Note: This article was originally published as a Friday File for the Stock Gumshoe Irregulars on October 26. At that time I did not own shares personally, but I now do own shares and have an additional limit order in to buy more if the price drops. The ad has still been running recently, and the company and stock have not changed particularly since publication. The article below has not been edited or updated since it was originally published.
Well, no, probably not. But it is a great investment thesis to work with. And it might be a fun and worthwhile newsletter teaser to sniff out.
“The Golden Cross” is Tom Dyson’s description of a big setup for a certain class of companies — he’s trying to recruit subscribers for the Palm Beach Letter, which he publishes with Mark Ford. And the stock they tease in this ad is one I’ve been meaning to look at for a long time, and it’s in an industry that’s been proven quite capable of creating huge long term growth for the better companies, so I thought we’d take a look today.
Is that enough to tease you to keep reading? OK, OK — since you are my delightful Stock Gumshoe Irregulars and you’ve paid to read this far, I can jump the gun and tell you that the fabbo industry being teased is insurance, and that the one stock that is specifically hinted at by Dyson is Greenlight Capital Re (GLRE), David Einhorn’s captive reinsurance company.
But I don’t want to spoil the fun as we take a look at the teaser, so we’ll also have a gander at what Dyson calls this “Golden Cross” and at how he teases and touts Greenlight … OK?
Insurance is a great business in part because it can create free leverage for good investors — that’s something you probably already know if you’ve paid any attention to Warren Buffett’s annual letters (which are required reading for folks who want to understand investing basics, though if you’re brand new to the investing game you might want to read Greenblatt’s The Little Book that Beats the Market first, that’s the simplest explanation for why you’d want to buy a piece of a company, and how to figure out which companies are the best bets — not that Greenblatt talks about insurance, but I often get asked what my favorite introductory book is, and that’s it).
Basically, it works like this: Insurers collect premiums, and they have to hold money aside to back up the liability they’re assuming in exchange for those premiums. So if they collect $600 from you to ensure your house, they have to hold part of that money in reserve in case your house burns down. If the year passes and the insurance coverage is over, they “earn” that premium. For some kinds of coverage, like worker’s compensation insurance when big issues like asbestos work through the courts for decades before big payouts happen, liability doesn’t expire for a long time, so an insurance company might have to hold the cash for years and years until the potential liability is exhausted and they actually get to “earn” the premium money.
But during the time that they hold these “unearned” premiums, they can invest the premium money they’re holding (it’s usually called the “float,” though that isn’t an accounting term that’s standardized in SEC filings) and they earn the investment returns on that money, even though the money has not been earned yet and it isn’t really theirs yet. In most cases, this float is invested in safe stuff, because a big chunk of it will end up being paid out eventually … so insurers often suffer when interest rates are low because they can’t just break even on their underwriting and collect a free 5% from long term government bonds.
But insurers who can write their policies profitably, breaking even or making money on the actual core business of taking risk in exchange for premium payments, get free leverage for their investment portfolio and, if they’re good investors, can dramatically ramp up their earnings as a result. In Buffett’s case, part of the reason he’s been able to build Berkshire Hathaway into such a colossus is that his effective insurance companies, like GEICO, were so well-run that they consistently made money on underwriting and therefore he not only got to use other people’s money to invest … he actually got paid by those people to invest that money.
So the key is: Underwrite profitably and invest profitably. Most insurers don’t do either all that well on a consistent basis, many are better at one or the other, and a select few, like Warren Buffett, do both really well over a long period of time and get godawful rich.
With that in mind, let’s look at Tom Dyson’s tease and see how he describes the situation:
“This rare, little-known strategy only works under specific market conditions. For the past 38 years it has been out of reach… but the window has just opened once more….
“The Golden Cross is very simple…
“If I had to explain it as an equation, it would look like this:
Cash-Rich Insurance Company
Genius Money Manager
Thankfully, he doesn’t just stick with the “equation” but goes into the story of Warren Buffett building Berkshire Hathaway, one example of this kind of “golden cross” …
“Buffett was a great investor, but the greatest thing he ever did was take advantage of a rare but amazing window of opportunity that opened up for him some forty years ago….
“The window for the Golden Cross opens up when all of the following elements are in place:
- First, you need a major market crash. Stocks are cheap… companies are hungry for cash… it is a perfect time to buy… if you have cash and know what you are doing.
