Volkswagens improbable rise sends hedge funds scrambling

Date: Wednesday, October 29, 2008
Author: Eric Reguly, Reuters

ROME -- Hedge fund star David Einhorn is best known for making a killing by riding the collapse of Lehman Brothers. This time, the Greenlight Capital manager got caught on the other side.

One of the biggest short squeezes in history battered Greenlight, along with other hedge funds, as soaring shares in Volkswagen AG briefly made the car maker the world's most valuable company.

Volkswagen shares were propelled by hedge funds willing to pay virtually any price to cover their speculative positions, spurring one of the biggest hedge fund massacres in history. Greenlight was among those that suffered heavy losses, German media and Reuters reported last night.

After Porsche AG had announced it had control of almost three-quarters of VW's shares, VW opened at €420 ($681 Canadian) and reached €1,005, giving the company a market value of more than €290-billion, making the company briefly worth more than Exxon, the world's biggest publicly traded company.

VW shares closed at €910, up 93 per cent, taking their one-year rise to 383 per cent.

BaFin, Germany's stock market regulator, said it is monitoring the short squeeze but has not started a formal probe.

Analysts said VW will come down with a bang once the hedge funds finish buying all the shares they need to cover their speculative positions. For 2008, VW is expected to earn about €11.60 a share. The figure for 2009 is €7.46 as consumer confidence sinks, unemployment rates rise and autos remain stuck in showrooms. If VW were to trade at BMW's relatively high multiple of 10.9 times earnings, its shares would be worth about €80.

"VW's share price is outside any reality," said George Thilenius, the fund manager who runs Dr. Thilenius Fund Management in Stuttgart. "VW is doing as well or as bad as any other mass car producer."

In New York, shares of Morgan Stanley and Goldman Sachs Group Inc. tumbled yesterday on speculation the banks might be caught on the wrong side of a trade involving Volkswagen, traders said. Morgan Stanley spokesman Mark Lake said the company does not have any exposure to Volkswagen. Goldman declined to comment, citing its policy of not responding to market speculation.

VW will update on its financial health tomorrow, when it releases interim results for the January-to-September period. Analysts do not expect good news on growth rates as the industry gets flattened by credit ratings downgrades and falling profit as sales shrink.

Born in New York, Mr. Einhorn is perhaps best known in Canada for taking on Magna International Inc. founder Frank Stronach over his control of MI Developments.

He also took on Washington-based Allied Capital, which led to accusations he drove down the company's share price through false allegations. Mr. Einhorn, 39, has defended his actions in a recent book, Fooling Some of the People All of the Time.

The short squeeze on VW shares became inevitable on Sunday, when Porsche, the sports car maker, surprised the market when it revealed it controlled 74.1 per cent of VW. Porsche's previously known holding was 30.3 per cent. The latest ownership is held in the form of 42.6 per cent in shares and another 31.5 per cent through options.

Porsche first invested in VW in 2005, partly, it claimed, to protect it from the hedge funds. It made no secret of its desire to take outright control, though the precise timing was unknown. "VW was in big danger of being taken over by a hedge fund. We know that," Porsche CEO Wendelin Wiedeking said earlier this month.

The short squeeze was extreme because VW's free float is less than 6 per cent of the outstanding shares. Almost 20 per cent is held by the German state of Lower Saxony and Porsche controls most of the remainder.

Porsche said on Sunday that it disclosed its higher ownership level to help prevent severe market distortion. The company, it said, "has decided to make this announcement after it became clear that there are by far more short positions in the market than expected." Porsche went on to say that the disclosure should give the short sellers "the opportunity to settle their relevant positions without rush."

Analysts didn't buy the explanation. In a Monday note, Max Warburton of Sandford Bernstein said: "We find it surprising that Porsche can claim there were more shorts than expected given Porsche and its counterparties own nearly all the stock, so only they can have supplied the stock for lending (aside from Lower Saxony), so they should have been reasonably aware of the short positions."

Short squeeze explained

Investors who short a stock (or bet its price will fall) face potentially huge losses if it soars in price.

If the stock begins rising, they will be forced to buy it in order to limit their losses. When this happens on a large scale it is called a short squeeze, and leads to an even larger increase in the share price.