PRO Strategy: Investing like David Einhorn

Published Fri, Jun 17 20165:00 AM EDT

Editor's note: This is PRO Strategy, a column on how to use the philosophies of the smartest minds on Wall Street to generate quality investment ideas. David Einhorn is known for his successful short bets against stocks like Lehman Brothers, but his value buys on the long side have had just as much to do with his impressive multidecade track record. How can we learn from his success and apply his investment philosophy to a stock? Einhorn started his Wall Street career as an investment banking analyst at Donaldson, Lufkin & Jenrette. After DLJ he joined Siegler, Collery & Co., an investment firm, before starting Greenlight Capital. From inception in May 1996 to the end of 2015 Greenlight Capital generated annual net returns of 16.5 percent compared to the S & P 500 at 8 percent. The fund doubled the market's return, even after a rough 2015 when it was down 20 percent, according to an investor letter. This year is starting off better as the fund was up 3 percent at the end of the first quarter. Greenlight Capital has $9 billion of assets under management. CNBC PRO researched Einhorn's strategy using previous media interviews and Greenlight Capital client investor letters. Here are the key themes of his philosophy. "We also find opportunities when there is a large upheaval or rejection of a particular company or sometimes an entire industry for reasons that are obviously just plain old cyclical or otherwise based on what the investment fashion of the moment is." — David Einhorn, Value Investor Insight Upheavals may come from corporate spinoffs or overreactions to short-term earnings results, he stated in an interview with Value Investor Insight in 2005. An example is how Einhorn bought Michael Kors after the shares fell 25 percent on poor sales results, he explained in an October 2015 investor letter. The hedge fund manager stated the market overreacted from a distribution center shutdown and a poor winter product line. Both factors he believed were temporary in nature. This "upheaval" gave the value investor an opportunity to buy at attractive prices. "We are value investors. This means that we buy what we believe are misunderstood companies at low valuations relative to their underlying assets and future cash flows." — David Einhorn, October 2015 investor letter Einhorn said he flips the traditional value investor process around and doesn't use screens like low price to sales or price to earnings in the Value Investor Insight interview. Instead he starts by looking for special situations where a company may be misunderstood or mispriced relative to future cash flows. He outlined the valuation case for Mylan , a generic pharmaceutical company, in a January 2016 client letter. After analyzing the company's multiyear drug pipeline and the impact of share buybacks Greenlight forecast 2018 earnings per share of around $7. The firm bought the company's stock at an average price of $45.32, according to the letter. "We run a concentrated portfolio. Our philosophy is to invest the most capital in ideas where we have the most conviction." — David Einhorn, October 2015 investor letter The hedge fund manager also emphasized he wants to size positions according to the risk-reward and upside opportunity, so the fund will be compensated appropriately if they get the fundamental analysis correct. Let's look at a stock with Einhorn's investing framework. The hedge fund manager showed how he analyzed Yelp , the "dominant search and review website for local businesses" in a May 2016 investor letter to clients. Instead of focusing on current results, he again looked to the long-term future potential a few years out. Einhorn estimated that if the company executed its plan of "adding more transaction-based revenue, gradually relocating its sales force to lower-cost cities, and providing more (return on investment) reporting tools to its customers" revenue would double by 2019 and EBITDA (earnings before interest, taxes, depreciation and amortization) would rise to $300 million. He then put a "peer group" multiple on this EBITDA forecast and calculated a $55 stock price target. Greenlight was able to buy a position in Yelp at a price of $21.16 due to temporary worries from a negative documentary, a significant discount versus the $55 valuation, according to the letter.

David Einhorn, president of Greenlight Capital

Andrew Harrer | Bloomberg | Getty Images

Editor's note: This is PRO Strategy, a column on how to use the philosophies of the smartest minds on Wall Street to generate quality investment ideas.

David Einhorn is known for his successful short bets against stocks like Lehman Brothers, but his value buys on the long side have had just as much to do with his impressive multidecade track record. How can we learn from his success and apply his investment philosophy to a stock?

Einhorn started his Wall Street career as an investment banking analyst at Donaldson, Lufkin & Jenrette. After DLJ he joined Siegler, Collery & Co., an investment firm, before starting Greenlight Capital.

From inception in May 1996 to the end of 2015 Greenlight Capital generated annual net returns of 16.5 percent compared to the at 8 percent. The fund doubled the market's return, even after a rough 2015 when it was down 20 percent, according to an investor letter. This year is starting off better as the fund was up 3 percent at the end of the first quarter. Greenlight Capital has $9 billion of assets under management.

CNBC PRO researched Einhorn's strategy using previous media interviews and Greenlight Capital client investor letters. Here are the key themes of his philosophy.