As I began working on my first well-researched short sale, I quickly realized that I would need to learn under the guidance of someone experienced. Who better to look to than David Einhorn of Greenlight Capital? Reaching out to him wouldn't be easy, so I found another way to learn.
David battled unmotivated regulators, journalists who just didn’t care, a company that was pulling his phone records without his permission, and he had to pay for legal expenses out of Greenlight’s own pocket. Instead of getting support for uncovering a great problem in the markets, he was seeing a strong lack of support from the very people who should care – analysts, investors, board members, and everyone else associated with Allied Capital. Did I mention that during all of this, Greenlight Capital decided to donate 50% of all profits made on this particular investment?
Fooling Some of the People All of the Time is a book that thoroughly explains David Einhorn’s “long” short position in Allied Capital. After conducting research into Allied’s situation, David made a presentation at the 2002 Ira Sohn Conference, and on the following day, the shares of Allied opened down 20 percent. At the time, Einhorn did not realize just how much of his effort this investment would take, even though it was only 3-8% of Greenlight’s portfolio at any given time. It wasn’t until 2008 that they would see Allied fall by 50%.
In the process of being handed over 6 years of his wisdom gained from the Allied situation in a book that is only 350 pages long, I made a discovery – I found James Taggart. James Taggart is a character from Atlas Shrugged, by Ayn Rand. In the book, James makes many references to maintaining social order, operating his business because the country needs it, and in general, working for a social purpose.
As I read Fooling Some of the People All of the Time, I realized I found James in real life. Look at these 2 quotes from Allied Capital’s CEO, Bill Walton, that Einhorn included:
"We've got 85,000 retail shareholders that depend on the dividend. We really operate the business for dividends. I think that's a pretty good SOCIAL PURPOSE..."
"I think most informed investors would appreciate some time spent with us so they can talk these things through unless you're simply trying to develop the short thesis to scare people and make a quick buck and move on. I don't find that a very high SOCIAL PURPOSE."
Businesses exist in order to create wealth for shareholders. This happens because mankind starts with nothing, and creates things. We dig things out of the ground and modify them to improve our lives. You’ll even hear arguments about a limit on natural resources, however those are false as well. Thanks to technology, we are learning to do more with less – we can extract oil from algae, information can be transmitted in milliseconds across the globe, and we are curing medical problems much better than ever before. When a CEO creates a business out of a social purpose, you need to question if he understands that wealth is created and not distributed. If businesses exist to create wealth, consumers and employees of these businesses will all benefit, therefore it is in the best interest for everyone to support businesses, not the other way around. Based on this, you should wonder why the CEO of a company says they exist for a social purpose – if they create great things, the social benefit will be very easy to see and measure.
For Atlas Shrugged fans, this alone should be enough of a pitch to read the book.
If you haven’t read Atlas Shrugged, do yourself a favor and stop everything you’re doing and go read it. It is a very valuable book to read and once you read it, you’ll see 2 types of people in this world: Those who have read it and those who haven’t.
Going back to Fooling Some of the People All of the Time, I will present information about the 5 parts the book is divided into.
Part One: A Charity Case and Greenlight Capital
The first 5 chapters cover David’s life before Greenlight’s formation, the formation of Greenlight capital’s business plan on a napkin, early wins thanks to insurance company demutualizations, spin-offs, etc. We also get an early glimpse into short sales of Boston Chicken and Samsonite. This led him to value investing through the internet stock bubble, including value investment in AOL despite questionable accounting practices. In all, you are walked thorugh many early successes and relatively smaller, short term, wins that would help David and his team through the longer struggle of dealing with Allied Capital. The end of this section of the book brings us to Allied Capital and a basic overview of how Allied Capital rated its investments and you get to dip your toes in early issues that were discovered.
Part Two: Spinning So Fast Leaves Most People Dizzy
The following 10 chapters (6-15) start off with a description of the reaction just after his presentation. The morning after his presentation, he had a mutual fund analyst waiting outside to find out just what happened the night before. Allied Capital opened 20 percent lower this morning. We are also introduced to the concept of Allied selling the winners and keeping the losers, because it helps maintain their high book value and keeps the income statement in line with expectations. More events followed, with the uncovering of bad loans by Off Wall Street, further investigation into Business Loan Express, WorldCom’s bankruptcy filing, numerous quarterly conference calls, accounting changes, improper valuations for Business Loan Express, and the list goes on. In essence, the title of Part 2 is very appropriate and Greenlight Capital’s perseverance is demonstrated as they kept up with all of this information and stayed on top of every occurrence.
