Smart Money Masters — December 2017 Issue

Nicholas Vardy

Nicholas Vardy has a unique background that has proven his knack for making money in different markets around the world.

Giving a Green Light to a Top Value Play

Your Smart Money Masters portfolio closed another positive month, with some familiar names generating the most significant gains.

The standout performer of the month was Prem Watsa, the “Canadian Warren Buffett” who is betting big on BlackBerry Ltd. (BB). The stock closed the month 26.03% higher.

Carl Icahn’s wager on PayPal Holdings Inc. (PYPL) gained 14.08% to give the portfolio a second double-digit-percentage gain since the last issue. Dan Loeb’s Baxter International (BAX) ended the month 3.64% higher, while Bill Ackman’s Restaurant Brands International (QSR) jumped another 2.53%.

PayPal remains your Smart Money Masters portfolio’s top performer, up 82.38% since my initial recommendation. Fiat Chrysler (FCAU) is up 56.20% just in the last three months. Restaurant Brands International Inc. has gained a solid 28.35% so far since I recommended it.

When I recommended Restaurant Brands International, I called it Bill Ackman’s top investment. That’s because Ackman has a massive 40.1% of his fund Pershing Square Capital Management invested in the company’s stock.

Here’s what I have found out since. While private equity firm 3G Capital is the largest shareholder, owning 42.5% of the shares, the secondlargest shareholder, holding 11.6% of QSR, is National Indemnity. National Indemnity itself is a subsidiary of Warren Buffett’s Berkshire Hathaway (BRK-B). Once you look through the ownership structure, together, 3G and Berkshire own about 54% of QSR. That means that 3G and Berkshire control the entire company. Warren Buffett’s hand is everywhere.

hares of Priceline Group Inc. (PCLN) dropped sharply by 13.52% to $1,645 on Nov. 7 after it released a third-quarter earnings report that raised questions about its growth prospects. It now is near its stop price of $1,610. I’ll be keeping a close eye on the stock in the days ahead.

A Big New Bet on the Automobile Sector

This month’s Smart Money Masters recommendation — General Motors Company (GM) — is a contrarian bet on the unloved the U.S. automobile sector. GM is also the largest position in value investor David Einhorn’s fund, Greenlight Capital.

Einhorn began investing in GM back in Q1 of 2015, gradually growing his stake since. According to its most recent 13F filings with the Securities and Exchange Commission, Greenlight Capital has invested a whopping 30.86% of its assets in this American icon. Today, Greenlight is one of GM’s most significant shareholders, as it owns 3.7% of the auto maker’s outstanding shares. It is a position that has done well this year, rising 20.46%.

David Einhorn’s Investment Philosophy

Like many of the Smart Money Masters, David Einhorn is a value investor.

Value investors look for stocks selling at low price-earnings ratios, low book value and high free cash flow. If the market price is below what they determine to be the stock’s intrinsic value, then they have a candidate to buy. Buying cheap shares is the key to consistent absolute investment returns independent of market conditions.

While Einhorn identifies himself as a value investor, he says he takes a very different approach from most. After all, anyone can identify cheap stocks. Einhorn starts by asking why a security might be mispriced. And his ability to answer this question is what Einhorn believes is his edge. He never invests in a stock unless he feels that he has identified something about the company the rest of the world has not. He calls this ability his “analytical edge.”

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Einhorn also identifies himself as an absolute return investor. His goal is to make money regardless of market conditions. In the worst case, his goal is at least to preserve capital. This approach follows Warren Buffett’s two rules of investing:

Rule No. 1: Never lose money.

Rule No. 2: Never forget rule No.1.

Unlike other value investors we have profiled in Smart Money Masters, Einhorn adds a dimension. Einhorn actively bets against — or “goes short” — companies he believes to be overvalued. Einhorn does not short to hedge — that is, to lower the portfolio’s overall volatility. Instead, he does it to make money.

Here, too, he does not short a stock based purely on valuation. Rather, he focuses on an “analytical edge” such as when a company is engaging in fraud. His two most famous short bets were betting against Lehman Brothers in 2007, and Allied Capital in 2002.

Einhorn is an activist investor. He takes positions in companies and then pushes the management to implement changes to aid the stock price. Einhorn often takes these battles public, making his case in the financial media. He has pursued this strategy, thus far, unsuccessfully with GM.

Einhorn has a specific “portfolio construction” strategy. He prefers a concentrated portfolio consisting of at least 20% in a single holding. The next top five holdings then make up 30- 60% of the portfolio. The short positions he takes are usually half the size of the longs.

As a value investor, Einhorn has been frustrated by the stock market since it bottomed in March 2009. After all, “value” investing has underperformed “growth” in recent years. This underperformance of value strategies has weighed on Greenlight’s investment returns heavily.

In late October 2017, Einhorn sent out an investor letter that lamented the apparent end of value investing as a winning strategy. As Einhorn put it, “Given the performance of certain stocks, we wonder if the market has adopted an alternative paradigm for calculating equity value.”

Einhorn was, of course, being ironic. His view is that with so many bubble stocks in the market, such as Tesla (TSLA), Netflix (NFLX) and Amazon (AMZN), today is an excellent time to be a value investor.

A World-Class Value Investor… and Poker Player

D avid M. Einhorn, born to a Jewish family in New Jersey, graduated from Cornell in 1991. After graduation, he was unsure of his prospects, even interviewing for a job with the CIA. Einhorn took a job as an analyst at investment bank Donaldson, Lufkin & Jenrette (DLJ). Einhorn hated the job. He hated, even more, the 100-plus hour work weeks.

Two years later, Einhorn joined a small hedge fund, the SC Fundamental Value Fund. There he learned “(to) understand the nature of the business, the economics of the business compared to reported earnings, and whether the managements’ decisions aligned with shareholder interests.”