- Second, you need a slow recovery period. A big drop, followed by rapid recovery, does nothing for quantum growth. The reason being that people get back their confidence and begin buying again. This pushes prices back up too fast for Golden Cross investors to get in at the right price.
- Third, you need access to large quantities of liquid cash. All the opportunity in the world is nothing without the cash to take fast and immediate action. And, as you’ll see in a minute, nothing spins off ready cash like a well-run insurance company.
- Fourth, you need a true investment genius. This is essential. You cannot do it without a brilliant money manager to create the growth. There were many people who began investing at the same time as Buffett… but they did not have his genius.
“When you combine these four elements in one investment, you have a rare opportunity for Golden Cross-type returns.
“The Golden Cross Window Is Open Now”
There’s obviously a danger in taking one or two historical occurrences and extrapolating into the next occurrence — which is basically what you’re doing when you say that now is similar to the time when Berkshire Hathaway started really building steam in the 1970s and 80s, and that not only is the time similar, but that the company you’ve chosen or the manager you’ve chosen is going to be equally brilliant and fortunate.
But we can dream, can’t we? And you don’t have to be the next Warren Buffett to run a good company that might make investors money, of course — we hear about the next Warren Buffett at least a few times a year, whether it’s Prem Watsa or Bruce Flatt or whoever, but it’s kind of like trying to find the next Michael Jordan when he’s playing in high school … you’ll find a lot of really good players, but finding exceptional, once-in-a-lifetime talent that fulfills its promise is, well, rare. Duh. And until the last ten years or so, when he has become essentially deified, you could have always found folks to say Warren Buffett was just lucky, or had lost a step, or missed the tech revolution, or what have you. So the next Warren Buffett won’t seem like that until we look back.
So Dyson thinks that this “Golden Cross” window is open now, and he also goes on to add that having an atmosphere of political mistrust helps — comparing the political chatter now to the 1970-early 80s period of OPEC embargo, Carter’s malaise, Iranian hostages, etc.
In his words:
“The markets are moved by emotion. When political times are shaky, money dries up, people get fearful. The average investor following conventional wisdom gets slaughtered.
“Unrest also makes people skeptical. This gives the Golden Cross time to form and take root, without being gobbled up by the masses. This is important, as you’ll see in a minute.”
And the investment idea?
“When the market is like this (as it is right now), all we need is a true money genius and a well-managed, cash-gushing insurance company.
“I’m writing to you today because I believe my research team and I have found exactly that.”
So why isn’t everyone all over these insurance companies/golden cross opportunities? More Dyson:
“I have often wondered why Wall Street and big-league investors never see a Golden Cross until long after it has proven to make a handful of people exponential returns.
“I think it is because it is standing out in the open, wrapped in the ordinary, plain, vanilla packaging of a holding company.”
Which gives him the chance to cite some of the favored “golden cross” ideas that have been built into great insurance company-led conglomerates over decades, like the Tisch brothers and Loews (L) and the slow-building success of Markel (MKL) in addition to Buffett’s Berkshire Hathaway (BRK-A or BRK-B), all opportunities that have been very successful over the long run but had their boom years out of the spotlight, often during or following times of market duress.
Just to get you even more excited, here’s a bit more from the ad:
“History shows that the sweet spot for investing in—and wildly profiting from—a Golden Cross is about seven years following a major market crash… while the company is growing at 20% or higher.
“After that, the money is good, but nothing like the five- and six-digit returns we have been talking about today.
“So it is important to note that the S&P hit a low spot in March 2009.
“The conditions were right, and I knew that somewhere, a young Warren Buffett… or Larry Tisch… or Samuel Markel would emerge and make a few far-sighted investors very wealthy.
“I’m writing to you today because I believe I have found a new ‘Golden Cross’ in its early stages.
“I know the players and the companies involved. I believe that in the coming years, we will see this combination begin a silent, unnoticed run in massive profits.
“I also believe that this will continue for several decades to come… despite the financial and political chaos happening all around us.”
So how does Mr. Einhorn’s little company get teased specifically?
“The trick—and why the formation of a Golden Cross is so rare— is because there are so few brilliant investors like Buffett out there. And Wall Street and other investors ignore those who are out there until it is plain and obvious that they can leverage money better than anyone else….
“I have identified the formation of a new Golden Cross.
“It’s a brand-new cash pipeline delivering money to an investing genius… and it’s only been around since 2006.
“It’s already cranking out returns above 20% per year, despite the weak economy we’re in right now….
