Seeking Value with Two Beat Up Hedge Fund Reinsurers
The reinsurance business has taken a turn for the better lately, but some continue to struggle, especially two that are run by hedge funds. Can we find some value here?
Value investing involves people finding companies whose stocks are distressed, if not the company as well, and jumping on in hopes that things will turn around for the company and its stock and we can turn our entry into a nice profit later.
There are good and bad ways to approach this, and one way that we don’t want to use is just seeing a company’s stock beat up and somehow believing that people will just start liking it because it is beat up. You see references to valuations and if a company is valued low that’s supposed to be a good thing, as if stock prices depended solely on such things or even that this really matters very much.
There are lots of things that affect stock prices, and when we are comparing stocks, a lot of a stock’s price represents its future potential and may have little to do with things like current earnings. If people traded stocks based upon these things, we could go with this approach, but they do not, and that should put an end to this strategy right there.
If we see a stock that is beat up, what we need to ask ourselves is what the stock may have going for it to cause us to believe strongly enough that it will recover to want to put money on this. When we use price to earnings ratio, or book value in the case of reinsurers, since book value is looked at a lot more with this type of stock, all that really tells us is that the stock is doing badly, and stocks doing badly is the problem, not the solution.
If we see the poor stock results from problems with the company, and also reasonably foresee that the company may turn its prospects around, now we at least have something to be hopeful for. If we are going to bottom feed based upon fundamentals, we at least need to see the sky having enough of a chance of clearing before we should want to get involved ourselves.
There are two reinsurers that have been in the news lately and are both being recommended as a buy by some people, as a value play, but the fact that both trade below 70% of their book value isn’t something meaningful in itself. Once again, this part just tells us how big of a hit the stocks have taken, something we can see quite plainly with the charts.
If a company is trading that much below book value and does have some real hope, and also appears to be as beat up as they probably will get, now we’ve got something that may indeed work out to being a good play and perhaps may be worthy of our attention and even some of our capital. You wouldn’t want to put too much of your portfolio in such a stock, but this sort of play can work out quite well if we pick the right stocks and our timing is right.
Two Hedge Fund Reinsurers That Definitely Qualify as Bottom Plays
Both of these reinsurers, Third Point Reinsurance, and Greenlight Capital Re, are reinsurance arms of hedge funds, Third Point and Greenlight. Hedge funds set up reinsurance companies as both a means of accessing additional capital to invest and also as a tax strategy.
This is why you see these companies set up in places like Bermuda, where Third Point Reinsurance is located, or the Cayman Islands, where Greenlight Capital Re is set up. This allows hedge funds to avoid paying tax by funneling money into these companies as well as the hedge fund charging them fees for managing their investments.
Insurance companies carry a lot of assets in reserves to deal with claims, and while they are hanging on to this money, they can invest it and make more profit. Reinsurers insure insurance companies so they deal with bigger threats and keep even bigger amounts of money in reserve, and this can really provide an opportunity to make investment profits.
That’s how Warren Buffett built his empire, by using reinsurance money mostly, and many have tried to emulate this model, including hedge funds. Reinsurers run by hedge funds are clearly less desirable to invest in than reinsurers without a yoke around their neck, as the hedge fund run ones are used to siphon off a lot of money for the fund, by way of fees.
The hedge funds are generally subject to the same fees as clients of the fund pay, and Third Point collects 1.25% of the funds under management plus the usual 20% performance fee over target. This might seem pretty reasonable, as a lot of clients are more than happy to pay this, but that’s only because they get better returns on average than they could get themselves.
Institutional investors aren’t so needy though and can hire their own people to invest for them, on a level comparable to what a hedge fund would do for you, and while institutions do hire hedge funds to manage certain investments, being married to this arrangement totally isn’t really the ideal situation.
We need to keep in mind that they are siphoning off money that is designed to hedge insurance risk, and these outflows may deplete the reinsurer’s ability to maintain their obligations. We know for sure though that this does affect their profits, versus those who are not under such an arrangement and get to keep all the money that they make.
It is therefore quite natural for hedge fund reinsurers to have their stock prices lower than non-hedge fund operations, because they do not have this financial burden. Most trade above their book values, but these two are well below, and this is one of the reasons.
Hedge funds need to make sure that they don’t get too greedy with these fees. Greenlight pays 1.5% per year on their portfolio and 20% above the bar, but also pay 10% below the bar as well. This is not an arrangement that is set up to maintain the health of the reinsurer and looks even more like cannibalism than your average hedge fund re.
Of these two potential stock picks, both had a terrible 2018 and both lost money last year, although Greenlight’s $10 a share loss was particularly horrible given that their stock isn’t even worth this much these days.
Their charts are simply horrible. Both stocks are well below their initial price, 5 years ago with Third Point and 12 years ago with Greenlight. Over the last 2 years, Third Point has lost 34%, and Greenlight has dumped 74%. When you see huge losses on the balance sheets and huge losses on the stock charts as well, this is a sure sign that the drop in price has been well deserved.
Where These Stocks Are Headed is What Really Matters
Stock prices are all about the future though, and if we’re looking to pick a bottom fundamental play, we need the future to look a whole lot brighter than the past. This is not the case though for Greenlight at least, even though they earned a profit last quarter. This came as a result of their adjusting their investments toward more conservative ones, which was necessary after the massive investment losses they suffered last year.
Greenlight’s insurance business isn’t doing that well though and barely staved off a downgrade by rating agency A.M. Best that could threaten their ability to gain new business. As for their investments, Greenlight hedge fund principal David Einhorn has stated that this new conservative strategy isn’t getting it done for him, which is another way of saying that he would like to be able to cannibalize the insurance company more, which gives us a very good glimpse of what is actually important to them.
There are even some questions about the future of Greenlight Re, and all this is exactly what we don’t want to see with a bottom play. In spite of some investors such as David Rocker being enamored with their ever-decreasing percentage to book, now around 65%. Greenlight Re is, by any sensible account, not a play that has enough upside to make sense of it, especially when we try hard to find anything positive about this stock and come up empty.
Third Point, on the other hand, at least looks like they are turning things around a bit and enough to at least provide a decent amount of hope to shareholders and prospective ones. The stock has been going the wrong way over the past 4 months, but they are nearing the lows they put in last December and may find another bottom there.
More importantly, their business is picking up and CEO Dan Malloy expects a profit from their insurance underwriting this year, due to better prices and terms, provided that we don’t get too many disasters. Third Point recently took on a lot more exposure in Florida, and with a major hurricane possibly hitting early next week, that could be a game changer right there.
The market knows about the better performance of Third Point’s business though, although it hasn’t stepped up and given it more love, at least yet.
Wise investors would be very well served to just toss any ideas about getting in on Greenlight’s reinsurance company into the garbage, as the light with them is not green and is instead a bright red. Third Point, on the other hand, does have enough potential to keep an eye on, and while those on the daring side might want to make the leap now, while prices are this low, waiting to see if it holds up over the next little while would make a lot of sense.
We don’t want to be too bold with bottom plays of any sort though, and if we’re looking for a stock to stop falling and rebound, it’s a good idea to wait for it to stop falling at least, or at least await the outcome of Hurricane Dorian.
If Third Point can show us that it really isn’t interested in going below $9 and starts moving away from this, or if we look to jump the queue and get in now and put our stop there, this could end up being a pretty good play as long as Mother Nature doesn’t rain down on it too much.
Chief Editor, MarketReview.com
Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.
Contact Ken: ken@marketreview.com
Areas of interest: News & updates from the Federal Reserve System, Investing, Commodities, Exchange Traded Funds & more.