis that was in the government department but largely, it turned out almost an economic type of thesis. And I was very interested in that, and I wanted to go get a Ph.D. in Economics. And I applied to several schools, and they did me a huge favor by rejecting me, which allowed me to go towards the career that I’ve gone to.
Host: Okay. So never a kind of career in government or something about that area?
David: Yeah. Even though I studied it, I easily could’ve got involved in the academics’ side of it. I never really envisioned myself as like truly part of the government or part of the politics or process like that.
Host: Okay. And then, how did you get started with the business? And how did you take Greenlight from the two-man operation that you started with to the huge hedge fund that it is today?
David: You know, a lot of it was really due to not having a lot of planning, but being able to be in a particular situation, and in my case, also getting a fair amount of good fortune. And then adjusting to the circumstances that we were there, and making what I think turned out to be good decisions. And so, I had the happenstance of being at fund where I got some good training, and then also at the same time realizing at a point, relatively early, in my career that I didn’t have a long-term future there. And so, the fellow who is in the office next to me kind of had the same view about his career and we went out for coffee one day, and decided to walk out and start our own. And three weeks after that we were in snow, in January, in Manhattan looking for like a Starbucks to sit in, you know like, to make some phone calls to people and get the business started. And we did not have enormous aspirations, but we felt that in the way that the industry was set up, there are very low barriers to entry, and we felt that even with a small amount of money, if we could do a good job with it, we could make a good enough income stream that we would have, you know, have a satisfactory life. And I never in a million years would have guessed that the thing would have turned out the way that it has. That was never an aspiration, it just worked out that way.
Host: Great that it did, right?
David: Very lucky.
Host: Yeah. If you had to say that was one sole reason for Greenlight’ success, what would you pin it down to, if you had to pick one?
David: If I had to pick one, and think it’s critical thinking skill. And it’s the ability to look at a situation, and see it for what it is, which isn’t necessarily what is presented to you, and when something makes sense, to figure out what makes sense. And when something doesn’t make sense, to question it, to challenge it, to look at it from a different way. And to often come to the opposite conclusion. And you don’t have to do that very often. Because of most of the time, when someone tells you something it makes sense, it just makes sense, that is that. But sometimes it really doesn’t make sense, so there is another side to it and when you can come to a view, you know, maybe just a few times a year, where you have an important difference of opinion with what everybody else is thinking about a particular situation, if you can figure that out, and figure out that it’s important, we’ve been able to make a small number of larger investments that the vast majority of the time have worked out very well. Because we really have had an important difference of opinion, between what we think and whoever is on the other side of that transaction when we enter it.
Host: Okay. And how would you say that is translated into Greenlight’s culture as a firm?
David: I mean the culture as a firm is very…. We are a lot of nice, smart people, we interact well. I think there is a lot of humility, I think that people respect one another. People respect one another’s views. People respect me, I respect them, I respect their time, which I think is, I wouldn’t call unique, but it’s unusual management culture for senior people to respect the time of junior people and so forth truly. And so, you wind up with a group of people that are critical thinkers that think and reason things out before that they speak. That can adjust to new facts, that can adjust to feedback, you know, and can work well within a culture. And that is what we have.
Host: Yeah. Would you say that is in contrast to kind of the rest of the finance industry?
David: No, I wouldn’t contrast to the rest. We are our own, and there’s a whole continuum. There are probably even people who’ve done, what we are trying to do even in a better way. So, I don’t want to say that we are unique, but we do it our particular way, and it works pretty well for us much of the time, and from there is a whole continuum of different types of work cultures and trades that people are looking for.
Host: And you said you worked in investment banking earlier. How did you find the culture there? Do you think the culture in that industry has changed? Do you ever see it changing?
