Description

"Many shall be restored that now are fallen and many shall fall that now are in honor." Horace

For most of my career, I have found myself most interested in the most hated areas of the market (see Antero Resources writeup!).  At our shop, we like to make relatively long-term investments in people/businesses that are currently repulsive to most investors.  I suspect a recommendation for Greenlight Re currently meets that criteria.  The company has been written up on several occasions here on VIC, most recently by rickey824 in February 2013.

Normally, an investment in a reinsurance company would require some significant research on the quality of the insurance operation and its likely success over the years.  I intend to skip that conversation in this writeup because I don't think it is a necessary part of the thesis (I feel the below average votes coming right now). If I recommended shares of GLRE at a price above book value, then I think the insurance discussion would be considerably more relevant.  However, in this case, we can buy shares at a discount to book value (as I will demonstrate later), so the "going concern" value of the reinsurance business is less vital to our thesis.  This is not to say we hope they run this off, but rather, we aren't paying for the ability to grow the insurance business.

Before I leave the topic of insurance, note that GLRE has produced an average combined ratio of 104 for the past five years (not NPE weighted, just average of the CRs).  We think that is on the high side of future CRs just given the nature of 2017's catastrophe payouts.  The important point is that while the CR is impossible to predict in any given year, we think it is likely to be in the historical average range over time.  Another interesting characteristic of the reinsurance biz here is that NPE have grown north of 3% annually for the past 4 years (so this isn't a shrinking business, at least not yet).

Our investment thesis rests on the investment portfolio, which has had a miserable five-year run.  We think David Einhorn is a terrific investor who does excellent work (work that I believe is among the best that I've seen throughout my career).  His strategy has not been in fashion for the past five years.  Since DME (Mr. Einhorn's firm) runs the entire investment portfolio of GLRE, the GLRE financials have been adversely impacted.  Consider that in the past five years, the GLRE investment portfolio has achieved a total return of -1.6%, or -0.3% annually.

Prior to this stretch, Mr. Einhorn's track record was stellar (and still is, even including this rough 5-year stretch).  We like the idea of exposing some of our capital to Mr. Einhorn's investment strategy given the current price of such an investment.

Let me explain with a little math.  At year-end 2017, the GLRE portfolio managed by DME was $1.36 billion.  Shareholder's equity was $831,324.  Thus, a GLRE shareholder at book essentially gets 1.6x leverage on Greenlight Capital.  Now, I know we could drill down further and adjust based on our expectation of CR (which we think is above 100), but precision is not the thesis here (though in my EPS estimates in the table above, I am assuming a 104/103 CR for the two earnings figures).

There is more bad news.  Through February, the GLRE portfolio suffered a 10% loss so far in 2018.  Using the year-end figure, that reduces book value by $136 million.  For 2018, we are assuming that Greenlight's portfolio remains -10% (and thus the $4/share loss).  That would leave book value at roughly $696M today, or ~$18.80 per share.  A purchase of GLRE shares today is at a discount of 14% to marked book value.

Let's say that Mr. Einhorn is still a terrific investor (which we believe is the case) and that his strategy begins to bear fruit starting in 2019 (if it comes earlier, all the better).  If we can assume an 8% return from Mr. Einhorn's portfolio, we assume that our return on equity would amount to ~12% given the leverage of investment assets to shareholder's equity (some is lost given the >100 CR assumption). 

Put another way, an investment in GLRE allows an investor to buy a historically great hedge fund manager portfolio at a 14% discount to marked book value at a time when said manager has suffered through the worst five-year period of his career.  If Mr. Einhorn can generate an 8% return for five years, we estimate book value would climb to approximately $33/share at the end of the holding period (keep in mind that GLRE is not a big taxpayer).

Given the likely risk profile of Mr. Einhorn's portfolio (102% long, 70% short) at the end of February, there is far less market risk than an index.  Yet, the discount to book and the potential for book to grow at a healthy rate provide a very significant return oppportunity.  If in 5 years, GLRE trades for book value, we estimate that the stock price would double from here (or ~15% annualized return).  We like that expected return given the risk.

I started this writeup with the statement that we like to sift through ideas that are hated by others.  Hedge funds certainly fit that profile, especially when they have results like those of Greenlight over the past five years.  Clearly, our risk is that Mr. Einhorn underperforms so significantly that shareholder's equity declines significantly from here.  We think that is a risk worth taking in a market we believe is otherwise quite overvalued.

Catalyst

A return of the long/short hedge fund strategy... it could return with a vengeance.  GLRE is a call option on that return, with no expiration date.