Part Three: Would Somebody, Anybody, Wake Up?
The next 6 chapters talk about hiring an independent organization to dig into specific Allied investments that were concerning them. On May 8th, 2003, Einhorn spent the morning with the SEC and was grilled with questions such as, “When did you start manipulating Allied stock?” These lawyers might as well have been saying, “Why were you sleeping with the president’s wife?” Any answer you return with puts you as someone committing an evil and to be clear.
A lot of research from the independent organization began coming in and customers of a company Allied held a stake in described the management as incompetent, dishonest, and crooked. This research was enough to prove that Allied was clearly lying about the value of the investment in this company. Allied Capital was writing loans backed by the Small Business Administration (SBA) and even with such clear evidence, they couldn’t get the SEC or SBA to take action against anyone other than short sellers.
In one of many interesting developments, we also learn about Allied accepting defaulted loans from BLX (Business Loan Express) for full value. There was a bankruptcy for a convenience store that revealed Allied had taken $9 Million of such loans.
Part Four: How the Systems Works (and Doesn’t)
The following 6 chapters bring us even more ridiculous events. It starts out in the middle of 2004 when Einhorn gets calls warning him of phone records being stolen. Initially, his accounts seem okay, however soon after he finds that someone had gotten access to his entire phone history. The only analyst with a sell rating on Allied had his records stolen as well.
Greenlight began working under the False Claims Act, which allows them to share in the money gained by reporting fraud against the federal government. Jim Brickman was working on this case and with his efforts, both quickly learned that there was little caring on the government’s part. We also saw more attacks against Einhorn’s short sales, this time coming from Overstock.com’s CEO.
Should the lack of governmental inquiry into the loans made by the SBA backed lenders be a surprise?
The federal government issues this standard for governmental employee ethics:
The District government ethics rules are designed to guide and regulate employees to achieve these ethical standards and to add to the overall appearance of integrity, promote government efficiency, and maintain the public’s trust and confidence.
If you’re worried about the appearance of integrity, what does that say about an organization’s ethical behavior and intentions?
Part Five: Greenlight Was Right … Carry On
The following 7 chapters wrap up the whole story and we learn that good guys really do win, and this entire book is proof of just that.
It began with a tiny disclosure on page 82 of a filing that BLX made making it clear that the SBA and Department of Justice have been investigating the lending practices of BLX. After a lot of problems had been uncovered, Allied’s management still told analysts that what was found in the Detroit office under Harrington’s control was a single event and bad behavior that was discovered did not exist anywhere else at BLX. Soon after, the SBA was considering suspending their preferred lending status, a crucial piece to BLX’s and Allied’s profitability on paper.
Fitch even came out and said, “… the large majority of its nearly $2.7 billion in serviced loans are viable assets.” Off Wall Street’s Mark Roberts reached out to the author of the Allied rating piece on Bloomberg and was told that there was no interest in research showing this Fitch rating might have not been correct. Einhorn wrote a letter to the board of Allied, which was made public, and the stock fell $2 down to $28 on January 22nd, 2007.
Less than a few weeks later, Allied issued a press release that admitted they had stolen Einhorn’s home phone records. A half hour after this, a press release was made talking about a 1-cent increase to the quarterly distribution, you can draw your own conclusion about why they might have done this.
Months later, in June, the SEC released results of the investigation. It outlined 3 examples of problem investments and in essence, basically said that Greenlight was right all along.
Message to David Einhorn and Greenlight Capital: Keep up the good work – you guys have done some amazing research and set an example for investors everywhere. David, you put up with a lot because you believed in what you were doing – I bet if your goal was to make a quick buck, you would have left this short much earlier on. I hope your team made a lot of money on this and I have no doubt that your amazing team will continue this level of excellence.
Fooling Some of the People All of the Time is an excellent book to read and if you're at all interested in avoiding fraud or learning about the steps taken to uncover a fraud, you will be well served by taking out the time to read this book.