David: Yes. I worked in Investment Banking for two years. I was in a program where they kind of just owned you. And you, I didn’t realize that I’ve signed up for that, which was one of the problems, I didn’t know anybody who’d done this. And I grew up in the Midwest, and that meant that like everybody’s dad was home for dinner, and certainly on the weekends, and I didn’t know from this kind of work environments. But the environment there was is you show up, and you are in a division, and there are 200 people in the division. And by definition, all 200 of them have been there at least one day longer than you, and anybody who’s been there one day longer than you is your boss. And so, you have 200 bosses. And you know, if you are not good in figuring out, like, how to manage people’s expectations, if two people tell you to do opposite things at the same time, for me this was something that I was never able to really to wrestle to the ground in a way, so I wound up not really succeeding within that culture. And the other side is that the culture, therefore, is very disrespectful of younger people. Because if you are the senior person, it meant that you’d once been the younger person, and you’d that experience, and you were almost obligated to inflict upon them whatever has been inflicted on you, sort of as a rite of passage as if it was like a growth thing. And I never really understood that. And I kind of think from a managers perspective I’ve looked at it and think it’s a negative example. And so sometimes, the best lessons you have in life are when somebody does something, and you say I would just do the opposite of that, were I to be in that person’s position. And I’ve tried to do that as I become a manager of people within my own firm.
Host. Okay, so I guess leading on to talking about culture and the finance industry. We’re coming up to 10 years since the global financial crisis, do you think we’ve learned our lesson?
David: Do you think I’ve learned a lesson from the global financial crisis? It depends on what one thinks that the lesson was, unfortunately. You know, as I looked at the global financial crisis as it happened, I thought that there three or four or five really obvious problems, structural problems that were exposed. You had institutions that were thought to be able to fail, but in fact, there were deemed to be too big to fail. You had some of the so-called structured credit, where the risk was being transferred, but it wasn’t really being transferred, and it wasn’t being properly evaluated. You had the problem of these credit rating agencies, which were being that there’s really only 2-3 major ones, what wind up with is a centralized decision maker as to who’s creditworthy and who is not creditworthy. And that is a really bad way to allocate credit. What you really want is a large number of people evaluating each credit to determine the creditworthiness, rather than having 1-2, because I you have 1-2, you created a crisis of confidence when the 1 or 2 change their minds. And you lose the opportunity to go out into the market and find other people who might look at it differently from the credit rating agencies. And that’s separate and apart from the corruption that was involved there relating to the triple-A ratings and the structure of a product like that. I think there was a lesson that was learned about derivatives, and derivatives could’ve been dealt with differently, and what we’ve done instead is we’ve created a clearinghouse for derivatives, which essentially had created yet another too big to fail institution, where all the credit is on undercapitalized entity that everybody assumes, you know, will perform under all circumstances, when of course, it can’t as the counterparties began to actually have problems. And so, from my perspective, if you look at all the obvious problems from the financial crisis, we really kind of solved none of them. And we went on a different way, and we basically, went the bailout route. And said we are going to create a whole lot of moral hazard, and we’re going to sweep as much of this stuff as in the rough under the rug as we can, and we are going to move on as quickly as we can. And so, that solved some things in some ways, but I think it is left the basic structure, more or less, as it was. And I think that it is susceptible to the same type of events or series of events sometime in the future.
Host: When you say sometime in the future, would you put a number on that?
David: Whenever the next down cycle occurs.
Host: Okay. So, growth is done very well against value in recent years. And you recently appeared in financial news headlines when you told your investors that Greenlight reliance on value may have been wrong. Do you think that this trend will reserve? And how have you coped with adjusting your own investment philosophy after so many years?
David: Okay. This is the problem with communication, sometimes when you do what is called rhetorical writing, or ironical writing, or maybe, even slightly sarcastic writing. And so, I wrote a missive to our investors in our quarterly letter, and I was a little bit sarcastic I think many people understood what I was trying to say, and some people took it absolutely stone-cold Amelia Bedelia literal and came to the opposite conclusion of what I was saying. So what I was basically saying was look value investing over time has work, we think this is the best and right way to invest, it’s not going to be true every day, in every environment, but we are in an environment right now, where it doesn’t seem to be working at all, and in fact the opposite seems to be working, because people are looking at things and saying, the ownership of a company is something other than the risk adjusted future profits of the company, maybe it’s the social disruption, maybe it’s the social desirability, maybe is the charismatic value of the CEO. Whatever it is that you have that is contributing in the mind of the market to the equity value of the companies. I would have equated this sort of from a decade ago when people thought that companies should be valued on how many eyeballs were watching on their screen. I think this is a cyclical phenomenon. And people would like to say it’s different this time, but for our philosophy, it’s not, and at some point, this will revert. But nonetheless, sitting and watching the portfolio trade every day, and watching companies that don’t make profits, don’t have real prospects of making profits, may not even exist for the purpose of making profits, have the value of those stocks going up a lot, while other companies that have the misfortune of actually trying to earn a return on capital and pass some of that to their shareholders, see their stocks d-rated and devalued in the present environment. It’s a challenge to our strategy as long as that persists, and our results over the most recent period have certainly suffered because we have been investing in a more traditional way, at least that is the way that I’d describe it.
