Billionaire hedge fund manager David Einhorn says critical thinking is the single most important factor for investing success.
“If I had to pick one, I think it’s a critical thinking skill. It is the ability to look at a situation and see it for what it is, which is not necessarily what is presented to you. And when something makes sense to find out what makes sense. And if something doesn’t make sense to question it, challenge it, look at it differently, often come to the opposite conclusion,” he said in an interview with a financial website.
Einhorn says investors should bet big when opportunities come with high conviction.
“You don’t have to do it often. Usually when someone tells you something and it makes sense, it just makes sense. And that’s that. But sometimes it really doesn’t make sense… And if you can maybe only come to a viewing a few times a year, where you have a major difference of opinion with what everyone thinks about a certain situation, if you can think of that sort it out and find out it’s important. We were able to make a small number of large investments that paid off very well most of the time,” he says.
David Einhorn is known in the financial markets as an activist investor and an eminent shortseller. He has long been considered one of the most successful and meticulous hedge fund managers in the financial industry.
He is known for correctly deploying a short position in Lehman Brothers before it collapsed during the financial crisis.
Einhorn is also the president and co-founder of Greenlight Capital Inc. After receiving his BA from Cornell University’s College of Arts and Sciences in 1991, he began his career with the hedge fund Siegler, Collery & Co. in 1993.
Greenlight Capital is a New York-based hedge fund founded in 1996 by David Einhorn. From its inception in May 1996 to the end of 2016, the fund has risen to 16.1%, significantly ahead of the S&P 500.
Einhorn’s company invests in both long- and short-term stocks, but is best known for short-selling. It uses a long-short equity strategy where it takes long positions in stocks that are expected to rise and short positions in stocks that are expected to fall. The company implements the strategy depending on whether an asset is labeled as undervalued or overvalued.
The fund analyzes various aspects of the investment market, including quantitative analysis, annual reports and market sentiment.
The Einhorn Effect
In the investment circle, the “Einhorn Effect” refers to the influence David Einhorn’s commentary on markets and specific stocks has on their price.
The market often reacts significantly to Einhorn’s public comments on stocks, looking at why the term “Einhorn effect” was coined.
Einhorn follows the principles of value investing and has developed a twist on the regular process of value investing. He initially finds reasons for likely asset mispricing and then performs traditional value investment analysis rather than performing traditional value investment analysis first.
According to Einhorn, the reasons for mispriced assets include spin-offs, accounting problems, and changes in secular or technology trends.
“We’re taking the traditional value investor process and turning it around a bit. We start by identifying situations where there is a reason why something could be misunderstood, where it is likely that investors have not properly understood what is going on. Then we do the more traditional work to confirm whether there is indeed an attractive investment to be made. That’s as opposed to starting with something that’s just cheap and then trying to figure out why. We think our way is more efficient,” he says.
Einhorn is a firm believer in taking long positions in companies he believes are undervalued and shorting stocks in companies he believes are overvalued or have accounting problems.
He looks at the intrinsic value of a company when striving for a constant return.
Einhorn says an investor’s job is to discover puzzle solutions in situations involving various combinations of risk, uncertainty and ignorance.
He says the process of discovering puzzle answers is inherently probabilistic in nature.
“What I like is solving puzzles. I think what you are dealing with is incomplete information. You have little things. You have facts. You have analysis. You have numbers. You have the motivations of people. And you try to piece this together into a puzzle – or decode the puzzle in a way that gives you a much better than average chance of getting it right if you solve the puzzle correctly, and that’s the best part of the trade, “he says.
Einhorn shared some valuable investment tips that can help investors achieve extraordinary success.
Einhorn says the goal of investors should be to make money, or at least conserve capital, with every investment, and not lose money.
“Securities need to be mispriced enough that we will get it right if we get it right, but if we get it mostly wrong we will be about break even. The trick is to avoid losers. Losers are terrible because it takes a success to compensate them, just to get back on track,” he says.
Einhorn says a value investor’s goal is to buy the asset at a spot price and then wait patiently.
“Trying to make short-term forecasts instead of waiting is folly, and value investors instead rely on the combined long-term effects of a purchase with a margin of safety, knowing that prices will return to the mean in the long run,” he says.
Avoid “too hard”
Einhorn says if an investment is too hard, investors should just move on to the many other opportunities that aren’t hard.
“Why bother with investments you don’t know what you’re doing, especially if there are other bets where you do that? Playing against weak competitors is not a sin in investing or doing business. There are no bonus points in investing for doing things which is really difficult,” he says.
Ensure a good process
Einhorn says that in the real world, a good process can lead to a bad outcome, just as a bad process can lead to a good outcome.
“Both luck and bad luck can play a role in investment results. But the best investors understand that a good process will outperform in the long run,” he says.
Einhorn says the ability to make the best choice at a later date, when investors have more information, is valuable, as markets are always changing.
“I’m a big believer in not making decisions before they have to be made. Circumstances change, people change, facts change and options change. Why start early when you can have the advantage of deciding later with more information?” he says.
Einhorn says the biggest challenge for investors is dealing with unfamiliar unknowns, the risks that are uncertain in character and magnitude, but certainly exist.
He says that one principle investors can adhere to in dealing with these risks is to avoid financial leverage.
“We manage risk based on the level of investment we make. We are not handicapped. We don’t borrow more money to invest even more. That’s one way to avoid risk or manage your risk. If you never have to repay someone, you are not bound by any loan terms,” he says.
Diversification is important
Einhorn says that even the very best stock ideas have no guarantee that they will work, as any company can have some hidden risks that investors are unaware of.
He says this is why diversification is so important, not because investor analysis may be bad, but because even the best analysis in the world may not be enough to arrive at the right conclusion when faced with the unknown.
He recommends that investors have a risk management system in place and put limits on the losing position they can afford.
Re-evaluate investments from time to time
Einhorn says investors should re-evaluate all of their investments to find out if they’ve worked out well or not.
He says that once investors have worked this out, they should sell or reduce the investments they are no longer interested in.
“Some that have not worked, we close or reduce because we decide that whatever we thought is no longer true or probably won’t come true. We adjust the positions accordingly and we do that position by position and we do that or it whether it’s good for us or not good for us. It’s part of our ongoing process,” he says.
Take advantage of market extremes
Einhorn says market extremes occur because investors don’t make independent decisions and aren’t perfectly informed rational agents.
“The longer your investment period and the crasser the returns you’re willing to accept, the happier you’ll be and the better your returns will be,” he says.
Put your investment strategy to the test
Einhorn says investors should encourage other peers to counter and challenge their investment thesis from time to time, which will certainly help them improve their strategy and achieve investment success.
(Disclaimer: This article is based on David Einhorn’s various interviews)
This post David Einhorn’s Investment Strategy: Bet Big When High Belief Opportunities Come By: David Einhorn
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