“… is being executed by one of the greatest—and least-known—investment geniuses of our day.
“He started his hedge fund at the age of 25 with just $900,000.
“He is not your typical hard-charging hedge fund manager. He is mild-mannered, polite, and speaks deliberately and softly. He was born in Demarest, N.J., and moved to Milwaukee when he was seven. His formal education is in government—not economics or business—from Cornell University.
“His father was a banker who worked on mergers and acquisitions of companies. His parents gave him nearly all of the capital to start his fund.
“The Most Successful Investor Operating on Wall Street Today
“Today, our hero is 40 years old and can rightfully claim to be the most successful investor operating on Wall Street.
“Between 1996 and 2011, his hedge fund went up 1,635%. During the same time, the S&P 500 rose 165%.
“If you had invested $100,000 with him in 1996, it would now be worth $1.6 million. The same investment in the S&P 500 would be worth $265,000. That’s a return of 21.6% per year versus 6.7% per year for the S&P 500.
“That kind of investment performance is unmatched by any other investor during the same time period. Best of all, his results were accomplished safely. He has had only three down years since he began his fund in 1996. He uses no debt.
“Today, his hedge fund has $5 billion in it.”
OK, yes, so although he’s actually 43 or 44 now, that’s David Einhorn — who was a year ahead of me in college and in the same major, so I probably had classes with him, but we never met that I can remember. My college career was substantially less heralded than his, which probably has nothing to do with the fact that I likely drank a lot more beer than he did, and I did not start a hedge fund with $900,000 from my parents a couple years after graduation, (I did, however, get a lovely education and eventually find a job, I’m not bitter — he’s a lot better at investing than I am, and if you had given me $900,000 when I was 25 I suspect I would have done something more frivolous than turn it into mega-millions). I’ve read a lot of Einhorn’s work, and seen his presentations a few times at conferences, and he is consistently the smartest-sounding and best-prepared presenter at every conference I’ve been to, and his hedge fund’s performance has obviously been stellar.
So should we buy his insurance company? Well, here’s how Dyson teases that:
“His immediate track record is an average of 20%, with consistent annual returns reaching higher than 25%.
“Those are excellent, safe returns.
“But what does the long-term forecast look like?
“Right now, his structure is valued at around $881 million. This is relatively small, compared with mammoths like Loews and Berkshire Hathaway. If we compound estimated returns at 21.5%—his current pace—in 20 years, it’ll be worth $42.3 billion.
“This means that a hypothetical $25,000 investment in this Golden Cross, under this scenario, will be worth $1,276,000.”
So that “vehicle” is Greenlight Capital Re (GLRE), a reinsurance company for which David Einhorn’s fund management firm provides investment management. Einhorn is the chair of the board as well. Greenlight Re went public a little over five years ago, though it had been slowly built up before that, and you can argue either that it’s a niche reinsurance company that is picking and choosing some profitable business lines that it can build from, or that it’s a small fish in a big, commoditized business that is essentially there to help Einhorn keep a large pool of investable capital that he can work with without having to worry about investor redemptions.
For what it’s worth, Einhorn was arguably the first to build a captive hedge fund investment vehicle around reinsurance (lots of folks, including Buffett, have used insurance to build up their investable capital, but I can’t think of other public reinsurance companies that were set up thusly) — but he’s not going to be the last, both Steven Cohen and Daniel Loeb, hedge funds names that are even more prominent than Einhorn, are setting up reinsurance operations (both private so far, I think), and if they work to raise and keep money under management, I suspect we’ll see more.
And it makes sense, at least on paper — reinsurance is the business of taking risk from other insurance companies, so these companies are capital intensive but are often small in terms of numbers of people, overhead, and need for salespeople. They aren’t going to run TV ads, or have an agent down at the local strip mall, but if State Farm or Allstate thinks they’ve gotten overexposed to a potential risk — like they have too much exposure if a hurricane were to hit, for example, or they’ve written too much exposure for their balance sheet to handle if something bad happens — then they can slough off some of that exposure to a reinsurer in exchange for a premium payment. This might be a simple policy where the reinsurance contract covers the insurance company once claims hit a certain amount, or it may mean the reinsurer takes half of the losses on a specific batch of insurance contracts, or whatever — the reinsurance business is volume-based and is sometimes commoditized to a degree, but very specific deals for reinsurance and risk-sharing are also common. In general terms, the reinsurer is assuming that either they are a better underwriter than the insurance company and can price the risk better, or that they have more scale and flexibility to handle broader risks, or just that the reinsurer is willing to have more volatile performance (insurance companies can also use reinsurance contracts to “smooth” their earnings to some degree, making sure that they don’t suddenly get crushed by a single catastrophe). So that sets up nicely for having a company with excellent management and risk analysis modelers and investment acumen, but with relatively few people handling a large amount of money.
