Tag Archives: David Einhorn

Value Matters

I recently saw an interview with Damian Lewis, the actor who plays hedge fund billionaire Bobby “Axe” Axelrod in the TV show Billions, where he commented on the differences in reaction to the character in the US and the UK. Lewis said that in the US, the character is treated like an inspirational hero, whereas in the UK he’s seen as a villain. We all like to see a big shot hedgie fall flat on their face so us mere mortals can feel less stupid.

The case of David Einhorn is not so clear cut. A somewhat geekie character, the recent run of bad results of his hedge fund, Greenlight Capital, is raising some interesting questions amongst the talking heads of the merits of value stocks over the run away success of growth stocks in recent years. Einhorn’s recent results can be seen in a historical context, based upon published figures, in the graph below.

click to enlarge

Einhorn recently commented that “the reality is that the market is cyclical and given the extreme anomaly, reversion to the mean should happen sooner rather than later” whilst adding that “we just can’t say when“. The under-performance of value stocks is also highlighted by Alliance Bernstein in this article, as per the graph below.

click to enlarge

As an aside, Alliance Bernstein also have another interesting article which shows the percentage of debt to capital of S&P500 firms, as below.

click to enlarge

Einhorn not only invests in value stocks, like BrightHouse Financial (BHF) and General Motors (GM), but he also shorts highly valued so-called growth stocks like Tesla (TSLA), Amazon (AMZN) and Netflix (NFLX), his bubble basket. In fact, Einhorn’s bubble basket has been one of the reasons behind his recent poor performance. He queries AMZN on the basis that just because they “can disrupt somebody else’s profit stream, it doesn’t mean that AMZN earns that profit stream“. He trashes TSLA and its ability to deliver safe mass produced electric cars and points to the growing competition from “old media” firms for NFLX.

A quick look at the 2019 projected forward PE ratios, based off today’s valuations against average analysts estimates for 2018 and 2019 EPS numbers from Yahoo Finance of some of today’s most hyped growth stocks plus their Chinese counterparts plus some more “normal” firms like T and VZ as a counter weight, provides considerable justification to Einhorn’s arguments.

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[As an another aside, I am keeping an eye on Chinese valuations, hit by trade war concerns, for opportunities in case Trump’s trade war turns out to be another “huge” deal where he folds like the penny hustler he is.]

And the graph above shows only the firms with positive earnings to have a PE ratio in 2019 (eh, hello TSLA)!! In fact, the graph makes Einhorn’s rationale seem downright sensible to me.

Now, that’s not something you could say about Axe!

Tails of VaR

In an opinion piece in the FT in 2008, Alan Greenspan stated that any risk model is “an abstraction from the full detail of the real world”. He talked about never being able to anticipate discontinuities in financial markets, unknown unknowns if you like. It is therefore depressing to see articles talk about the “VaR shock” that resulted in the Swissie from the decision of the Swiss National Bank (SNB) to lift the cap on its FX rate on the 15th of January (examples here from the Economist and here in the FTAlphaVille). If traders and banks are parameterising their models from periods of unrepresentative low volatility or from periods when artificial central bank caps are in place, then I worry that they are not even adequately considering known unknowns, let alone unknown unknowns. Have we learned nothing?

Of course, anybody with a brain knows (that excludes traders and bankers then!) of the weaknesses in the value-at-risk measure so beloved in modern risk management (see Nassim Taleb and Barry Schachter quotes from the mid 1990s on Quotes page). I tend to agree with David Einhorn when, in 2008, he compared the metric as being like “an airbag that works all the time, except when you have a car accident“.  A piece in the New York Times by Joe Nocera from 2009 is worth a read to remind oneself of the sad topic.

This brings me to the insurance sector. European insurance regulation is moving rapidly towards risk based capital with VaR and T-VaR at its heart. Solvency II calibrates capital at 99.5% VaR whilst the Swiss Solvency Test is at 99% T-VaR (which is approximately equal to 99.5%VaR). The specialty insurance and reinsurance sector is currently going through a frenzy of deals due to pricing and over-capitalisation pressures. The recently announced Partner/AXIS deal follows hot on the heels of XL/Catlin and RenRe/Platinum merger announcements. Indeed, it’s beginning to look like the closing hours of a swinger’s party with a grab for the bowl of keys! Despite the trend being unattractive to investors, it highlights the need to take out capacity and overhead expenses for the sector.