Host: Okay. Speaking of kind of disruptions to the market and kind of new funds coming along disrupting what currently exists. What do you think is the next big technology that will disrupt the landscape that we may not even be aware of?
David: I have no idea. It’s not really my field of expertise. I certainly will not be the first person to tell you about the technology that all of the scientists, data scientists, material scientists, engineers, physicists, computer scientist, that are sitting in this room, are spending all your time on. You know what technology is more likely to be changing the world than I do. That’s for certain.
Host: So, moving quickly on then. You are an avid poker player and say what is your approach to risk, both when dealing with cards and chips and then dealing with stocks.
David: Yeah. Investing in a poker game, and investing in stocks at least the way I do it, it’s a very similar skillset. You have certain facts that you know, and in stock investing, it is whatever objective information you know about a company or a situation, you know, what is the stock price is a good one. But also, what the company does, what their sales are, so forth. These objective things that you know. And then, there are things that you can surmise, but you don’t really know, you are making an implication, so that would be, you know, what is the motivation of the CEO, what is the strategy, what are the various interests that are there, what does the competition looks like. These are not objective, these are things that through work, you can make an educated guess about, but you don’t really know. And then you have a range of things that you don’t know that are going to come in the future, which are future events, that are fundamentally unpredictable, but they live within a range of possible future events. So, you combine what you know, with what you think you can surmise, combined with understanding the range of outcomes related to the uncertain things, and say is this a good place to commit a fraction of my capital. And then you could translate that to poker, what is it that you know, you know how many chips you have, you know what cards you are holding in your hand, if there are cards that are displayed face up on the table, you can what those are, right? And there are things you can surmise, what are my opponent’s cards likely to be, how he is betting the hand, I can get information that way or by sitting in a table and playing with him for a while, I can see what his personality is, what his style is, what his skills and I can make inferences about the present hand based on upon his past behavior. So those are things you are trying to deduce. And then there is the uncertainty which is the range of future cards that are concealed in the deck that is yet to be displayed, that is important, right, and there is a range of those possible outcomes. And you take a look at all of those things, what you know and what you can surmise, and the range of outcomes and say do I want to, you know, play this hand? Do I want to bet chips into this hand and so forth?
Host: Okay. And then kind of leading on from taking risks to playing poker. You are also known for donating your winnings to charity, so you founded the Einhorn Family Charitable Foundation. Do you want to tell me a bit more about this and the causes you’ve chosen to raise awareness for and why you’re passionate about this causes?
David: So, our charitable foundation has a professional staff of 7 at this point, helping me make good decision in allocating philanthropically. We have one theme. The theme is helping people get along better. And we define that very broadly. I would say, when you think about what that means, from our perspective, we like to say that we are in the fire prevention business, not the fire-fighting business so. You don’t go into the middle of the war somewhere, where people are shooting each other and say, hey everybody, we are going to help you get along better. It’s kind of a little bit too late, for philanthropic interest. But there are things that you can do that makes this less likely, so you can build understanding between people’s, and share experiences and bridging differences, and creating pro-social skills and social-emotional learning. And parents bonding well with their children, and in people bonding well within the community, and welcoming immigrants and things like this. So, we basically break the philanthropic interest into 3 different areas, which we basically call from birth up through, you know, schooling, and then there is school age people, and then there is campus and community. And we have a group of different entities that we support for different purposes within that range. We built a nice portfolio of things that we support.
Host: Through kind of partnerships with other organizations.
David: We don’t actually do anything, we are a grating organization. So, we give grants to other philanthropic organizations that are well aligned, we tend to sometimes ask for very specific grant proposals. So, there is a reason like, if you ask for money from us, you’re going to take the money because you are going to do a particular thing, and then we are going to fund that particular thing, but sometimes we just like the organization, and we’ll donate to the infrastructure and overall general support of the organization as well.