Reinsurance companies also have a tendency to be a bit more volatile than regular insurance companies, though that’s a broad assertion and it ignores the fact that a lot of larger insurance companies also do reinsurance, including Berkshire Hathaway. There are relatively few “pure plays” on reinsurance in the US, and most of them trade at a discount to reported book value — Greenlight Re, however, trades at a small premium to book value. Is that because it’s getting a David Einhorn premium?
The stock has had an uneven history, as you would probably expect for a young company with extremely lumpy earnings (pretty much all reinsurance companies have lumpy earnings — they should be expected to have some huge earnings years and some years of tough losses since they’re more levered to “big picture” catastrophes than are most regular insurance companies, so while every US property and casualty insurance company has better earnings in years without big hurricane losses, reinsurance companies should expect to feel those events more dramatically (losses don’t hit the day the hurricane reaches land, of course, the claims trail in and are paid out over time, but there’s a wave of loss if you have a big claim-creating event). Greenlight Re had a spectacular year in 2009 and did well in 2010, but the stock performed disastrously (compared to the market) last year — partly that’s the claims they had to pay out, partly that’s likely because David Einhorn didn’t have a spectacular year managing money in 2011, when he beat the S&P by just a couple points. Greenlight Re essentially invests alongside Greenlight Capital’s hedge fund, so it has holdings in most of the stuff Einhorn talks about, like long positions in Apple and General Motors and gold as well as his short positions that get more attention. You can see Greenlight Capital’s latest investor letter here that talks about some of their key holdings, and the basic portfolio of roughly 90% long/70% short and the top holdings, as far as I can tell, are going to be mostly the same as Greenlight Re’s portfolio.
So when it comes to Greenlight Re, we’re basically getting exposure to David Einhorn’s hedge fund (which has been closed for a while, but which was never going to be open to the hoi polloi like you and I anyway), and I’ve read that we’re getting it slightly cheaper, too (Einhorn’s management firm collects only a 1.5% annual fee instead of the customary 2%, though he still gets the 20% kicker). So that part is fairly understandable, if we like Einhorn and his strategy (and I do), then shouldn’t we want to invest in this sort of mini hedge fund that he runs?
Well, maybe — we also have to figure out if the reinsurance operation is profitable or stable enough to buy — after all, great insurance investments require both good investment management and good risk management. So, as Hurricane Sandy threatens to come up the East Coast and clobber those of us in New England with another Halloween Surprise (or, as they’re calling it in Manhattan, “Frankenstorm”), should we buy a small company that’s taking on risk from insurance companies?
Einhorn is not an insurance guy — no more than Warren Buffett is — and he’s the chair of Greenlight Re but he’s not the CEO and he doesn’t run the day-to-day insurance operations. So it’s not whether he knows risks, it’s whether his firm has hired good managers who can handle the risks. And that’s something that you can’t judge on a couple years of performance — if they do well, they’ll be profitable in most years and they’ll trade at a premium to book value; if they do poorly they’ll lose the confidence of investors and trade at a discount to book value (that’s an oversimplification, but it’s how insurance company investing seems to work — steady and consistent companies rarely get much below book value, companies that can’t consistently underwrite profitably or manage risk effectively can often trade at a big discount down to 50 or 60% of book value). GLRE has a new CEO, Bart Hedges, who took over from the man who had run the company since inception (Len Goldberg, who retired last year), and he was promoted from within (he was the chief underwriting officer) and seems steeped in the business and GLRE’s unique take on reinsurance.
Right now, GLRE trades at about the lower end of where it has historically traded on a price/book value basis — but it’s a short history. Right now their price/book ratio is at 1.1 and they’ve never consistently traded below 1X book, there is likely somewhat of a floor under the shares right around book value. But book value can fluctuate, of course, if the value of their assets or liabilities change — if book value falls, so will the share price.
I do very much like that the company is managed for profitability — they’re pulling in cash for Einhorn to manage, but they’re not so desperate to pull in that cash that they want to lose money on the underwriting. They are losing money in some business lines, but they address those specifically in their recent presentations and they’re working on it. Doesn’t mean they will be successful, naturally, but it’s good that they’re not ignoring weak performance.