I have posted previously on the impact of reduced pricing on risk profiles, shifting and fattening distributions. The graphic below is the result of an exercise in trying to reflect where I think the market is going for some businesses in the market today. Taking previously published distributions (as per this post), I estimated a “base” profile (I prefer them with profits and losses left to right) of a phantom specialty re/insurer. To illustrate the impact of the current market conditions, I then fattened the tail to account for the dilution of terms and conditions (effectively reducing risk adjusted premia further without having a visible impact on profits in a low loss environment). I also added risks outside of the 99.5%VaR/99%T-VaR regulatory levels whilst increasing the profit profile to reflect an increase in risk appetite to reflect pressures to maintain target profits. This resulted in a decrease in expected profit of approx. 20% and an increase in the 99.5%VaR and 99.5%T-VaR of 45% and 50% respectively. The impact on ROEs (being expected profit divided by capital at 99.5%VaR or T-VaR) shows that a headline 15% can quickly deteriorate to a 7-8% due to loosening of T&Cs and the addition of some tail risk.

click to enlargeTails of VaR

For what it is worth, T-VaR (despite its shortfalls) is my preferred metric over VaR given its relative superior measurement of tail risk and the 99.5%T-VaR is where I would prefer to analyse firms to take account of accumulating downside risks.

The above exercise reflects where I suspect the market is headed through 2015 and into 2016 (more risky profiles, lower operating ROEs). As Solvency II will come in from 2016, introducing the deeply flawed VaR metric at this stage in the market may prove to be inappropriate timing, especially if too much reliance is placed upon VaR models by investors and regulators. The “full detail of the real world” today and in the future is where the focus of such stakeholders should be, with much less emphasis on what the models, calibrated on what came before, say.

A visit to the dentist

Last week, Raghuram Rajan, the current governor of the Indian Central Bank and the author of the excellent book Fault Lines, warned about asset prices and macro-economic policies in the developed world. Rajan said that things may work out if “we can find a way to unwind everything steadily” but added “it is a big hope and prayer” and that the reality of history is one of sudden movements and volatility. Also this week, hedge fund manager David Einhorn said that his fund was having “difficult time finding new investments this quarter” and that “as the market continues to rise in the face of conflicting economic data, global unrest, and looming overdue Fed exit from quantitative easing we remain cautiously positioned”.

As regular readers will know, I am also wary about valuations in the current market which seem to be largely driven by the lack of return as a direct result of macro-economic policy (see Buttonwood post). I am comforted by the fact that, as a part-time investor, I am not bound by the pressures that professional money managers have in the beauty parade that is the relative annual performance competition. So that affords me and other part-time investors (our own family offices in a way!!) the luxury of watching developments from the sidelines. Trying to find the holy grail of an undervalued stock in today’s market is unrealistic and fanciful in my opinion, given the resources of a lone investor at one’s disposal. So I tend to let my attention drift to whatever comes my way with the intention of broadening my mind and maybe broadening my list of stocks to keep an eye on.

That brings me to my visit to the dentist last week. My visit was primarily to get a new crown on a neglected tooth. I had rescheduled the appointment a number of times and as a result had not really thought about the procedure beforehand. Compared to a similar procedure a number of years ago, the process was totally different. First off, my mouth was scanned by a camera and a 3D image of my teeth was produced. I was then asked to wait in the reception for 20 minutes and upon my return the ceramic crown was ready having been produced in a milling machine onsite. The crown fit perfectly and was easily fitted. My dentist conducted the procedure using a new one-day crown system produced by a German firm called Sirona Dental Systems. The system includes a computer that takes digital images of the damaged tooth, software to design the crown and a milling machine. There have been some concerns about the use of such crowns for front teeth due to colouring issues or the suitability of such crowns for people who grind their teeth heavily. Within my mouth, I have a live comparative test of a laboratory fabricated crown and a new one day procedure produced one. It will be interesting to see how the new crown gets on!