Einhorn started Greenlight Capital in 1996 with $900,000. Half of the money came from his parents. Greenlight had a storied first decade, generating close to 30% annual returns. That performance ebbed in recent years, and Greenlight’s long-term annualized return for investors from 1996 to 2016 has fallen to 16.5%. Today, Greenlight Capital manages over $9 billion in assets.

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Einhorn quickly developed a reputation as a short seller. In May 2002, Einhorn gave a speech at the Sohn Investment Research Conference where he recommended shorting Allied Capital. The day after the speech, the company’s stock collapsed by 20%. Allied sued Einhorn, and the Securities and Exchange Commission (SEC) investigated the claims. Einhorn eventually was cleared of any wrongdoing. Einhorn published a book, Fooling Some of the People All of the Time about his six-year fight.

Einhorn’s most famous short bet was against Lehman Brothers, a stock he shorted into bankruptcy.

Einhorn is also a well-known poker player. In 2006, he finished 18th in the World Series of Poker. Einhorn is a minority shareholder in the New York Mets baseball team. According to Forbes, Einhorn has a net worth of $1.54 billion. That makes him the 44th youngest billionaire on the Forbes 400 and the world’s 18th highest-earning hedge fund manager.

Greenlight’s Activist Campaign to Unlock Value in GM

Greenlight has had a position in GM since the start of 2015. But it was only in Q4 of 2016 — about a year ago — that he began to increase his position in the company substantially. On January 27, 2017, Einhorn wrote about his view of General Motors in his quarterly letter to clients:

“GM’s valuation is extreme: at its year-end price of $34.84 per share, GM trades at less than 6x earnings. It is rare for a company to pay out only a quarter of its profits in dividends and still yield 4.4%. GM has substantial foreign operations that (other than China) barely contribute to profits and could improve over time. Finally, we believe that GM can unlock substantial value through modest changes to its capital structure.”

Soon after he wrote this, Einhorn began an activist campaign to unlock the value in GM’s shares. His fundamental argument was that GM’s management could be doing much more with its $20.4 billion cash hoard. And if it could not, it should return that cash to investors in some form.

In the spring of 2017, Einhorn began to push aggressively for his proposal for GM to issue a dual class of common stock: a dividend stock and a capital-appreciation stock. Einhorn calculated that the value of those shares would be between $42 and $60 per share. The dividend stock also would give GM a vehicle to return some of its massive cash hoard to investors, including, of course, Greenlight Capital.

GM dismissed Einhorn’s proposal as “a high-risk experiment in financial engineering that is not in the best interests of GM shareholders, would result in a downgrade of GM’s credit rating and would not increase value for shareholders.”

GM’s board also recommended against the move. Ultimately, GM shareholders voted to reject the proposal in a vote in June. Despite the failure of this campaign, Einhorn has maintained his massive holding in GM and has reaffirmed his commitment to the investment publicly on several occasions.

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Betting on GM as Part of ‘Pairs Trade’

When Einhorn bets big on a stock, he usually balances it with a bet against a stock that he expects to fall. This strategy is often called a “pairs trade.” In this case, Einhorn’s long position in GM is balanced by betting against — or going short — wonder boy Elon Musk’s electrical vehicle company, Tesla (TSLA).

Both of these trades have been frustrating for Einhorn.

On the one hand, despite its record earnings and massive cash hoard, GM’s stock has massively underperformed the broader U.S. stock market. GM stock has risen a mere 23.80% compared with 119.21% for the S&P 500 since the company’s 2010 initial public offering (IPO) at $35.00.

On the other hand, Tesla, which already has burned through about half the cash it raised in the first quarter, is up more than 42% this year. As Tesla has soared ahead of the long-awaited Model 3 launch, its market capitalization passed GM’s in April.

Einhorn called Tesla’s shares a bubble waiting to burst. He even castigated Tesla’s ever-bullish shareholders, whom he calls “hypnotized” by Chief Executive Elon Musk.

As Einhorn put it:

“The enthusiasm for Tesla and other bubblebasket stocks is reminiscent of the March 2000 dot-com bubble… As was the case then, the bulls rejected conventional valuation methods for a handful of stocks that seemingly could only go up. While we don’t know exactly when the bubble will pop, it eventually will.”

Einhorn also pointed out in this month’s interview (see page 4) that Tesla manufactures about 100,000 cars compared to GM’s 9 million. GM also manufactures about half as many electric vehicles as Tesla does. The number of electric cars manufactured and sold by GM is only likely to grow in the coming years.

Einhorn’s view about the relative positions of GM and Tesla already may be coming to fruition. After the recent correction in Tesla’s stock price, GM today is now worth about $10 billion more than its upstart rival.

The Bottom Line on Investing in GM

GM is a traditional value play. It operates in a sector that is out of favor. It remains an inexpensive stock with a high yield. Although the stock has risen by over 20% since Einhorn first increased his investment in GM in Q1 of 2017, the stock today still trades at a lowly 7.7 times earnings and yields an impressive 3.41%.

As one of the world’s leading value investors, Einhorn has seen stories like GM versus Tesla play out profitably many times before. Einhorn’s willingness to bet over 30% of his fund on GM is reason enough to track his bet. The overall direction of GM to a value investor like Einhorn is clear. And as the market recognizes GM’s strengths, Einhorn believes the company’s stock will rise even more.

So, buy General Motors (GM) at market today and place your stop at a wide $32.00. I have given this recommendation a risk rating of 3.

Note: As Smart Money Masters does not recommend short positions, I am not formally recommending that you short Tesla’s stock.


Nicholas Vardy

Nicholas A. Vardy


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