Host: And kind of thinking a bit more about the aims of the foundation, where does the focus on empathy stand from, for you personally I guess?
David: Well, empathy it’s part of… It’s a core skill in getting along with other people, there are other core skills as well, but empathy is certainly one, if you can understand where somebody is coming from or why they are feeling a particular way, and related to them on that basis, it bridges, you know, it bridges
Host: And what next, what are other causes that you have a look at? Have you ever thought about expanding internationally?
David: You know, we’ve done a few things internationally, over time. But it actually turns out that there is really plenty of people not getting along well enough right where we are. And so, we tend to be focusing, you know. The closer it is. Just like the investment, the closer it is to where we are, the better chance it is that we’ll understand it, we’ll understand the people, understand the likelihood of being able to make a contribution that will make a difference. And so, our bias is towards being closer to home whenever possible.
Host: Okay. Do you have a particular moment that stands out for you through your charitable work or a particular cause that you’ve donated that stands out for you?
David: I don’t think… I don’t think I have a personal moment. I tend to be away from, in a certain sense, I get involved in the decisions, and the grant-making, and the allocations, and involved, you know, supervising the structure and the strategy of the team, but I do not tend to participate directly on the ground.
Host: Okay. Do you think kind of take, going back say 20 years? Would you have known that you would have had an interest in the kind of, world of philanthropy and that you would have given so much to this kind of, these causes?
David: No, because I had no idea that the kind of opportunity to do that was in front of me. I’m truly surprised, and it’s a blessing and an honor and a privilege to be able to have this aspect of my life, which I would never have forecast.
Host: Okay. And we’ve spoken about kind of what next in the philanthropic area. Where next and what next in the financial career? What is it motivating you to carry on managing the fund? And kind of, where next?
David: I love trying to solve the puzzles. I love trying to find investments. I love trying to figure out what it is that is motivating a situation where we have a difference of opinion. You know, people ask, what is the most exciting part is, is it like, when you have some company, and you proved right, is that the most exciting part? That is actually not the most exciting part, that’s not a bad part, but that’s not the most exciting part. The most exciting part is when you think you figured out the joke, and you kind of get the joke, and you understand what it is that you are doing, and why it is that you have the opportunity now, where you are going to be able to deploy capital, and it’s very likely to work out well. And those situations come up few and far between when you really have it, and it’s really, really exciting, cause then after that it’s just a question of watching it happen.
Host: So, what next, what are the plans? Inter expansion of the fund? Are there particular areas that you are looking at investing next?
David: No, at the moment we are trying to do well with what we have, and that’s proving to be very difficult for us, in the current environment. We invested in domestic market, sorry, developed markets so we will invest in Europe, we will invest in Japan, will invest in Australia and Canada, and the US, and maybe a couple of other places that are developed markets that I’m not thinking of. But that’s the vast majority of where we are. And I have no aspirations to get further away because I find that once you get into places further away, you are subjected to what is going on with the insiders, and there are local rules, there are local customs and there is local knowledge. And it’s very very hard to compete with that sitting in NYC, even if you get on an airplane and go and visit once in a while.
Host: Okay. So, from there, shall we open up from questions from the audience? So, if anyone has a question if you’d like to raise your hand and we’ll try and go through as many of you as possible. Say, first hand right up there at the back.
Audience: I have two questions about the current market environment. The first one would be, you said that the barrier of entry was very low when you entered the market, and I wonder whether that is still the case today, or even, especially the case today with a lot of money in the market. So, my question would be, are those barriers to entry still very low? The second question would be, you said that the rules of valuation of companies seem to be somewhat off today and that there is a cyclical moment, for you I assume that right now you have to differentiate between firms that have a joke and firms that are just, that is just highly valued by this current market environment. What are the specific difficulties of doing that, telling the jokes from the weird ones?
David: Yeah, look, when I started, there were people who started their funds, and they said in order for us, it depends on your structure is and what you are doing… in order for us to be in business, you know, I need to be here, I need to have 5 different industry analysts helping me, I need a CFO, I need 3 assistants, I need a lawyer, I need someone who can program computers, I need a couple of traders, and before you know you are hiring 10 – 15- 20- 40 people to launch a fund. If you are going to do that you need to launch with a certain amount of capital, so that you have enough income for management fees, to fund the getting going of the business. That was true then, and I think it’s true now as well. So, if you are going to create an elaborate organization, you need to have the fees, that create elaborate organizations. And the barriers to entry them were not zero, and the barrier entries to that now are not zero, you have to figure out where that initial pool of capital is going to come into. But just like then, if somebody is going to give you, or if you had a way to raise a couple hundred million dollars, you could do that then, and if you know where you are going to get your first couple hundred million dollars, you can do that now. And you can compete on that basis.
