Our investment program employs the skills I learned at SC to analyze the economic value of companies and the alignment of interests between decision makers and investors. Our research process reverses the analytical framework that most traditional value investors use. Many value investors determine whether a security is cheap. If it is, they seek to determine whether it is cheap for a good reason. A typical process to identify opportunities is through computer screens that identify statistical cheapness, such as low multiples of earnings, sales, or book value combined with rising earnings estimates. Then, they evaluate the identified companies as possible investments.
Greenlight takes the opposite approach. We start by asking why a security is likely to be misvalued in the market. Once we have a theory, we analyze the security to determine if it is, in fact, cheap or overvalued. In order to invest, we need to understand why the opportunity exists and believe we have a sizable analytical edge over the person on the other side of the trade. The market is an impersonal place. When we buy something, we generally do not know who is selling. It would be foolish to assume that our counterparty is uninformed or unsophisticated. In most circumstances, today’s seller has followed the situation longer and more closely than we have, has previously been a buyer, and has now changed his mind to become a seller. Even worse, the counterparty could be a company insider or an informed industry player working at a key supplier, customer or competitor. Some investors believe they have an advantage trafficking in stocks that have minimal Wall Street analyst coverage. We believe it doesn’t matter if a stock is “underfollowed” because the person we are buying from probably has followed the stock and we need to have a better grasp on the situation than he does. Given who that may be, our burden is high.
Many traditional long-only managers design their portfolios to perform over the next six to twelve months. Hedge funds attack the resulting inefficiency from both sides. Some believe that horizon is too long. They do not care whether a stock is going to do well in a year. They want to do well today or this week or, at worst, this month. These funds usually hold positions for a short time. Many of them are “black box” funds, where computer programs tell them what to buy. Others are news driven and want to know whether the next piece of news, or “data point,” will be positive or negative. Some of these short-term-oriented funds rely on technical analysis, the study of security trading patterns, to decipher the likely near-term future direction, while others rely on the manager’s trading instinct, feel, and experience. Many use a combination of insights, and some have been quite successful. These types of funds, though, tend to have little to no transparency. Nobody on the outside really knows much about the portfolio. Even if they were willing to disclose a lot, it would not be so informative because the holdings change so frequently. When the investing is computer driven, the managers of the fund are not interested in sharing the program, because the program is the business.
Greenlight believes the traditional investment horizon is too short because equities are long, if not indefinite-duration, assets. When we make an investment, we usually don’t have any idea how long we will be invested. If the downside of an opportunity is no short-term return or “dead money,” we can live with that. We are happy to hold for more than a year before succeeding. In practice, some “dead money” opportunities work out more quickly than we expect. A portfolio where some investments work quickly, some work slowly, and the rest retain their value generates exciting results. The trick is to avoid losers. Losers are terrible because it takes a success to offset them just to get back to even. We strive to preserve capital on each investment. It does not always work out that way, but that is the goal.
As we generally have long holding periods, there is no reason not to disclose key positions. Some of our peers disclose little because they worry people will gossip over their inevitable errors. Journalists seem increasingly joyful to report stories about hedge fund mistakes. Greenlight experienced that when we were large holders in (and I was a director of) New Century Financial, a subprime mortgage originator, which imploded in early 2007. My view is that actually losing money is much worse than the mere embarrassment of others’ seeing we were wrong.
Though our research process relies heavily on my SC training, Greenlight constructs the portfolio differently from SC. The largest investments at SC were “pair trades.” A pair trade matches two companies in the same industry trading at widely disparate valuations. SC would buy the cheaper company of the pair and sell short the more expensive one. In the best cases, the long had better prospects or more conservative accounting than the short. Pair trades attempt to hedge a portfolio’s investments by eliminating both market risk and industry risk and capturing the valuation convergence over time.
Starting with a good idea and finding a disparately valued industry comparable to match creates a pair trade. Often, the second half of the pair trade is not a worthwhile investment other than as an industry and/or market hedge. If one ranked investments on a scale from one to ten, with one being a perfect long idea and ten being a perfect short idea, a portfolio
