How to Invest in a Hedge Fund Via Greenlight RE, GLRE

I was up a lot last night thinking of the problems facing our markets.  We face lots of macro risks, but at least now there appears to be some reward in select stocks I am buying. 

Macro risks to keep in mind:

1) Economic concerns in the US, as slowing government spending and weak consumer spending might push the US into a recession next year.  I think odds are better than 50% we'll double dip so to speak.  Even if we don't double dip, GDP growth in the first half of this year was a meager 0.9%, and the trend is not your friend right now.

2) European banks, which hold so much European sovereign debt, that there actually could be a liquidity crisis in the next 3 months.  With French bank BNP Paribas down 24% intraday last week, liquidity fears are clearly beginning to boil over.  It was summer 2008 that stocks like MS, MER, GS, LEH were getting hit 10% - 20% per day.  Eventually the Fed let Lehman go under, but then reversed course and bailed out the entire banking system via $800BB of TARP money.  It didn't stop financials from collapsing and the equity markets to fall 37%.  Today it's the European financial system.  Leverage among these banks is as high as it was in 2007.  It got very ugly in 2008 amidst the run on the banking system.  I honestly expect that the odds of a European bank panic are close to 100%, I just don't know when.  But it is out there.

3) China.  Yes, China has been the savior to the world's economy since 2008.  Pumping capital into infrastructure projects, lending money to consumers at an astronomical pace, loading up on commodities worldwide.  But when 60% of your GDP is derived from fixed asset investments (ie infrastructure projects), there is massive downside risk to spending.  Because FAI is not recurring in nature, eventually it has to revert to normalized levels.  FAI growth was 67% in 2009, 33% in 2010, and 25% in the first half of 2011.  I read that FAI growth accounted for 8% of their 8.7% growth in GDP last year.  When will China simply reach a level of overcapacity and slow down?  It's not consumer spending driving GDP in China, its the government.

Greenlight RE
So, looking for defensive stocks makes sense to me, but also one perhaps that has some upside if the market rallies.  The one I recommend buying now is Greenlight RE, ticker GLRE.  Greenlight is technically an insurance company.  They underwrite 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 that 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.  Essentially, he 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, Einhorn 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 ala hurricanes, etc).  This is $66 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 (tsunami's 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. 

			Loss reserves		Chg in NI
2010			8678		-8678
2009			-7597		7597
2008			-11988		11988
2007			-1077		1077

This is good, clearly the insurance business at Greenlight isn't very likely to hurt you, and in fact could help you some.

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 beat 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 generallizing 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 seen him speak several times and met him once, and can tell you first hand: this guy is lightyears better than almost anyone in the business.

Here is what Einhorn said from 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.

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 $21.75 today.  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 PA. 

4) with the stock at 1.07x book value and with losses expected to mitigate on the insurance side, its 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
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, the S&P is down 7.5%, his top longs are only down 2.2%.  Pretty solid.  But what I like best about GLRE is that I don't think its 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 1.3 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 monthlies 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 GRLE book, 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.