One of the few stocks I have been keeping a close eye on this year is Brighthouse Financial Inc. (BHF, Financial).
I first noticed this company when David Einhorn (Trades, Portfolio)'s Greenlight Capital revealed it had acquired a large position in the stock. Greenlight paid $57.92 per share at the end of last year. Even though the hedge fund manager has struggled to generate a positive performance for his investors over the past several years (at the end of the second quarter, he was down 18% for 2018), I still have a huge amount of respect for him because of his long-term record. So when I discovered that Brighthouse had become his firm's largest holding, I decided to keep an eye on the stock to see if it might be worth following Einhorn's movements.
Unfortunately, in addition to being one of Greenlight's largest holdings, it is also its worst-performing stock. Year to date, Brighthouse is down 30%, underperforming the S&P 500 by around 38% excluding dividends.
Unloved spinoff
Brighthouse was spun off of MetLife (MET, Financial) last year. Ever since the spinoff, the stock has traded lower and at a significant discount to the value of its assets. At the end of the second quarter, Brighthouse reported a book value per share of $112.17, or $105.37 excluding accumulated other comprehensive income. With the stock changing hands from around $40 today, this is a discount of approximately 62%.
For his part, Einhorn does understand why Brighthouse is underperforming. In his second-quarter letter to investors, he wrote:
"All told, we really don’t understand why the stock is performing so badly. It now trades at about 37% of book value and less than 5x earnings. Generally, when an insurance stock trades this poorly, there is either a large capital hole or an enormous reserving problem. We don’t see evidence of either."
Einhorn does not see evidence of the company's problems, but it is obvious the market has a different perspective.
Complex business
It would appear the primary reason why investors are avoiding the business it is because of its complexity. Brighthouse is one of the largest U.S.-based life insurance retailers and its main products are universal life insurance with secondary guarantees, or ULSGs. These guarantees mean that if certain minimum premium payments are made for a given period, the life policy remains in force for the guaranteed period even if the cash value drops to zero. These guarantees mean the company's future is very complex to try and analyze because unforeseen market movements could leave it nursing larger losses than expected.
To hedge against these movements, Brighthouse makes heavy use of derivatives, particularly equity derivatives, which it explains in its second-quarter 10-Q filing:
"Equity index options are used by the Company primarily to hedge minimum guarantees embedded in certain variable annuity products offered by the Company...
Equity variance swaps are used by the Company primarily to hedge minimum guarantees embedded in certain variable annuity products offered by the Company...."
The gross notional value of foreign currency, interest rate, credit default and equity index options, swaps, forwards and cap derivatives on Brighthouse's balance sheet at the end of June was just under $100 billion according to the company's filing. For the second quarter, Brighthouse reported a net loss to shareholders of $239 million, driven primarily by net derivative mark-to-market losses.
This exposure reminds me of a Warren Buffett (Trades, Portfolio) quote where he said derivatives "are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
At the time of writing, Brighthouse's market capitalization is a little under $5 billion, approximately 5% of its total derivative exposure. It seems this could be the reason why the market is so afraid of the business.
Brighthouse might look cheap and be on track to earn around $8 per share this year, but it won't take much for the balance sheet to blow up. A sudden change in interest rates or an equity market black swan could change everything. For this reason, it appears the company's low valuation is indeed justified.
Disclosure: The author owns no stocks mentioned.
