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Bram de Haas
Bram de Haas
Articles (452)  | Author's Website |

David Einhorn Is Betting on Inflation

3 interesting positions highlighted in Einhorn's latest letter

August 05, 2020 | About:

Greenlight Capital's David Einhorn (Trades, Portfolio) is a true value investor who buys companies at low earnings multiples and shorts overvalued ones.

Occasionally, he will make a macro bet. For a long time, he’s been invested in gold and recently traded some bullion exposure for the VanEck Vectors Gold Miners ETF (GDX).

This quarter he has added another macro-inspired trade through inflation swaps. Einhorn explains this trade as follows:

"All that said, as we studied the various ways to profit from higher inflation, we settled on the most direct method – betting on unexpected increases in the U.S. Consumer Price Index (CPI). Inflation swaps are a highly liquid derivative of Treasury Inflation-Protected Securities (TIPS), the value of which are based on the official CPI at a future date. In May, we observed that the 2-, 5- and 10-year inflation swaps implied future annual inflation of approximately 0.1%, 0.8% and 1.3%, respectively. As annual inflation has averaged 1.7% over the last 10 years, we recognized that we could make a substantial return if actual inflation merely reaches the long-term average. If inflation turns out to be even higher, so much the better. Accordingly, we created a new, large macro position in 2-, 5- and 10-year inflation swaps. At quarter-end, inflation expectations had already begun to rebound to 1.3%, 1.4% and 1.6%, respectively. In theory, higher inflation creates higher long-term interest rates and lower Treasury prices. However, we do not believe that shorting Treasuries is nearly as attractive as inflation swaps, as Treasury prices no longer reflect a free-market price. Not only has the Federal Reserve (the Fed) directly entered the Treasury market with large purchases, it has further announced it will “study” yield curve control (YCC). Speculating on materially lower bond prices is now a tougher call, as the market knows that the Fed is considering YCC. To wit, since the March lows, 10-year inflation expectations have risen an entire 1% without any move in 10- year Treasuries."

This position is already working out very well, by my estimates. Shorting bonds, a trade he also references, would also work under inflationary circumstances, though it may not work if there’s yield-curve control. However, it does serve as a hedge in case the inflation swap strategy doesn’t work. Inflation swaps depend on official measures of inflation. Inflation that doesn’t show up in these statistics could still affect bonds. Shorting bonds can also work in scenarios where inflation isn’t going up but for whatever reason yields are “normalizing” anyway.

Einhorn also has a few recovery plays going on. One of his major positions is a long in Aercap (AER), but he also added additional airplane exposure. 

Building off of this, I personally think there is a really nifty find in the freight specialist Atlas Air Worldwide Holdings (NASDAQ:AAWW). As long as passenger traffic remains considerably down and the economy holds up to a certain extent, this freight company should continue to do exceedingly well. If you expect that a substantial amount of passenger air traffic will not return for many years to come, I think it is a great play.

Einhorn wrote the following in the recent letter:

"Prior to COVID-19, approximately 50% of global airfreight was carried in the belly of passenger planes, mostly on long-haul international flights. With long-haul international passenger traffic down more than 90% year-over-year (and likely to be the last segment of passenger travel to recover), there is a historic shortage of airfreight capacity. After an initial surge in demand to ship Personal Protective Equipment (“PPE”), the market is transitioning back towards more traditional airfreight products such as electronics, capital goods, perishables and pharmaceuticals.

Market shipping rates increased by over 100% year-overyear in the second quarter and are expected to remain strong. As a result, we expect AAWW to see significant growth in earnings per share in 2020 (from the $5.24 it earned in 2019).

In response to the capacity shortage, some passenger widebodies are temporarily operating as freighters (nicknamed “preighters”), particularly to fulfill urgent PPE demand. However, due to lower cargo capacity, more cumbersome loading and unloading and similar overall trip costs, preighters cost roughly 2.5x as much per ton shipped compared to dedicated freighters. Preighter activity departing from China and Hong Kong has already declined by more than 50% since May as shipping rates have partially normalized. Over the next three years, we don’t expect many large freighters to be either produced or converted from passenger service given the cost and lead-times involved. While most of the increase in earnings will occur in AAWW’s charter segment, AAWW also has attractive and substantial long-term contractual relationships serving DHL and Amazon, which stand to benefit from the growth in e-commerce and relatively steady business supporting the U.S. military. We acquired our shares at 0.54x Q1 2020 tangible book value and approximately 7x 2019 earnings that were achieved during much more competitive conditions. AAWW ended the quarter at $43.03."

The third and last pick by Einhorn I’d like to highlight is his long bet on Brighthouse Financial (NASDAQ:BHF). Brighthouse Financial provides annuity and life insurance products in the United States. Einhorn has held the company since 2017. The company was spun out of Metlife (MET) in 2016. Here's his updated take:

"Take BHF, for example. In 2017, we bought the company at a $6 billion valuation. At the time, the consensus view was the company would have trouble transferring “adjusted” earnings into GAAP earnings and wouldn’t be able to return capital to shareholders until 2020. Fast forward to today: the company has since generated $6 billion of retained earnings, while repurchasing 22% of its shares. In response, the market now values the company at about $2.5 billion.

In May, the company demonstrated that it had effectively hedged the first quarter’s market turbulence. Due to a large hedging gain, the company reported $47 per share in quarterly earnings. Yes, BHF earned more than the entire price of the company in a single quarter. Moreover, it bought back 12% of the outstanding stock at depressed prices. Despite all of this and a rapidly rebounding S&P 500, BHF stock only advanced from $24.17 to $27.82 during the quarter, leaving it down 29% for the year. During the quarter, the shares barely outperformed the company’s bonds maturing in 2027, which now yield 3.3% – although the equity languished, the credit markets have reversed any pandemic-induced concerns.

Perhaps we just need Dave Portnoy to select “B”, “H”, “F” out of his bag of Scrabble tiles.

We understand that book value and GAAP earnings are problematic metrics for BHF. There is a change of accounting pending next year that we expect will take out a chunk of the book value, but at a price to book ratio of 0.16x, this should not be a risk to the stock price.

In addition, there is a mismatch between the GAAP accounting for hedges and the risks being hedged. As a result, we expect a large loss in the second quarter, as some of the hedge gains will be reversed due to improving market conditions – just as the first quarter resulted in record GAAP income.

Like many companies, BHF provides “adjusted” earnings that take into account the problems with GAAP accounting. On that basis, its P/E ratio is 3.3x. Management has targeted a goal of repurchasing $1.5 billion of stock by the end of 2021. It has $636 million to go. At current prices, this implies the company will retire an additional 23% of the stock over the next 18 months."

Adjusted earnings are usually something you have to be very careful with. However, in this case, I think there’s a legit reason for giving them some weight and considering what it implies; that BHF is extremely cheap.

Life insurance and annuity providers have been in the doghouse for years now because they aren’t a great business given the historical policies they wrote and the interest rate landscape. However, increasingly these businesses have adapted to the “new normal” and should, over time, get rid of the discounts the market places on them. Buying back 23% of shares over an 18 month period is encoaraging as well, potentially signalling the company considers its stocks to be undervalued.

Disclosure: no positions but the author reserves the right to go long BHF [Brighthouse Financial] in the next 24 hours.

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About the author:

Bram de Haas
Bram de Haas is managing editor of The Special Situations Report and Founder of Starshot Capital B.V.

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