Our thing wasn’t really like that, it was another guy and me, and we were in an office, and 130 sq. Feet and I kind of had to suck in my gut, to get between my desk and the file cabinet to get around to my chair. And we had a T-shaped desk, you know, facing each other with computers, back then we share an AOL email account, and we sent the monthly result, which I personally did by fax that was on a radiator. So, my partner would calculate the result, print them out, hand then to me and I’d fax them one at the time to the investors. That was where we were technologically back them, we probably didn’t even state at the art at the time, but it’s the way it was. But I’ll tell you that with very very small amount of assets under management you could do that because there was nobody that needed to be fed. There was not a lot of expense. I literally wrote a check for $10000 and my partner wrote a check for $10000, and them I purchased for us the filing cabinet, the television, the computers, wherever it was that we needed, and the rest we made a deal effectively with our brokers and so forth, to kind of get us going with a few infrastructures like a copy machine and a coffee maker. And I think you could still do that today. And if you had a differentiated strategy and articulated it well, develop a client base and have good success that backs up the story, I think it’s completely replicable now, just as it was for me 20 years ago. So, it’s a question of what it is that you are trying to do and what kind of barriers entry there are to do that. I’m sure there are regulatory changes, and other changes have made it, but on the other hand, there is a whole industry that along the way has developed, which is capital introduction. And you have these big banks, that if they decided that they are going to back you up, they’d get you in front of 50-100 potential clients, and you can tell your story and raise that initial capital. And we didn’t have that back them, the industry was not as developed. So, we had to do it a different way. Ultimately, when we told our initial story, you know, literally 3-4 people signed up. And that was it. They signed for a small amount of money. And the good news was that as we kept telling our story and the result were good, and some of the initial investors, one of the initial investors after 6 months, said hey, you did a really great job for me, here is my 15 friends, tell them I called and went meet all of them. And that kind of word of mouth is how effectively we were able to build our company. The second question you have to remind me because I talk too long.
Audience: I was how you decided, how to differentiate the jokes against the companies that are just highly valued in this current market.
David: Generally speaking, we don’t short companies on what we think to be valuation, we’ve always insisted on overvaluation combined with some kind of deterioration. On the other hand, about three years ago, which we though were 4 years into the building of this, we managed to miss the whole first 4 years of it, in a lot of appreciation, in a lot of this I think questionable companies. We kind of for whatever reason thought we were getting towards the end of it, and we decided that if we could look at the company, none of the companies were profitable or materially profitable, and said if we didn’t know what this business was. But we knew what the financial statements were, and we knew what the projected financial statements were, and we thought a little bit about the business, we didn’t even know what the business was, but we just looked at the financial circumstance and future financial circumstance that comes, if we closed our eyes, and we didn’t know what the company did, if we didn’t know if it was a, you know, an office supply company or a paper maker or Netflix, right? So, if we didn’t know what if was, and you just looked at all of the numbers, and you say what would you pay for this stock, and if the answer was 90% less than where it was trading, we created a basket with about 40 – 50 of this, and shorted a small amount of a large number of them. Over time, at least, until the beginning of this year that basically worked out. Because even though we have 2, 3 or 4 that really worked against us, in a pretty big way, a big number of those 50 ultimately failed or d-rated, the stocks went down a lot, and certainly, and the gains were roughly enough to cover the ones that appreciated. This year has not been the case, pretty much everything that’s remained, or even we put into that basket, has only continued to go up. But the thesis on all of them is that none of them are actual viable business, and the market may disagree with us on this, but when they start showing real profits will take a different point of view on particular names.
Host: Was there a question over there? Yeah. The one at the back, yeah.
Audience: So, my question is just, I mean you’ve been contrarian investor for some time, I think a lot of your investments during the bubble, during both in the dot-com and later on have been contrarian, and a lot of people around you must have gone, you know, long all the time, so the question really is, how do you sort of stick to your guns, when it comes to entering contrarian positions and holding it until it works out?
