Greenlight Capital Re, Ltd. (GLRE)

ValueArbitrage (50.74) Submitted: 9/04/08 6:06 PM : Start Price: $22.68 GLRE Score: -22.56

Two of the most important characteristics investors desire (or at least should) of the business interests in which they own are the ability of those businesses to generate a high rates of return on their equity and the opportunity to reinvest excess cash flow back into their business to grow earnings and improve results.

Indeed, these are the traits of any excellent business, and by excellent I mean businesses that are growing their per share economic values, have high returns on capital and have managements with a history of intelligent capital allocation as well as acting in the best interests of long-term shareholders.

Greenlight Re is exactly this type of business, and investors who purchase shares at or around today's levels will likely reap outsized returns for decades to come, driven by a combination of multiple expansion and earnings growth from current levels.

GLRE is in the business of reinsurance, and like all similar companies is valued on an appropriate multiple to book value. As a general rule of thumb, businesses with high ROE's should trade at higher book values, and vice versa.

A quick analysis:

Greenlight's unique operating strategy as well as the character and investment acumen of its chairman and investment manager David Einhorn, provide important clues to what GLRE's normalized ROE is likely to be and hence what a normalized (appropriate) book value multiple should be. For a variety of reasons, I believe that GLRE should trade around 2x book (at minimum) for the forseable future. Here's why...

One thing that sets GLRE apart from your typical insurance business (similar to MKL or early BRK-A) is Greenlight Re's investment strategy is primarily long/short equity driven (instead of the typical insurers float being invested in primarily fixed income instruments). By managing the asset side of the equation for capital preservation on an investment by investment basis in common stocks, and concentrating only on Mr. Einhorn's best ideas, Greenlight Re is likely to compound their investment assets at a much faster clip than would ordinarily be possible. Although this unique strategy will increase the volatility of GLRE's results in the short term, over the full cycle this investment strategy should significantly outperform relative to other insurance companies bond dominated float on a risk-adjusted basis.

A quick browsing of the companies latest investor presentation provides a sensitivity analysis regarding investment returns and their likely impact on Greenlight's ROE. The results are enlightening. Although still relatively unknown to the public, David Einhorn's track record speaks for itself. In comparison to an essentially flat S&P 500 over the last ten years, Einhorn's Greenlight Capital was able to produce investment returns net to partners (after his 2&20 fees) of roughly 25% over the same time period. Assuming GLRE simply breaks even on the underwriting side of the equation and investment returns are considerably less going forward than they have been historically, say 15% annualized instead of 25%...and assuming a BV multiple indicative of an avg. business with an avg. ROE of 1.5x (which this certainly is not), returns should approach %40 yoy.

Looking forward 5-10 years and assuming Einhorn can compound GLRE's capital at his historical pace, mangagement underwrites consistently profitable business, and the market comes to his senses and awards a more appropriate book value of 2X the upside gets ridiculous.

Also worth noting is the reinsurance units unique operating strategy, which allows the company to operate w/ a fraction of the capital its competitors require (GLRE has only of handful of full time employees). Additionally, Like any insurer worth their salt, mgmt is focused first and foremost on profitability, as opposed to a volume at any price mentality that so often destroys undisciplined competitors. And last but not least, Mr. Einhorn sunk roughly 50 million of his own money into GLRE last year, putting his money where his mouth is, and aligning his interests firmly with those of his shareholders.

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