Street Capitalist: Event Driven Value Investments

Another casualty of the credit crisis was announced today, Erin Callan the CFO of Lehman Brothers (LEH). I find this interesting because Callan has only held the job since December. Callan was even the feature of some favorable stories in the Wall Street Journal:

After sifting through the numbers for nearly an hour, Ms. Callan coolly answered more than 20 analyst questions. Then she strode down to Lehman’s bond-trading desk and high-fived trading executive Peter Hornick. Later that day, bond traders gave her a standing ovation, a Wall Street rite typically reserved for CEOs. Profit had plunged, yet Lehman shares surged 46%.

Six months into one of investment banking’s toughest jobs, the 42-year-old Ms. Callan is emerging as a galvanizing force at Lehman and a finance chief who topples much of the conventional wisdom about CFOs. She also is the highest-ranking woman on Wall Street. Many Lehman insiders consider her among the contenders to become the firm’s president someday.

Unlike Lehman’s two previous CFOs, Ms. Callan isn’t an accountant and had never worked in the finance department.

Lehman’s Straight Shooter (WSJ)

These changes weren’t enough when Callan famously came up against famed value investor David Einhorn of Greenlight Capital as he launched a short campaign against the company. David Einhorn is one of the best value investors today, he definitely is able to apply traditional value investing to areas that most investors skip over like pharmaceuticals, technology, and financancials. He should be studied by any aspiring investors.

The difficulty that Callan faced was having to defend Lehman Brothers against Einhorn’s insurgency in a time when the company already faced extreme pessimism. In an environment like this, a company like Lehman is weak. The large amounts of leverage they employ hold them hostage if there’s a crisis of confidence. Lehman had winded down some of their leverage, going from the low 31.7:1 to 25:1, but still - this is still excessive. Einhorn’s claims were easy to rock confidence in Lehman because he questioned their accounting, the foundations of their financial position - in doing so he (or the market) forced Lehman to pursue $6 billion in capital.

To see how Callan sought to pacify Einhorn, just look here:

In his comments, Mr. Einhorn squared off in particular against Erin Callan, Lehman’s chief financial officer and the executive who has led the public charge against the firm’s critics. Mr. Einhorn met with Ms. Callan last week to discuss his research.

In a statement, a Lehman spokeswoman said: “We will not continue to refute Mr. Einhorn’s allegations and accusations. Mr. Einhorn cherry-picks certain specific items from our quarterly filing and takes them out of context and distorts them to relay a false impression of the firm’s financial condition which suits him because of his short position in our stock. He also makes allegations that have no basis in fact with the same hope of achieving personal gain.”

In attacking Lehman, Mr. Einhorn took issue with large, unrealized gains the firm booked in the first quarter from marking up equity positions that don’t trade in public markets. Like other brokers, Lehman has large amounts of illiquid assets that it values using management-driven financial models.

A Shorter Slams Lehman (WSJ)

By choosing to ignore or “not continue to refute” Einhorn’s claims, Lehman makes it easy to appear sketchy to any of the company’s outsiders. I’m not expert on the company, but when someone like David Einhorn goes around giving presentations that easy describe and show how weak your company is to hedge funds and the general public - the precise people who can hurt your company, you should not decide to “not continue to refute”.

In refuting, a company legitimizes the short-seller but they also have a chance of countering whatever may be flawed in the analysis. Not refuting almost makes it look like Lehman has something to hide. From my experiences, I’ve noticed that most companies try to brush aside short-sellers, as if de-legitimizing them is good enough. Often it isn’t. Often, companies need to engage in an aggressive operation where they actively come up with easy-to-consume evidence that counter’s the short’s claim. I’m talking 100 slide power points a la Bill Ackman. This could be a problem if your company really is sketchy and in that case then the short will triumph. Also, Lehman could have tried to push its efforts towards discrediting Einhorn. No investor is infallible, just look at Einhorn’s investment and directorship of New Century Financial (he did note that Greenlight’s analysis was “sub-prime” for New Century). This would have been better than simply ignoring him and hoping he goes way. If a company can bring evidence that its position is sound, then it should do everything in its power to show that, at the very least it can bolster or even increase their stock price.

Lehman’s precipitous fall in stock price demonstrates that they did not do enough to assuage investor fears and with any luck, under the new CFO Ian Lowitt, Lehman will be able to handle these issues with better execution. Management of companies who are currently engaged with short sellers could do themselves a favor by reading up on counterinsurgency (COIN). COIN after all is in its essence is “winning hearts and minds of the people”. Winning the hearts and minds of the investor community would do good for any company’s stock price.