William_Potter
Dear Partner:
The Greenlight Capital funds (the “Partnerships”) returned 8.4%[1] in the second quarter of 2022 and 13.2% for the first half of 2022, compared to a 16.1% decline and a 20.0% decline for the S&P 500 index for the quarter and half year, respectively.
The quarterly outperformance vs. the S&P 500 was the best relative performance in the history of the Partnerships. We believe the recent outperformance came from the same discipline that contributed to the prior period of underperformance.
Does this mean that value investing is back? We think the answer is still a resounding no.
To be clear, the environment has been most favorable for us since early last year, after the tail end of the parabolic move in bubble stocks culminated in the meme stock craziness. Still, it isn’t as if investors are now embracing value investing and pouring into value stocks. The community of disciplined value investors has shrunk considerably. Traditional long-only active managers have lost assets to index funds and have generally scaled back their research efforts. Short sellers are significantly diminished and many have left the industry.
The market is still dominated by the types of investors who we described in our year-end 2020 letter: those that either will not (index funds), cannot (untrained novice investors) or choose to not (valuation indifferent professional investors) have valuation as a cornerstone of their investment processes. A lot of these investors have had a tough go of it during the current bear market.
We believe that part of the reason value stocks have fared better lately is because value investors have suffered a full redemption cycle and there is hardly anyone left to sell. Another factor may be that some value stocks have become so cheap relative to the earnings of the underlying businesses, companies are able to buy back a large portion of their own market capitalizations.
We aren’t relying on other active investors to buy the stocks that we own, so we instead are choosing to emphasize investing in companies that appreciate this dynamic and are creating value both through their operations and through buying back their own stock at very low prices.
Let’s review our five largest holdings as of June 30th in this context:
Atlas Air Worldwide (AAWW)
The shares ended the quarter at $61.71. This is about 65% of book value and less than 4x consensus earnings. The company has bought back 4% of the stock this year and has authorized another 6% buyback.
Brighthouse Financial (BHF)
The shares ended the quarter at $41.02. This is about 25% of book value and less than 3x consensus earnings. [2] We expect the company to repurchase 1020% of its shares this year.
CONSOL Energy (CEIX)
The shares ended the quarter at $49.38. Though it trades at a nosebleed 2.6x book value, we expect the company to generate approximately $50 per share in after-tax free cash flow by the end of 2023. Capital returns have not yet begun, but we expect they will shortly.
Green Brick Partners (GRBK)
The shares ended the quarter at $19.57. This is about 1.1x book value and less than 4x consensus earnings. The company bought back 5% of its shares as of its last quarterly announcement and authorized another buyback of an additional 10% of the shares.
Teck Resources (TECK)
The shares ended the quarter at $30.57. This is about 85% of book value and less than 4x consensus earnings. The company recently began buying back its shares. When the CEO was asked on the April 27th quarterly call what the plans were for playing his “really strong hand of cards here,” he responded with, “I’d like to buy the whole company back myself.”
We appear to be entering a softening period of the economic cycle, where it is likely that earnings will fall. So, these stocks may not be as cheap as the P/E multiples suggest. However, we have done our own sensitivity analysis and we think that it is doubtful that any of these companies will see earnings fall by more than 50%. While investors may not be excited about 3-5x “peak” earnings, might they get excited about 6-10x “trough” earnings?
Actually, it isn’t so much about investors, who seem absent as described above, but more likely the companies themselves that will create long-term value above and beyond business earnings by repurchasing a chunk of themselves cheaply.
Over the short term, having few others practicing value investing probably does not help us. Over the intermediate term, we believe this setup could generate potentially exciting performance. For example, it might get very interesting if CEIX returns its entire current market capitalization to shareholders in the next 2 or 3 years.
We continue to believe that we are in a bear market. The large declines in the major indexes in the first half of the year make that an obvious statement at this point. However, the tone of the bear market shifted in the second half of June. For a number of months, our portfolio, which is positioned to benefit from inflation, did just that. In mid-June the bear market broadened and inflation beneficiaries fell sharply.
To that end, the Fed raised interest rates by 0.75% and promised to do more. It also began shrinking its balance sheet to tighten monetary conditions. As we expected, the inflation has begun to create an economic slowdown as consumers have to spend more on necessities, leaving less available for discretionary purchases.
Commodities of all sorts have fallen considerably. This appears to be driven by speculator sentiment shifting from bullish to panic. Everyone remembers 2008 when commodities collapsed during the recession. However, the physical markets for most commodities remain very tight. There was little supply response to higher prices and the fall in demand is more anticipated than achieved at this point. We believe that the failure of higher prices to create additional supply should provide support for commodities, and could easily lead to a reversal on any change in sentiment.
Nonetheless, falling commodity prices appear to be leading to an economic consensus that inflation is now under control. Inflation swaps currently suggest that inflation will be less than 4% in the next 12 months and less than 3% after that. With gas prices falling, it is likely that July’s inflation report will be softer than any we have seen in recent months.
In response, last week Fed Reserve Chairman Jerome Powell announced that with an additional 0.75% increase in rates in July, rates were now “neutral.” He acknowledged that financial conditions have tightened “a good bit.” He seemed pleased that inflation expectations have moderated; and rather than promising further action to combat inflation, he suggested the Fed would go “meeting by meeting.”
Ultimately, he said that the committee believes that it needs to get policy to “moderately restrictive.” Implicitly, this will solve the inflation, which as of last month is running at over 9%. The press conference did not quite match President Bush’s famous “Mission Accomplished” photo op and speech from 2003, but that was the vibe.
