In these trying times of stock market volatility and economic uncertainty, I find it makes sense to seek out defensive stocks. In bull markets, I prefer mutual funds. They are mostly long-only, risk trading vehicles that, if picked properly, can outperform the market and provide nice returns.
In down markets, however, I prefer hedged vehicles, including hedge fund investments, bonds, and cash. Bonds and cash are easy to find, but it is difficult to find retail investments that truly act like hedge funds. Or if there are, they have short or unimpressive track records, or trade at large premiums to book value. That is, until now.
Lately, Greenlight RE (GLRE) has traded down substantially - too much in my opinion - and looks attractive. Greenlight is technically an insurance company. It underwrites a variety of property and casualty reinsurance, but the reality is that it's essentially an investment in a hedge fund, but one with daily liquidity despite the fact that NAV is published only quarterly.
So, why GLRE in this market?
First of all, GLRE is only 30% net long right now. That is, their portfolio is heavily hedged. If the market falls 20%, then GLRE's portfolio will fall far less than the market, perhaps only 5-6%. Second, you have to understand the track record of David Einhorn, who manages the money for GLRE. Einhorn's hedge fund has racked up double digit returns in all but 3 years since 1996, when he launched Greenlight Capital. In 2004, he started Greenlight RE, patterned somewhat after Berkshire Hathaway (BRK.A). Essentially, his firm sells insurance policies and then invests the float in public equities. Through the insurance premiums he collects, he essentially gets free, long-dated capital, assuming you can at least run your insurance business at a 100% combined ratio. That is, without losses or at a breakeven level.
Boring Insurance Stuff
So, Greenlight RE raised $200mm back in 2005 via an IPO and established a vehicle that essentially invests in his hedge fund called DME Advisors. His firm writes reinsurance property & casualty policies, collects the premium and invests it hedge fund style. So, while there are some risks to his insurance book, his biggest exposure is $66mm in cat risk (catastrophe risk a la hurricanes, etc). This is $66mm on a book of $810mm, relatively minor. Overall though, the key is that they run the insurance business P&L neutral, or flat net income so that they can retain the premiums for investing purposes.
Generally, given the natural disasters this year (tsunamis in Japan, fires in Australia), most expect pricing on the insurance side to firm up, which should bode well for 2012. Pricing has been horrible the last 18 months as there were few natural disasters and capital levels in the insurance industry got pretty high. Net net, looking at the numbers below, you can see that in 2010 & 2011 to date, they incurred only small losses on the insurance side despite the weak environment, but positive insurance net income in 2008 and 2009.
| 2008 | 2009 | 2010 | 2011 | ||
| Combined Ratio | 96.50% | 96.50% | 102.80% | 102.10% | |
Most importantly, the company books reserves for future losses in a fairly conservative manner. When you see banks or insurers taking write-downs, you really can't ignore them. They are the result of under-reserving for future bad loans or future insurance losses. It's bad underwriting and speaks to poor management. At GLRE, they have had reduced loss reserves in later years, meaning they actually slightly over-estimated future losses on the balance sheet, and increased net income later to adjust for this. (figures in thousands)
| Loss reserves | Chg in NI | ||||
| 2010 | $8,678 | $-8,678 | |||
| 2009 | -7,597 | 7,597 | |||
| 2008 | -11,988 | 11,988 | |||
| 2007 | -1,077 | 1,077 | |||
This is good. Clearly, the insurance business at Greenlight isn't very likely to hurt you, and in fact, could help you some going forward.
The Meat
The important side of the business is Einhorn managing the float, or your money if you buy the stock. While he has only beaten the market by 10% cumulatively since 2005, he does so with far less risk. He runs a long-short equity book, typically 50-100% gross long, vs 25-75% gross short. I am generalizing here, as he modifies his net long exposure to fit within his view of the market. In 2008, he was actually only down 17.6%, vs the market down 37%. Then in 2009, he was up 32% while the market returned only 27%. I have heard him speak several times and met him once, and can tell you first hand: this guy is light years better than almost anyone in the business.
Here is what Einhorn said on GLRE's quarterly call last week:
The Greenlight Re investment portfolio ended the month [July] approximately 87% long and 62% short, down from 93% long and 70% short at the end of the second quarter. We believe there are quite a few stocks and sectors such as REITs that are trading at all time highs, are overvalued and we are short some of them. It is our belief that the global economic situation has deteriorated so far this year and is in worse shape than we thought it would be at this point in the cycle.
