Thursday, September 27, 2012

Institutional Bias and the Story of Allied Capital

Over the past weekend, I started and finished the real-life tome Fooling Some of the People All of the Time by famed hedge fund manager David Einhorn of Greenlight Capital.  You could be forgiven for reading the book and thinking it fiction, as the story takes some unexpected twists and turns and at times reads more like a detective novel than a financial narrative.  It's a quick but thrilling read (although that may be over-selling it; I'm the kind of guy whose blood starts pumping when reading a really good 10-K).

The heart of the story is this: really smart hedge fund guy uncovers accounting irregularities at said public company and wages a years-long campaign to raise awareness of the likely-fraud and to ultimately force regulators to intervene.

While the mere existence of practices of aggressive accounting, management opacity, and outright fraud at a public company are distressing, unfortunately they are more common than many investors think.  Mr. Einhorn has done an exception job over the years of rooting out other public companies with such questionable practices.

What is more distressing to me was the burning, unanswered question I was left with at the end: why did it take so long--years, in fact--for the issues at Allied Capital to ultimately be recognized by its shareholders, by the market, and eventually by its regulators?  The stock price of Allied over the ensuing three years from May 2002 (when allegations were first made public) did not visibly discount this information (except in short blips) and actually outperformed the S&P 500 by over 7% per year.

More simply, it paid to be an investor in a company that had decent odds of being fraudulent!

I think the answer to my question, at least in part, lies in the "institutional biases" that motivate many shareholders, private and professional alike, and prevent markets from being perfectly efficient.

To wit:

1.  Few investors do their homework.  While the nitty-gritty details of Allied's accounting practices were laid bare for all to see in the company's regular SEC filings, few investors were willing to roll up their sleeves and do the analysis that ultimately proved incriminating.

2.  Investors love a check in the mail.  Allied's shareholder base had a large contingent of individual shareholders who, as long as they received regular, predictable dividends, did not pay much attention to how those dividends were generated.  They ate the sausage and didnt really care to see how it was made.  These dividend payouts also formed the basis of valuing the company.

3.  Wall Street is a deal machine.  Despite evidence of "irregularities" that should have been as plain as the nose on the face of your average Wall Street analyst, bulge-bracket analysts defended the company "to the death."  Addicted to Allied's regular and lucrative securities offerings, these analysts did not dare to jeopardize investment banking revenues for the sake of honesty.

And so it was, with this biases cemented in the minds investors and professionals alike, that Einhorn's allegations were taken less-than-seriously, and the stock was allowed to work its magic.

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In our own search for investment ideas, we constantly remind ourselves to be on the lookout for these biases in other investors.  They are the means by which securities become over-priced and by which they become under-valued.  They are the reason that markets always have been and always will be inefficient.

Many times, these recognizable biases can be a starting point for finding undervalued securities:

Companies with complicated financials whose small but meaningful nuances dont make it into the quarterly press release.

Companies that dont pay dividends in an industry where all of their peers do.

Companies who have no interest in playing the Wall Street game: no continuous equity offerings, unending road shows, or investment bankers on the payroll.

These biases lead other investors to shortcut their decision-making process, usually reaching a conclusion as to whether they should or should not own a stock based on reasons that don't always relate to the fundamental value of the company.  That is our opportunity, and one we seek to exploit every day.