We agree that inflation will likely decelerate. The June declines in energy-related commodity and food prices are likely to make headline inflation in the next report appear to disappear. To borrow a phrase from TS Lombard Research, we believe this is transitory disinflation.
While commodity prices are volatile, the stickier components of inflation are likely to remain. Rents appear very strong. If anything, higher interest rates are likely to suppress housing starts (especially multifamily), exacerbating the structural shortage. Wages and service price increases tend to be sticky. We noticed that last month alone dental care prices rose by almost 2%. That is the type of movement that is unlikely to reverse.
Further, the possible premature celebration of the end of inflation is likely to cause more inflation. Financial conditions are much less tight than they were a month ago, and since the Powell press conference, commodities have begun to recover. Should that continue, headline inflation acceleration may resume as soon as the August report.
A year ago we wrote:
The majority of investors accept the Fed’s premise and believe that inflation is topping and the Fed has the situation under control… The consensus view is that even the slightest adjustment to monetary policy will suffice to keep inflation in check. The recent market reversals reflect that view. We remain positioned on the other side, as there are – and we believe there will continue to be – too many dollars chasing too few goods and services.
We believe history is repeating.
Our year-to-date performance breaks down as follows:
|
Performance |
Alpha[3] |
|
|
Longs |
-22.4% |
5.8% |
|
Shorts |
24.6% |
9.0% |
|
Index hedges |
7.2% |
0.6% |
|
Macro |
6.5% |
6.8% |
|
Total (gross) |
15.9% |
22.3% |
|
Total ((net)) |
13.2% |
We achieved our positive year-to-date result despite being net long in the bear market. Our longs, particularly in late June, fell sharply. Fortunately, our single name shorts fell even more. Index hedges contributed as we would expect. It was also a strong period for our macro investments, led by investment grade and high yield credit default swaps and inflation swaps.
We had no material new longs during the quarter. It is a bear market and we are building some dry powder for future opportunities. We have lowered our gross long exposure from 127% at the beginning of the year to 86% at the end of the quarter.
We did add a new top-five long position in July. As it is a short-term investment and we have a full position, we will break our normal procedure of waiting until next quarter’s letter and will discuss it presently.
We haven’t written about Tesla (TSLA) since 2019, and, we won’t break that streak now. Elon Musk is a different story.
In 2019 we quipped:
“For now, the accepted reality appears to be that Elon Musk is above the law.”
At the time we wrote it we were half serious, half joking. In fact, we thought the law would catch up to him at some point. But it hasn’t. Rather, our quip that Musk is above the law has become a widely held belief.
Which brings us to Twitter (TWTR).
In April, Musk agreed to buy TWTR for $54.20 per share. Then, in May, he appeared to change his mind. The case law on this is quite clear. If it were anyone other than Musk, we would handicap the odds of the buyer wiggling out of the deal to be much less than 5%, or the percentage of bots that might be on Twitter.
But, it is Musk and therefore many believe that the laws again won’t apply. One former judge on the Delaware Chancery Court (where the case is being heard) went on CNBC to speculate that the court might let him out of the deal because Musk won’t respect the judgment, which would embarrass the court. Another variation is the court might rule against him, but TWTR might not be able to enforce the judgment.
Apparently, many people either believe these outcomes are acceptable or, in the alternative, are just the way the world works. We hope it isn’t so.
Actually, we can do more than hope. We purchased a position in TWTR at an average of $37.24 per share. At this price there is $17 per share of upside if TWTR prevails in court and we believe about $17 per share of downside, if the deal breaks. So, we are getting 50-50 odds on something that should happen 95%+ of the time.
We think that the incentive of the Delaware Chancery Court, the preeminent and most respected business court in the nation, is to actually follow the law and apply it here. If it lets Musk off the hook, it will invite many future buyer’s remorse suits. Cynical buyers might contract with targets and then use the threat of litigation and the resulting uncertainty to recut the deal.
The Delaware Chancery Court has spent years developing case law relating to merger agreements. The resulting precedent and clear understanding of buyers’ contractual obligations has created a great deal of predictability in this sphere. It will be up to Chancellor McCormick to follow that precedent and protect the sanctity of the court. We like the risk-reward that she will.
We closed out a large 4.5-year short position in C.H. Robinson Worldwide (CHRW). Ultimately, we had a modest loss despite the shares substantially underperforming the market during our holding period. We became concerned that the near-term prospects for the business have improved and covered the position.
We also exited our long position in Rheinmetall (OTCPK:RNMBF) after a 125% gain over a few months. It benefited from the expected increase in German and European defense spending that is likely to follow the war in Ukraine. At the current price, it is no longer obvious to us whether the shares are undervalued.
At quarter-end, the largest disclosed long positions in the Partnerships were Atlas Air Worldwide, Brighthouse Financial, CONSOL Energy, Green Brick Partners and Teck Resources. The Partnerships had an average exposure of 86% long and 68% short.
“In bear markets, stocks return to their rightful owners.”
– attributed to J.P. Morgan
Best Regards,
Greenlight Capital, Inc.
Footnotes
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[1]Source: Greenlight Capital. Please refer to information contained in the disclosures at the end of the letter. [2]The life insurance industry will experience an accounting change at the end of 2022. This is likely to have a material negative impact on BHF’s book value per share. Nonetheless, we believe that BHF’s current price will still be at a substantial discount to this more conservatively calculated book value. [3]Alpha contributions are calculated using the gross returns, on a position-by-position basis, against a local market index.
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Original Post (from lettersandreviews.blogspot.com)
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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