Given these concerns in addition to consolidating our long and short positions and our highest conviction investments in maintaining a modest debt long position, we continue to hold a significant position in gold, some sovereign CDS, options on higher interest rates and a few currency positions and hedges. We reduced exposures because we believe the opportunity set had become less attractive. Though we don’t usually comment on mid-month performance given the recent market volatility, we believe it's important to provide some additional commentary.
In recent days, the market has suffered a very large decline. Our conservatively positioned portfolios held up reasonably well with gains in the short portfolio and gold almost offsetting losses in our long portfolio. We have taken the opportunity of falling prices to cover some shorts and make modest long investments. As of now our quarter-to-date performance is approximately flat. We are approximately 86% long and 53% short.
You can read the full quarterly results transcript here.
Bullish Case
Lots to like here: 1) NAV (or rather Book Value per share) is flat since June 30th, while the market is getting crushed. Yes, GLRE itself has gotten crushed, but that just means you can now buy it at a mere 7% premium to NAV. It was as high as a 40% premium to NAV at the peak. The stock has traded from $28 just a few months ago, to roughly $21.75 now. Book value has fallen from $21.39 to $19.82 in that time.
2) Exposure is light, and he has a big position in physical gold, which is performing well.
3) He owns credit default swaps (CDS) on European sovereigns, which are blowing out. In the event of a complete liquidity meltdown, he will make money as interest rates skyrocket. If there is a default, he will make tons of money. I wish I could buy European sovereign CDS in my personal account.
4) With the stock at 1.07x book value and with losses expected to mitigate on the insurance side, it's pretty cheap. The stock has historically traded around 1.25x book.
As far as his long positions, his top 5 are:
| Month of August Returns to Date | |
| AAPL | -3.78% |
| GLD | 7.64% |
| MSFT | -7.08% |
| VOD | -2.56% |
| PFE | -5.04% |
| Top 5 | -2.16% |
These are names I like, and in fact have 3 in my own portfolio.
So, as of Monday this week: the S&P is down 7.5% this month, his top longs are only down 2.2%. Pretty solid. But what I like best about GLRE is that I don't think it's a carefully followed name. Case in point: they publish their returns on their portfolio every month, so in theory you shouldn't be that surprised when they report quarterly earnings. In May however, the stock fell 7% after reporting negative earnings. While the monthly numbers were published on their website well in advance, a 4% hit to BV/share caused an abnormally large 7% decline in the stock. Strange.
This month, I am hopeful that traders are panic selling a stock whose BV/share (or NAV as I call it too) is roughly flat since June 30th. In a bull market, this stock likely could trade at 1.3x to 1.4x book, or approximately $26-28 a share. In fact, it was $28 earlier this year. Further, if the bull market re-asserts itself and book grows as it has historically, then a $22 book could translate into upside of $29-30 a share.
Downside
The stock IS correlated to the markets. It's one to buy on a dip, as it has lately. Einhorn controls risk in bear markets, but it is almost impossible to make money when risk aversion translates into unbridled selling. This was the case in 2008. But if markets fall another 20%, I would expect GLRE's portfolio to perhaps fall 5-10%, given his net long position of 30% today. Worst case, the stock falls to a book value multiple, and book value itself falls say 8% to $18.25. From $21.75 to $18.25, down $3.50 a share or down 16%.
It might be smart to buy half a position now, and wait for a pullback to buy more.
Upside
Compared to a bull case of $30/share or up 38%, the risk reward is certainly skewed to the upside. I also think that there will be early warning signals to get a read on earnings. Their website provides monthly investment returns. Weakness there, coupled with strength in the stock, would be a clear sell signal (as was the case earlier this year). Alternatively, decent monthly returns lately against a beaten up stock should equate to a buy.
Finally, if you are a buy and hold guy, this stock is probably perfect for you. You get one of the best hedge fund managers in the business for a smidgen above book value. He manages risk far better than a mutual fund. Sure, he charges a hefty 2% & 20% to manage the GLRE portfolio, but his returns net of fees are also fantastic. Plus, he can short stocks, European sovereigns, go long in an appropriate way. Mutual funds are all pigeon-holed into one strategy, and run either 95% or 100% long without any short positions.
Since 2005, book per share has grown over 80% cumulatively, or 11% per year compounded. If that happened over the next 6 years, I would not complain, nor would I be surprised.
Disclosure: I am long GLRE.
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