Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New Epilogue Read Online Free PDF Page A

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 of pair trades will have a lot of threes and fours paired against sixes and sevens from the same industry. Greenlight generally does not engage in pairs trading. We accept more industry risk, but assemble a portfolio where we believe our longs are ones and twos and our shorts are nines and tens. We do not short to hedge. If we are uncomfortable with the risk in a position, we simply reduce or eliminate it. By having a portfolio of worthwhile longs and worthwhile shorts, we achieve a partial market hedge without having to spend capital on negative-expected-return propositions.
     
    Every time we risk capital long or short, we believe the investment has individual merit. Our goal is to make money, or at least to preserve capital, on every investment. This means securities should be sufficiently mispriced, so that if we are right, we will do well, but if we are mostly wrong, we will roughly break even. Obviously, if we are massively wrong, we will lose money. We do not use indexes to hedge because we can add more value by choosing individual names with poor risk-reward characteristics to short. An index hedge has a negative expected value because the market rises over time and the short pays only in a falling market. Selling short individual names offers two ways to win—either the market declines or the company-specific analysis proves correct. In practice, we have more long exposure than short exposure because our shorts tend to have greater market sensitivity and volatility than our longs. Also, the market tends to rise over time and we wish to participate. It is psychologically challenging to manage a portfolio that