The Fine Line Between Persistence and Insanity in the Markets

There are a number of investing books about legendary investors that give people the sense that they too can become a star stock picker.

I’m looking at you, every book ever written about Warren Buffett or Peter Lynch.

Fooling Some of the People All of the Time: A Long Short Story by David Einhorn is not one of these books.

This book makes you feel the opposite. It lets you know what you’re up against in terms of intellect, research, hard work and perseverance. It shows how hard it is to be competitive in today’s hedge fund landscape.

Einhorn goes into great detail about the story of a stock he shorted called Allied Capital. After presenting Allied as a short candidate at a conference in 2002, Einhorn spent the next 6 years going up against company management, regulatory agencies, Wall Street analysts, journalists, politicians and the FBI in an attempt to prove the company was acting in a fraudulent manner.

The countless hours of forensic accounting, research and attention to detail Einhorn and team put into this one stock was so impressive that it gives you a window into what you’re up against when competing against world-class investors.

Although Einhorn was eventually proven right as Allied Capital was forced to restructure following the financial crisis it took 6 years and a brutal PR campaign staged by the company for him to profit on his short bet. This investment thesis was a labor of love.

Following up on his takedown of Allied Capital, Einhorn predicted the downfall of Lehman Brothers well before the onset of the Great Financial Crisis.

So people’s ears perked up when Einhorn said this week in a letter to his investors, “we are now in the midst of an enormous tech bubble.”

The problem with this statement is Einhorn has been saying the same thing for more than 6 years now. This is from a CNBC story in April of 2014:

“Now there is a clear consensus that we are witnessing our second tech bubble in 15 years,” Greenlight Capital said in an investor letter Tuesday. “What is uncertain is how much further the bubble can expand, and what might pop it.”

The firm said there were several indications of the over-exuberance, including the rejection of conventional valuation methods; short sellers forced to cover their positions because of losses; and “huge” first-day stock appreciations after their initial public offerings.

“The current bubble is an echo of the previous tech bubble, but with fewer large capitalization stocks and much less public enthusiasm,” the letter said. The firm said it was shorting a group of undisclosed “high-flying momentum stocks.”

One of the stocks Einhorn has targeted for years is Netflix. Here’s another CNBC story from just after the 2016 presidential election:

Einhorn, the founder of Greenlight Capital, said in his annual letter to shareholders on Tuesday that he added Netflix to his “bubble basket” because the company is poorly positioned to take advantage of the incoming president’s policies, particularly tax cuts on corporate profits.

“Bubble basket stocks mostly don’t have profits, which makes them unlikely to benefit from corporate tax cuts,” Einhorn wrote. “Further, an accelerating economy should allow investors to find growth without needing to pay nosebleed prices for a narrow group of profitless top-line growth stocks.”

The stock is up 270% or so since this was published.

Another story says Einhorn has also bet against high-flyers like Amazon, Tesla and Chipotle, all stocks that have experienced massive gains in recent years.

I’m not sharing these stories to say Einhorn has lost his touch. Maybe he has, maybe he hasn’t. This cycle obviously hasn’t been an accommodating investment environment for value investors.

But what if perseverance works against you at times as an investor? What if that same stick-to-itiveness that helped him doggedly spend 6 years fighting to expose Allied Capital as a fraud is now working against him?

Am I being disciplined in my long-term approach or blind to the fact that the world has changed is the single most difficult question to answer as an investor because no one is right all the time. The truth is the answer to this question is always unknown.

Sometimes you have to look like an idiot for a while before your investment thesis pans out. On the other hand, there’s the old saying that insanity is doing the same thing over and over again but expecting a different result.

What if continuously betting against tech stocks in a big way proves to be the definition of insanity? These stocks would have to see a spectacular crash to fall back to levels last seen in 2016 or 2014. Stranger things have happened, I guess, but I wonder what would cause Einhorn to change his mind.

The problem with bubble-spotting is no matter what happens you assume you’re right. If prices fall then you nailed it and if prices rise it simply makes you think the bubble is still inflating. I don’t know if this is a bubble or not but the answer will likely look obvious with the benefit of hindsight either way.

Jeff Bezos once said, “Contrarians are usually wrong.”

The masters of the universe in the hedge fund space typically begin with the assumption that everyone else is wrong.

It can be just as useful to ask yourself, “What if everyone else is right but I’m wrong?”

Further Reading:
Investing Experts on an Earlier Version of the World

 
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