David: First of all, it’s not about sticking to your guns. It’s about reassessing constantly. And when the positions don’t work, or they go against you, the presumption is not we were right, the presumption is that we might have missed something here. And so then, you have to go back and think about it again and again and again and understand the other side, and see if anything has changed, and see if your view has changed, if it has changed, to modify the position. And you might eliminate it, or you might reduce it, or sometimes increase it, but very rarely. Generally speaking, my inclination is when the position is not going well it’s more likely that we missed something, so the choice is generally either to reduce or eliminate or just simply keep it if we think that it’s right. So it’s not about… on the other hand if we continue this way, and continue to think that we are right, then I find that patience is the way to go. And then we have to wait and let the story play out however it does, while we continue to reassess it to see if, in fact, we were wrong. Which you get both outcomes.
Host: Anyone else? Okay. The front here.
Audience Thank you so much for coming today. So I wanted to talk to you about, for example, the vulture funds, for example with the current situation in Puerto Rico, many people have realized that the cover indebtedness is very often exacerbated by vulture funds, actually does hedge funds exploit the situation instead of trying to help alleviate or refinance them. So I’m wondering how you think about that whether there are conflicts with the idea of let’s help people. Thank you.
David: Hm… Generally speaking, by putting a pejorative name, vulture, on what you call it vulture fund, you kind of convicted, the suspect without a trial. Fundamentally, what vulture funds do, is there are people who’ve to lend money, and the loan has gone bad, or appears likely to go bad, and rather to lose their entire investment or continue to work through a restructuring, they choose to sell their historical investment, and it’s a service to them, that there is someone who is willing to buy the other side of that, to let them have wherever money the market says is the right price for that. So, then the question is… then you have people who have expertise in accumulating portfolios or situations like that, buying them effectively at the right price, and them figuring out how to maximize the value, out of the previous loan that has been made. That’s essentially what they do. Now, occasionally, you know, more with corporate situations, than in governments situations like you talked about with Puerto Rico, but generally speaking, you know, sometimes, they try to enforce laws, or they try to work to try to get recovery. They generally operate within whatever the rules are, and I don’t really see why there is an obvious social problem to this. So, I’m not really sure that there is a genuine problem, but it’s very easy to say look, you paid 30 cents on a dollar, for something that was initially 100 cents, aren’t your greed by trying to figure out how to make that 30 cents into 50 cents. But the alternative, right, is to say you can’t do this, and if you want to buy a bond that yours to keep and so if you are the original purchaser at 100 and there is, you know, and something goes wrong, and the bond is now 30, you can’t sell it, you have to keep it, you go figure out how to collect, so you get a specialization of expertise that is created to this funds.
Audience Thank you so much.
Host: Okay, so in the aisle there. Just there.
Audience: I actually just wanted to follow up on your last point, you talking about misses, if you look, I know you don’t want to dwell on it, but if you look your last quarter’, and you compare it to the return S&P 500 and your note, again we are not trying to read too much into that sarcasm, are you gonna be changing anything going into the next few quarters continuing short your bubble basket? If you can give some details that would be appreciated.
David: Yeah. Our goal is to achieve attracted risk adjustments returns over time while taking demonstrably less risk than the market as a whole. Which means, fundamentally, we are not comparing ourselves to the S&P 500 or any index. And so, we don’t evaluate ourselves that way. Certain of our investments have worked out decently. Lately, certain of our other have worked out less decently, and what we do is we reevaluate all of them. And some of those that have worked, we sell or reduce because they worked and we are not interested in them anymore. And some, they haven’t worked, we exit or reduce because we decided that whatever was that we were thinking is no longer true, or is unlikely to be born out to be true. And we modify the positions accordingly, and we do that on a position by position basis throughout the portfolio, and we do that whether things are going well or whether things are not going well for us. So, I don’t have a very good specific answer because it’s just part of our ongoing process.
Host Thank you. The front row off the front, just here.