The first thing you should do if you’re looking into Greenlight Capital, even before reading the filings, is read the Investors Day presentation here – or better yet, watch or listen to it from Greenlight Re’s news page (from May) so you can get the explanation and nuance. The quarter to quarter stuff will be interesting and maybe useful, but it’s this big picture strategy that will determine whether this is something you want to invest in for years and let the underwriting and investment performance create compound growth.
They are a little bit different than the bigger reinsurance companies, both because they use Einhorn for investing and because they have tried to become a more stable, client-focused underwriter (ie, providing individual service to companies, not just selling reinsurance and taking on risk in big syndicated markets that are more commoditized). They say this means they have a big “frequency business” and less “severity business” — which we can interpret as exposure to lots of small claims, not so much big disaster-related claims, and which seems like it ought to be more stable over time. I have a suspicion that they will also have better performance than most reinsurers in the years to come, because there is a huge bias in the insurance business to have most of their “float” tied up in fixed income instruments and Greenlight does not fall victim to that bias — since I think that Einhorn’s investment strategy of a hedged, value-focused short/long portfolio will work better than lower (perceived) risk fixed income portfolios for the coming years, I think that will be a nice tailwind for GLRE. But it does come with risk, this is a much more active portfolio than most insurance companies hold, and they company is not so huge that they can handle really big investment mistakes.
Insurance can be a great business, but insurance stocks have been out of favor for years — over the very long term they’ve tended to move very closely to the S&P 500 index (you can compare KIE, the broad insurance ETF, to SPY in a stock chart to see what I mean), but they were clobbered far worse than average during both the 2008-2009 crash and the late-summer market drop last year. So you don’t necessarily want to own all insurance companies, I’d argue that insurance is a business where management matters a lot more than in some businesses — it’s basically a commodity, no one really cares very deeply about who their insurance company is, they just want a fair price and decent service … and in many cases you might not even really know who’s carrying your insurance (if you have a local agent who works for several different insurers, for example).
And surprisingly enough, despite the clear exposure that property & casualty and reinsurance stocks have to natural disasters, in many cases that’s on a company-by-company basis — the broad insurance index, which also includes more stable and boring folks like life insurers, doesn’t necessarily react to every hurricane (though it’s also hard to tell — the last huge, mega-damage hurricane, Hurricane Ike, hit Galveston and started doing massive damage two days before Lehman Brothers declared bankruptcy and the markets began to swoon in earnest, so causality is not exactly easy to ascertain. Some insurance stocks I keep an eye on, like Markel, tracked right along with the S&P during those days, and others, like WR Berkley, bounced back dramatically better than the broader market, this is an industry of individual performers, where underwriting performance and investment performance make a huge difference over time and individual catastrophe exposure can make a huge difference over the short term. Over the past two years, GLRE has been among the worst performing reinsurance stocks, over the last five years it’s been among the best — so go figure.
I am not sure what I think about GLRE’s valuation yet — it seems fair on the surface, but it will take me more reading to get comfortable with it — my initial sense is that the stock is a little bit undervalued, and that if you think Einhorn will invest well and their underwriting strategy that’s less big-catastrophe focused than some reinsurers will be profitable and allow them to grow. I do want to caution that David Einhorn has not necessarily shown an interest in having Greenlight Capital Re be his primary focus — this isn’t quite like Warren Buffett using a shell company to create and compound his big pile of capital, Einhorn is effectively managing the investments of the reinsurance portfolio, but GLRE is just one of the investment pools he manages and his hedge funds are still, on the whole, larger than GLRE.
I have long had a strong fondness for some of the better insurance stocks, particularly those that have niche businesses or excellent investment managers like Berkshire Hathaway and Markel, both of which are substantial personal holdings of mine and have been for many years — but insurance companies are not that easy to compare to each other, and odd duck reinsurance companies like GLRE are harder still. I like what I’ve seen so far after looking into them as I researched this teaser, and I think well-run insurance stocks are likely to continue to do well over the long term, but I haven’t yet bought in to Greenlight Capital Re. I’m going to get more familiar with their strategy and read more of their filings, and compare their business to some of the other insurance companies that appeal to me before I add them or other companies to the portfolio … but this one does at least get through to the next level, and I think it deserves some more time. If you’ve got anything to add on Greenlight, I’m sure I’d be delighted to hear it.