I had previously heard about new technology that could impact the dental sector. A specially designed camera, fitted to a smart phone, can scan your mouth and then send a 3D image to a central database whereupon a panel of dental experts could diagnose the issue and then submit the recommended procedure to a marketplace of dentists to provide a quote on a solution. Naturally, my dentist was skeptical on diagnosing problems with a smartphone scan! Given my first experience with a scan, I think such ideas may have potential to disrupt a protected professional sector. As a further illustration of how technology is impacting medicine, this article on a new app that can turn a smartphone into a highly portable and low cost eye scanner to diagnose eye health issues in remote areas is interesting.

So I had a look at Sirona, ticker SIRO, who coincidentally reported quarterly results last week. SIRO’s year end is September and, based upon an estimate for Q4, revenue has grown on average by 9% for the last 3 years with operating income by 15%. The stock price has doubled over that time. The graph below shows the share price since 2007 and the 12 month trailing PE ratio and the next 12 months (current quarter and estimated next 3 quarters) PE estimate.

click to enlargeSIRO Share Price & Earnings Multiples

SIRO’s revenue is split into 4 main segments: dental CAD/CAM systems (such as the one I experienced), imaging systems, treatments centers, and instruments. The first two segments are the larger making up approximately 35% of revenue each and are the higher growth and margin segments. Each are described below:

  • Dental CAD/CAM systems address the market for dental restorations, which includes several types of restorations, such as inlays, onlays, veneers, crowns, bridges, copings and bridge frameworks made from ceramic, metal or composite blocks. SIRO estimates it has an approx 15% market share in US and Germany.
  • Imaging systems comprise a broad range of systems for diagnostic imaging in the dental practice. SIRO has developed a comprehensive range of imaging systems for 2D or 3D, panoramic and intra-oral applications that allow the dentist to accommodate the patient in a more efficient manner.
  • Treatment centers comprise a broad range of products from basic dentist chairs to sophisticated chair-based units with integrated diagnostic, hygiene and ergonomic functionalities, as well as specialist centers used in preventative treatment and for training purposes.
  • SIRO offers a wide range of instruments, including handheld and power-operated handpieces for cavity preparation, endodontics, periodontology and prophylaxis, which are regularly updated and improved.

The graph below shows the historical segment & geographical revenue split and the historical operating margin.

click to enlargeSIRO Revenue Split & Op Margins

The growth in operating results is impressive, as is their balance sheet and cashflow. The issue is one of valuation with SIRO trading around 26 times this year’s earnings and about 20 times next year’s projected earnings. However, despite SIRO having some major competitors, they are growing their highest margin segments impressively and, in the vein of Peter Lynch’s philosophy of investing in what you know, I shall be putting SIRO on my watch list to keep an eye on them whilst I do some more research (the most obvious of which is seeing how my crown gets on!!) and wait for a better entry point.

Speaking of valuations, my dental experience did get me thinking about the much hyped 3D printing sector. The number of applications for 3D printing continues to grow from construction, to aerospace, to medical/dental, to fashion, to biotech, to a whole host of industrial design applications. Wohlers Associates project a CAGR of 30% for the sector over the next few years (I’d love to know on what basis these guys come up with their projections). I had a brief look over two of the most hyped firms in the sector – Stratasys Ltd (SSYS) and 3D Systems (DDD). Historical comparisons are difficult as both companies have been aggressive acquirers. SSYS has had more favourable results of late compared to DDD due to SSYS acquisition of MakerBot and to DDD’s recent stumble due to heavy investments in growth. A quick snapshot of some metrics since 2011 are in the graphs below.

click to enlargeSSYS & DDD Share price revenues and earnings multiples

With SSYS and DDD trading at 36 and 40 times next year’s projected earnings respectively, these firms are not for the faint hearted. Hyper growth stories in new sectors are normally areas outside my comfort zone due to the inherent uncertainties. In this case my experience at the dentist may mean I will do some more digging in the future of this new technology, time permitting. For the sake of curiosity if nothing else.

More musings on the online gambling sector

A previous post on Paddy Power, William Hill and Ladbrokes showed how online sportsbook and gaming revenue are becoming an important part of the revenues of these firms. Another recent post on Betfair showed a similar import. This post will focus on the online gaming (which is a gentlier word used in the sector for what is more aptly described as online gambling) part of the equation.