Audience: So, I was wondering, what is the sort of weight or value places, because you are obviously everybody in the world is making difficult decisions because everything is much more complex. The number and the significance of unknown unknowns I supposed or factors that you can’t necessarily… you can’t mitigate all risk. Basically, I think is where I’m getting at, so there is always be this element of intuition or experience I guess which factors in. How do you sort of weight that up versus what just the numbers and the rationale, you know, the advisors and people are saying, I guess maybe personally, or maybe just more in a business context? Something like that.
David: Yeah. The way you deal with unknown unknowns, which there is an unknown number of, but certainly exists, right? Is through portfolio construction. You know, we like to run a concentrated portfolio, but even in our best idea, we are not going to put all of our money in. You have to have set some limit, you have to have some risk management, you have to have some level of diversification, we have some number of longs and some amounts of shorts, and so depending on, you know, we have a certain amount of market risk that we are willing to take, on a knowing basis. And then you have the idiosyncratic risk related to the individual investment. I said as people say, there is a stock and it’s at 10 dollars, and it’s got one dollar of downside, and it’s got 10 dollars of upside, and I look at it, no, it has 10 dollars of downside. Because you can lose your whole investment in any stock when you make it. We manage risk further, by the level of the index that we make, we are not levered, we don’t borrow more money to make even more investments, that’s one way that avoid risk, or that you control your risk if you don’t have to repay anybody. You are not subjected to lending terms and conditions. That being said other people do things in different ways and they have risk management tools, you know. You asked about the financial crisis, and one of the funny things to me, is that one of the things that was most exposed in the financial crisis is the flaw on mathematical model on tail risk, in the so-called value at risk, which is a method that used by all of the large banks and institutions. And value risk does, I’m going to digress a little bit, is it basically, says if the risk is something that is going to happen beyond a certain level of frequency, you don’t have to put any capital aside. So, we are going to put capital aside, to cover 95% of all possible outcomes or 98% of all possible outcomes, but we are not going to put capital aside for really remote things beyond whatever the tail is. And I think that was one of the big problems. Because what happened was, it’s people said, if you don’t have to put any capital against it, I can take that bet in an infinite number of times. So, in other words, is like if you were on the other side of roulette, the house side of the roulette… And offering 35 to 1 odds on a 38 to 1 opportunity, and you have a rule that says I only have to put out capital for 1 in 25 events. How much capital do I have to set aside if someone is going to bet the number 13 against me, and the answer is zero. And so, since you didn’t have to put any capital aside, the financial institutions were willing to take an infinity amount of risk against it. And that how you end… and then what happened obviously, was a relatively unlikely, or they thought relatively unlikely happened, and there was not capital that was set aside against a terrorist that turned out to be much more likely and much more correlated that it was. So, I would view that as a kind of risk management I don’t want to practice. So, we take a more layer by layer, what are our investments, what is our risk on this investment, that investment, and the next investment. And we tend to think of risk as for how much can we lose in our worst case, so that’s why when I say it’s a 10-dollar stock, how much can you lose? The answer is not one dollar, it’s 10 dollars, and that is the way that I think about it.
Host: Shall we go to the lady just in the aisle there? Yeah, just there.
Audience: Hi. Thank you for coming. I just wanted, because you mentioned earlier that you look at the financial statement, and you give a price to the company in question, and compare to the marketplace. That sounds like something that might be computerized, and maybe machine learning can do a good job about. So, I was wondering if you are considering integrating that, and so forth.
David: First of all, that is true. And second of all, what I was trying to say that illustratively, which was that I was trying to make a point, that we generally don’t sell short stocks, just on valuation. But when we came to a point with certain stocks that the valuation was so, seemed to us to be so extremely out of whack, that is wasn’t really a debate as to whether the stock was an arrange of fair value, in other words, it was 90% or so overvalued, you don’t need a computer to figure that out. Because you so far of, and even when if you are wrong by 100%, instead of it being 90% overvalued, it’s 80% that was the point that I was making. We do not sit around all day and try to figure out the precise value of individual stocks. We just don’t do that, because those are not relevant to our actual ability to make decisions, so we if we have a stock and it’s, you know, 10 dollars the goal is not to figure out if it’s worth 11 dollars or 11,5 dollars or 12 dollars, the goal is to figure out is it worth lot more than 10 dollars. And since we are looking for, and not being precise about that, because it doesn’t matter whether is worth it… if we buy it at ten, it doesn’t really matter if it’s worth 18 or 20 or 25, and there is no point in us trying to figure that out right now, because the only decision we have right now is, do we want to own this stock at 10? And if we think it’s undervalued by a lot, that is good enough for us to decide to own it now, and by the time it starts approaching higher values, we can reassess it, and we can fine-tune our thinking on an ongoing basis, so when it gets to 15, we can say do we still think that this is very undervalued, or eighteen or twenty, and sometimes the facts will change. And so, if you would have maybe, if you bothered to figure out that it’s worth twenty in the first place, by the time it gets to 15, you might decide it’s worth 30 or alternately, you might decide you know what, it wasn’t ever probably even worth 20, it was probably worth 15. And so, you want to sell it at that point. And those are the kinds of on-going assessments that we make, but we do it in a very imprecise way, is a way I would describe it.
