David Einhorn, Investment Flows, and Market Inefficiency
Thanks to all who are reading this week - criticism is welcome.
David Einhorn went on Masters in Business last week, discussing, among other things, how different markets are than when he first started Greenlight. The interview’s titled “David Einhorn: Market Structures Are Broken”, which likely explains why it’s caused such a flurry of activity on twitter. I think the majority of these tweets are pretty uncharitable, and that there’s a decent chance most of their authors didn’t listen to the actual podcast. Before proclaiming that markets are ‘fundamentally broken’, Einhorn explains how the landscape has altered over the past decade:
“I think things have changed a lot…..When I started in 1996, you know, the main thing people would say when we would pitch our services was, well, what do we need another hedge fund for? Right, there's a million guys trying to do what you're doing. In addition to the hedge funds, there were all these mutual funds, and so there were lots and lots of people trying to pay attention and find undervalued things for customers. And that's changed a lot because the passive world has taken over and the number of active managers is down a lot, and the active long only managers are down a lot, and you still have people paying attention to certain stocks, but there's entire segments now, mostly in the smaller part of the market, where there's literally nobody paying any attention. Like these companies could announce almost anything other than the sale of the company and nobody would notice. And so we've had to adjust our thinking because our thinking before used to be, if we buy this at this time's earnings, and they're going to do 20% better than everybody thinks, and the multiple rerates as a result of that, we're going to do terrifically. And that assumes that we're going to figure out what somebody else is going to buy six months, a year, two years before they come to that conclusion. But what if those people aren't in business anymore, or to the extent they are in business, they don't have any capital to employ into new ideas. As those situations develop, they fire their staffs. There's way fewer people listening. And the result is if we buy these things, we're not going to get the same kind of return that we used to get.”
People have interpreted these words in a few different ways:
Greenlight’s performance hasn’t been great since 2010, but instead of taking responsibility Einhorn’s just complaining and looking to shift blame elsewhere.
Einhorn’s wrong on the facts here. Markets have gotten more efficient over the last ten years, not less.
In the above Einhorn claims markets are broken. However, elsewhere in the interview he says this is an exciting time to be a value investor because ‘the competitors have essentially left the field.’ But a key point of his argument above is that there are so few competitors that price discovery doesn’t happen anymore! Einhorn seems to be saying that a lack of competition explains why Greenlight underperformed, but also that a lack of competition explains why Greenlight will outperform going forward. Proposition p and not p can’t be true at the same time!
I think the above readings of Einhorn miss the mark. There are plenty of investors who would prefer to blame market structure rather than themselves for poor performance. More than a few value funds spent years decrying tech’s outperformance as evidence of another bubble, just as a certain growth investor blamed the Fed’s actions for her fund dramatically underperforming since late 2021. Shifting blame is not what Einhorn is doing here. Instead, he explains why the market is broken, and then explains how his strategy has evolved as a result:
“So what we have to do now is be even more disciplined on price. So we're not buying things at 10x or 11x earnings. We're buying things at 4x earnings, 5x earnings, and we're buying them where they have huge buybacks and we can't count on other long only investors to buy our things after us. We're going to have to get paid by the company. So we need 15-20% cash flow type of numbers, and if that cash is then being returned to us, we're going to do pretty well over time.”
Given the above, it’s unlikely that interpretation (1) holds water. Decrying changes in market structure and then explaining how your firm has adapted as a result is hardly shifting the blame elsewhere! It’s also unlikely that interpretation (3) is correct, although it’s at least more sophisticated than (1). A lack of competition might explain why Greenlight went through an extended period of underperformance, but, again, Einhorn’s point is that he’s adapted to this lack of competition by shifting his expression of the value strategy. Given that Greenlight now focuses on companies doing heavy buybacks rather than companies whose earnings will surprise by +20%, it makes sense to prefer little competition. All else being equal, a fund’s return will be better if it can buy a stock at 5x earnings rather than 11x!
That leaves interpretation (2), which on its face is more plausible. Few would argue that the quarterly earnings game is less competitive today than it was in the early 2000s; nor would many argue that front running S&P 500 index additions is still a reliable way to generate alpha. But it’s at least conceivable that not all parts of the market have gotten increasingly efficient over the past twenty years, particularly given the rise of passive investing and the concurrent decline of active mutual funds. At a minimum, it would be a stretch to argue that AMC or GameStop became more efficiently priced after r/wallstreetbets simply because, when one zooms out, alpha in markets is increasingly competed away. It’s of course easy to argue that there’s more talent in pursuit of alpha than there’s ever been in the past, but it doesn’t follow from that that all parts of the market have benefited from that talent. Few Harvard educated Goldman investment banking analysts are choosing to exit to small cap long-only mutual funds over offers from Citadel or KKR. It seems a stretch to argue that investment and talent flows out of an asset class don’t have a corresponding impact on its efficiency.