The Money Chase April 2011

Showdown in the Sunshine State

Two of Wall Street's savviest value investors, Bruce Berkowitz and David Einhorn, pride themselves on their rigorous analysis. Now they're locked in a scorched-earth dispute over the value of some Florida real estate. How could they look at the same facts and reach such wildly different conclusions, and what does that say about the “value” of value investing?
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Einhorn has a history of making bold short calls—as well as very public cases against the companies he’s shorted. Most famously, he shorted Lehman Brothers, told people the company was a house of cards—and was proved grimly right when the company, and the economy, imploded. More than a few people have argued that his public attacks on the companies he shorts are a rapacious attempt to create a self-fulfilling prophecy. CEOs, in particular, are fond of this argument.

Einhorn’s book on his six-year short of Allied Capital, Fooling Some of the People All of the Time, shows that he’s not above giving markets a push: hiring investigators, filing lawsuits, even getting regulators involved, all hastening the day when the companies he has shorted face a reckoning on the bourse. But it also conveys a sincere desire to fight the dark forces of fraudulent accounting—and for all the CEO complaints, Einhorn has uncovered malpractice at multiple companies. In asking essentially a single question—“Why are you carrying this asset on your books at that price?”—his dogged investigations have exposed not just overoptimistic valuations, but gross deceptions of investors and regulators, even fraud.

Einhorn isn’t suggesting that optimistic valuations are hiding darker secrets at St. Joe Company, but could that be the case? In January, after a number of shareholders started preparing to sue, the Securities and Exchange Commission announced that it was opening an informal inquiry into St. Joe’s accounting. But the parallels with Allied Capital and Lehman Brothers don’t quite work. St. Joe’s financial statements aren’t that hard to understand: the firm has a great deal of land and relatively few liabilities, and by Einhorn’s calculations it spends about $50 million a year to run operations. By contrast, the statements of financial firms like Allied and Lehman were a confusing tangle; only painstaking detective work uncovered their improper accounting for the default risk on the assets they owned, like loans and mortgage-backed securities.

Loans have a limited upside: they can’t really be worth more than the sum of the principal and the interest payments. So when companies didn’t factor in the risk that some of the loans would go bad, they were essentially valuing those assets at their maximum possible cash flow. Einhorn was saying the assets should be valued at what they could be sold for, not what the company thought they were “really worth”; that sale price would best reflect the riskiness of the assets.

That’s also what he’s saying about St. Joe Company’s real estate, but real estate is different: its value can, if conditions are right, go up quite a lot. Still, Einhorn’s argument seems compelling when you’re sitting in SummerCamp Beach’s empty restaurant, or walking, as I did the following day, through the vacant streets of WindMark Beach, his “favorite” of the St. Joe properties. Here, about an hour southeast of Panama City, everything has been laid out for a bustling community that has yet to arrive: stunning beaches, roads and boardwalks, even street lamps, and benches where neighbors can sit after a stroll. Only instead of houses, the streets are lined with neat rows of signs that name the owners of the empty lots, inviting writerly comparisons with grave markers.

The development’s commercial street looked to me more promising, at first; every building seemed to have a twee sign out front—and also a for lease sign in an empty window. Next to the main strip, a few houses had actually been built here and there—large, airy, comfortable-looking. But surrounded as they are by forlorn lots, they are somehow even more disturbing than the empty, waiting cul-de-sacs; the effect is that of one gleaming, pearly-white tooth jutting out of otherwise empty gums.

As Einhorn points out, speculators—or their bankers—own many of those empty lots and buildings, and they are eager to unload. This will undercut St. Joe’s ability to sell its remaining lots at the prices it needs to get. Meanwhile, taxes must be paid, a sales office must be maintained, headquarters must be subsidized. Unless people start coming, and building, one can argue that St. Joe’s real estate at WindMark isn’t so much an asset as a liability: to cover the carrying costs of residential land that can’t be sold, the company will have to continue selling off actually valuable rural land, until there’s nothing left. Walking through that commercial ghost town, I find it hard to disagree.

Bruce Berkowitz himself has said he doesn’t disagree with a lot of Einhorn’s points; he just differs in time horizon, vision—and his faith that management can be changed. While Einhorn wants St. Joe to cut its residential real-estate losses before the overhead eats up the remaining value in the timberland, Berkowitz wants to unlock the company’s potential. In the new year, he and his partner joined St. Joe’s board, floated a plan to streamline operations—and then startled everyone by resigning on Valentine’s Day, citing the board’s reluctance to confront management problems. “We may have a very different view with David on long-term asset value within the company,” Berkowitz told Reuters. “But we do agree that Joe has the wrong business plan, ineffective governance and needs to stop wasting stockholder money.” Berkowitz is still not giving up; as this article went to press, the resignations looked like the opening salvo in a fight for the board, which he may well win.

Despite all the hours I spent traipsing along empty roads, I’m not quite ready to bet against Berkowitz. For one thing, if you dig into the numbers in Einhorn’s presentation, you find that his $7-to-$10 estimate of the company’s share value is not all that different from the actual book value: $9.51 on the last financial statement. When Einhorn gave his speech, the company’s shares were trading at more than twice their book value. People weren’t buying the company for its liquidation value; they were buying it because they thought St. Joe Company’s land would be worth more in the future. That’s not a question of fraud; it’s a matter of opinion.

For Einhorn, good accounting seems almost like a truth potion: get the balance sheet right, and the “true value” of the stock follows. And for some of his short positions, that’s been true—it seems very unlikely that a change in strategy could have salvaged Allied’s dodgy loans. But changing the relative weights of timberland and residential developments on the balance sheet doesn’t tell us whether prices will recover—or whether management will get its act together. And no accounting method can make investors stop dreaming about those fabulous beaches. Frankly, trapped as I have been in the cold snaps gripping Washington, I’m dreaming of them myself.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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