As a recap, the graph below shows the online gaming revenues from Paddy Power, William Hill, Ladbrokes and Betfair (with PP converted to sterling at today’s rate) which make up 17%, 16%, 8% and 17% of their 2013 revenues respectively. Ladbrokes has approximately half the amount of its competitors. The considerable growth in William Hill’s online gaming (mainly casino) revenue after the creation of WH Online (WHO) in 2008 can clearly be seen. H2 Gambling Capital are forecasting an approximate 9% annual growth in online gaming gross win figures over the next few years

click to enlargeNet Gaming Revenue

None of the firms above split out their operating margins for the online gaming sectors. As casino is the dominant source of revenue for many of the firms, it is interesting to look at a diminutive online casino firm called 32Red, as per the graph below. Although 32Red is relatively small, the reduction in its margin to an average of 6% suggests that competition has pushed margins down in this business.

click to enlarge32Red Operating Metrics

Another two public firms that have a majority of their business in online gaming are 888 and BWIN. 888 is a well established player, particularly in the online casino market, with 40% of revenues in the UK and 40% in the rest of Europe in 2013, and it has been rebuilding its profit margins in recent years. 888’s operating metrics are summarized in the graph below.

click to enlarge888 Operating Metrics

BWIN, following its merger with PartyGaming in 2011, has a higher revenue base across Europe (excluding UK) making up approx 70% of 2013 revenues (25% from Germany) with only 10% from the UK. After some poor results and pressure from shareholders, BWIN is currently cutting its expense base by €30 million or approx 5.5% and is looked at ways it “can increase shareholder value”. BWIN’s operating metrics are summarized in the graph below.

click to enlargeBWIN Operating Metrics

The share performance of these firms has been distinctly mixed in recent years with little old 32Red blowing the others away, as per the graph below. BWIN has clearly underperformed and may likely be broken up. Analysts have speculated that a number of potential bidders, including William Hill and Paddy Power, are looking at various BWIN assets. Janus Capital Management has being building its stake in BWIN over recent months to 11% as at mid-July.

click to enlargeShare price since 2011 888 BWIN 32Red

Comparing the mainly online gaming firms with their more established betting firms in terms of the PBT margin shows the trend for both is downwards, as per the graph below. Headwinds include increased regulation and taxes such as the proposed UK POC tax. Opportunities include the explosion in mobile gambling, the slow re-opening of the US market (although I am sure established US bricks and mortar gambling firms will fight hard for their turf), new product development such as social gaming and the expected market consolidation. Amaya’s recent purchase of PokerStars has focussed minds on what will be needed to succeed in the US.

click to enlarge2003 to 2013 PBT Margin Betting & Online Gaming Firms

One of the more colourful firms in the sector, Playtech, has some interesting things to say about where the future is leading. On increased regulation, Playtech say that “the regulation of online gambling can be a catalyst for market growth, depending on how regulation is introduced, what product verticals the regulator allows and the tax rate applied” and that ”opportunities exist as markets move from a ‘dot.com’ to a ‘dot.national’ regime, although some uncertainties through the transition period are expected”.

Specifically on the UK, Playtech commented that “many smaller operators are understood to generate operating margins lower than the expected tax rate of 15% and in the view of industry experts, will struggle to compete. Larger operators can rely on economies of scale and their leading brands to remain competitive. Analysts expect that in 2015 the UK market will undergo significant change led by consolidation, as those operators with the strongest brands, best technology and means to invest in marketing will prevail”.