No, we view these investments as investments as puzzles, there are the few things that you know, but they are not the most important things because everybody knows them. The most important things, are what is it that you can infer and how good are you assessing the possible ranges of the outcome, either the known unknowns or the unknown unknowns. And how do you construct that into a portfolio? And those things, I’m sure the machines have views on this, and the shorter term of the decision, the more likely probably the machine is gonna figure it out better and faster than the human. But our goal here is just to find things that are just widely misunderstood by a large margin. We are not really competing with that kind of technology. Because I don’t think we’d beat them
Host: Shall we go for, a question just in the middle there. Just forward a row. Yeah, there we go.
Audience Thank you very much. I’d like to hear your comment about the gap between investors and companies. What I think is a very oversimplified argument, but it is often said that there is a short-termism in the market, on the other hands, companies failed to justify the premium they pay for their margin acquisition. So, I liked to hear your comments on short-termism and how can a company fit in the gap between the companies and the investors.
David: I’m sorry I don’t understand the question. Is the gap between…
Audience: The investors and companies…
Audience: About the timeframe or investment, or capital share repurchase or dividend, or how to…
David: I see the idea that corporations have a longer horizon than investors do?
Audience: Yes… I would like to hear the gap… how to fill the gap.
David: Look, I think one of the inefficiencies in the market is that investors are generically too short-term oriented. And I think that time arbitrage is one of the best inefficiencies in the market. You know, there are lots of investors that if you say, hey, this stock isn’t going to go up in the next six months, they are going to say, then why should I buy it, I can wait 6 months, and I can buy it for them. Because I just really want to buy it in the period that it goes up. And that’s cute but also imprecise. And so sometimes, you know, if you have something in, you know, is either going to go up sometime in the future, because you think it’s undervalued, but all the other investor says I’m not going to buy it because it’s quote-unquote dead money. Sometimes those are just the best investments, because nobody wants them, and they may work out faster than people think. We’ve had that experience sometimes, where people have said, hey, you’ve got to do that. And so, some of them will work out faster, and some of them will work out on time, and some of them will work out later, and some of them will work out never. Now, relating to the difference of opinion then between what shareholders want and the companies wants, there’s a natural tension there, but there’s also a large agency difference. Because the career and the incentives of corporate managers are not always aligned with value creation, and it’s not always a question of the investors being on the short term and the management being on the long term. If the management job is just to simply make sure that the company is solvent, because as long as they are solvent, they’ll get their pension, then there’s no incentive to ever take any risk. And you do run into managers where that’s essentially their agenda. There are other times, where you have a company that has a well thought out strategy that’s going to create compounding value over a period of time, and needs its capital for whatever it’s doing, and just have time to do its research, its development, its market growth and so forth, and execute its strategy. And the management should essentially be left alone to do that. So, I view that as there is a tension that, and it should be looked on a case by case basis. And sometimes the shareholders who are suggesting a change, or would like to see things that might improve the value of the company, are right, and sometimes the management is right, and I think you look on different cases. When we get involved, which is very rare, regarding pushing an agenda, our view is, invariably, that if it doesn’t help in both the short and intermediate terms and the long-term, then it’s not a good solution to what the problem is. And so, the few times we stood up and advocated for something, we’ve been of the view that it would be beneficial to the company regardless of what the horizon is.
Host: I think we got time for one more question. Shall we go right to the back of the back corner?
Audience: David, I don’t know if you watch Billions, but how representative is it of hedge funds life?
David: I do watch the show. And it’s really entertaining.