“‘I view the markets as fundamentally broken…Passive investors have no opinion about value. They’re going to assume everybody else has done the work.’”
That’s hedge-fund titan David Einhorn arguing it’s tough out there for active money managers thanks to the seemingly inexorable rise of passive investing. The remarks came in an interview with Ritholtz Wealth Management co-founder Barry Ritholtz in his “Masters in Business” podcast.
“Value is just not a consideration for most investment money that’s out there. There’s all the machine money and algorithmic money which doesn’t have an opinion about value it has an opinion about price: ‘What is the price going to be in 15 minutes and I want to be ahead of that,’” he explained.
Amid what’s left of active management, “the value industry has gotten completely annihilated,” he said.
That can make for a vicious circle. As money moves from active management to passive, value managers are forced to deal with redemptions. They then sell their holdings, which causes value stocks to fall further, triggering more redemptions, Einhorn explained.
“All of a sudden the people who are performing are the people who own the overvalued things that are getting the flows from the indexes. You take the money out of value and put it in the index, they’re selling cheap stuff and they’re buying whatever the highest multiple, most overvalued things are in disproportionate weight,” he said.
Then the active managers participating in that part of the market get flows and they buy even more of the overvalued assets.
As a result, stocks, rather than “reverting toward value” instead “diverge from value,” Einhorn said. “That’s a change in the market and its a structure that means almost the best way to get your stock to go up is to start by being overvalued.”
Einhorn said it took Greenlight some time to adjust to the shift.
The firm made significant changes, Einhorn said.
It is no longer going to pay 10 times earnings for a stock expecting earnings to get 15% better and receive a 13-times-earnings multiple allowing Greenlight to make 50% over a year and a half. That’s because with the rise of passive investing, “there’s nobody who is going to pay attention to notice the earnings were 15% better … if nobody notices, nobody’s there, nobody’s going to buy, nobody’s going to care,” Einhorn said.
But that “complete apathy” in the market now means that you no longer have to pay 10 times earnings to profit from the same situation, he said. An investor can now find the same scenario at four or five times earnings. And if an investor pays four to five times earnings and the balance sheet isn’t levered, the company should be able to return cash and buy back 10% to 20% of its stock. That means in four or five hears, it’s either going to run out of stock or the price is going to go up, he said.
“So you’re literally counting on the companies to make that happen” rather than other investors, Einhorn said.
In a milestone, passive exchange-traded funds and mutual funds closed 2023 with more assets than passive funds, according to Morningstar.
The iShares S&P 500 Value ETF
which tracks the S&P 500 Value Index, is up 0.8% so far in 2024, while the S&P 500
has rallied 4.8%, notching its eighth record close of the year on Wednesday. The value ETF rose 19.9% in 2023 versus a 24.2% rise for the S&P 500.