Playtech is a software gaming firm which offers a fully integrated platform across games and sports-betting called IMS that many of the main players use (licensees include Betfair, bet365, William Hill, Paddy Power and Sky, amongst others). They also run a white label turn-key operation called PTTS and a joint venture business. Their most well known joint venture was one where they very successfully partnered with William Hill in 2008 in the creation of William Hill Online (WHO). William Hill recently bought out Playtech of their 29% stake for £424 million. In March 2013, Playtech entered into a deal with Ladbrokes (in an attempt by Ladbrokes to diversify their business and catch up with their competitors – see first paragraph of this post) where, according to Morgan Stanley, Playtech “has effectively been given a quasi-equity stake, where it will “own” 27.5% of any increase in profits”. A Morgan Stanley report, although over a year old, has more interesting background on Playtech (they are still hot on the stock). The graph below highlights some of the metrics behind Playtech.

click to enlargePlaytech Revenues and PBT Margin 2009 to 2013

Much of the colour behind the firm has been provided by its 40 year old Israeli playboy founder, Teddy Sagi, who has a bribery and insider trading conviction from his youth in the 1990s. Playtech bought many of the assets used in the WHO 2008 deal from Sagi and also the PTTS assets (70% of this business is from Imperial e-Club licensed in Antigua and Barbuda!) in 2011 which caused concerns about conflicts of interest. Concern over such conflicts on what Playtech may do with its new cash pile from the WHO sale (they returned £100 million in a special dividend earlier this year but still have £376 million in cash as at end Q1) and on potential problems that Sagi’s ownership position may do in gaining access to the US resulted in an offering in March this year which reduced his 49% stake to 34%.

Playtech has stated that their “the Board is seeking transformational M&A opportunities to take the business to the next level.” Although it’s a bit too colourful for me, a number of analysts estimate a 20%+ upside on its current share price and it’s interesting to note that David Einhorn’s Greenlight Capital is a believer with an ownership of 3.8%. That, I think, is a good place to end a post on gambling!

Slim pickings in the risk premia extraction game

One of my favourite investing quotes is one from Jim Leitner in Steve Drobny’s excellent book “The Invisible Hands” where he said “investing is the art and science of extracting risk premia from financial markets over time“. Well, there is not much over-priced risk premia to extract these days!

A recent piece on CNBC highlighted the convergence in some sovereign yields as a result of Central Bank intervention in markets. The graph below shows how the 10 year government yield from Spain has converged on that of the US.

click to enlarge10 year Government Yields

In fact, todays’ yields from Italy, Spain & Ireland are within 43, 38 & 15 basis points of the US! Does it make sense from a risk perspective that these countries are so closely priced compared to the US? Clearly not, market prices are being distorted by loose monetary policy across the developed world.

In today’s FT, Martin Wolf highlights the damage that low interest rates can do over the long term (it has been 5 years now after all). He finishes the article with this paragraph:

“Low interest rates are certainly unpopular, particularly with cautious rentiers. But cautious rentiers no longer serve a useful economic purpose. What is needed instead are genuinely risk-taking investors. In their absence, governments need to use their balance sheets to build productive assets. There is little sign that they will. If so, central banks will be driven towards cheap money. Get used to it: this will endure.”

Examples of low risk premia are everywhere. From corporate spreads (as per the graph below), to the influx of capital into insurance linked securities (ILS), to inflated valuations in the stock market.

click to enlargeFRED graph high yield vrs corporate AAA

A recent Bloomberg article cites two market strategists – Chris Verrone of Strategas Research Partners and Carter Worth of Stern Agee – who recommend the purchase of insurance to protect against a stock market pullback. The article states the following:

“While we are not ready to sell stocks across-the-board — there’s still plenty of global support from central banks — we think insuring against a potential pullback makes sense. So we are buying an at-the-money put on the S&P 500 Index with a 30-day maturity. Specifically, we’re looking at the 187 strike put which expires June 6, 2014. It costs $2.54, which equates to 1.4 percent. This is a premium we’re happy to pay in order to sleep more soundly.”

As regular readers will know, I believe a cautious approach is justified in today’s market and, where risk positions have to be maintained, protection using instruments such as options should be sought (if possible). If investing is all about extracting risk premia over time and risk premia is currently mispriced across multiple markets, then the obvious thing to do is simply to go and do something else until those markets correct.

The difficulty is that central bank strategies, as Martin Wolf highlights, are centred on keeping risk premia artificially low over the medium term to stimulate growth through consumption. It is also worrying that when David Einhorn, the hedge fund manager, got to discuss longer term monetary strategy with Ben Bernanke at a dinner in March he concluded that “it was sort of frightening because the answers were not better than I thought they would be”.