David Einhorn on ROE

Most people here have probably heard of David Einhorn , the infamous hedge fund manager who shorted Lehman Brothers. But to most other people who don’t know what a hedge fund is, I’d say that he’s an investor. Everyone knows what an investor is; people who make money buying stocks are investors, and people who lose money while picking stocks are called speculators (or is it the other way around?)

But not only is Einhorn known for his value investing skills, but also for his poker skills, which makes his story very interesting. But are investing and poker similar? Is gambling and investing the same thing? Is winning at investing and gambling purely based on luck? “Not really” says Einhorn, “but sample size matters. Over time, and over thousands of hands against a variety of players, skills win out”.

But let’s get to Einhorn’s opinion on Return on Equity (ROE) today. According to him, there are essentially two types of businesses:
Capital intensive ones and non-capital intensive ones. A capital intensive business is one which requires capital to grow, for example, to build another plant, a manufacturing facility of some sort etc.

Non-capital intensive businesses are those that do not require capital or physical resources to grow. These businesses grow based on intellectual capital and human capital. Examples would be, pharmaceutical companies (which rely on their patents to generate revenue), software firms (which rely on the software they built to generate revenue) and consulting firms (which rely on their people to generate revenue). Most other companies that sell services would qualify as well here.

Einhorn points out that it is irrelevant to worry about ROE for non-capital intensive businesses. If a consulting firm had twice as many desks and office locations, it wouldn’t really mean that per consultant revenue would double, especially considering they travel to client sites to advise them; it would be redundant to add such resources.
It follows from this that the price-to-book value ratio is irrelevant for such companies because they derive their value from brand equity, intellectual and human capital which is not reflected on the balance sheet.

But for these companies, the question becomes ‘what to do with the spare cash?’
They could return the cash generated to the shareholders or do something a lot worse, enter capital-intensive businesses.
Take for example, the infamous ‘investment bank’. Investments banking advisory services are wonderful non-capital intensive businesses. Fee is paid to these banks for their advice and the only important asset is the people who go up and down the elevator.
But once they start lending money to investors, they become a little capital intensive. Then they enter into PE and other illiquid areas and become even more capital intensive. And before you know it, they turn into capital intensive businesses. And the irony is that everyone else is coming to these banks for advice on how to create more shareholder value while these banks themselves dilute their own ROE with capital-intensive activity.

But this doesn’t mean non-capital intensive businesses are always excellent ‘BUYS’. Their high returns attract new entrants and competition ends up driving down the ROE.

Investing based on ROE can be tricky, but David’s point above is definitely worth considering. So what are you investing in, capital intensive or non-capital intensive businesses?

Read More: Einhorn's speech