Greenlight Capital commentary for the third quarter ended September 30, 2022. See the full letter here.
Dear Partner:
The Greenlight Capital funds (the “Partnerships”) returned 4.0%1 in the third quarter of 2022, net of fees and expenses, and 17.7% for the first nine months of 2022, net of fees and expenses, compared to a 4.9% decline and a 23.9% decline for the S&P 500 index for the quarter and first nine months, respectively.
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It is now clear that we are in a bear market. Our pivot in January from ‘cautious’ to ‘bearish’ has helped the Partnerships. While for many years, and since inception, the Partnerships have outperformed the S&P 500, over the last decade we have significantly underperformed.
Due to this year’s result, we have recovered the underperformance that occurred since the end of 2018. To fully catch up, there is a bunch more to go.
This quarter our returns came primarily from the long portfolio, which contributed 5.9% to the net return. Shorts added 0.1% to the net return, while macro detracted 2.0% from the net return.
The significant winners were Atlas Air Worldwide (NASDAQ:AAWW), CONSOL Energy (NYSE:CEIX), Eurodollar derivatives (short), Green Brick Partners (NYSE:GRBK), a housing hedge for Green Brick Partners (GRBK hedge) and Twitter (NYSE:TWTR). The significant losers were gold and two undisclosed shorts.
In August, AAWW announced it would be sold to a private equity consortium for $102.50 per share. Even though this price represents a very low multiple, and is likely to be an extremely attractive deal for the buyers, we happily exited our position after the announcement.
Over a 2+ year holding period, we achieved an IRR of almost 80% on this investment. As we have written many times, it has been a difficult environment for value stocks. However, there is an old saying that “good things happen to cheap stocks” and that certainly happened here.
We doubt this will be the last time private equity sees better value in our portfolio companies than other public markets investors do.
GRBK shares advanced from $19.57 to $21.38. The company announced second quarter earnings of $2.08 per share, which blew away consensus estimates of $1.24 per share. Also, GRBK was added to the S&P SmallCap 600 index during the quarter.
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We believe that the share price gain was dampened by a substantial slowdown in housing demand, which is now widely evident. Mortgage rates have exploded higher and have created affordability issues.
To mitigate our exposure, we hedged almost half of our position with a basket of housing-sensitive equities. The hedge was also a material positive contributor to our performance in the quarter. GRBK shares have outperformed peers, as we believe the market is correctly assessing its superior competitive position.
CEIX shares rose from $49.38 to $64.32. As we wrote last quarter, we expect the company to generate approximately $50 per share in after-tax free cash flow by the end of 2023. The company paid its first dividend of $1 per share in August and also announced a policy of distributing at least 35% of its free cash flow to its shareholders.
We have been short Eurodollar futures in the macro book since January. Selling Eurodollar futures essentially means predicting that the Fed would raise interest rates more than expected. Rate hikes have occurred and expectations for additional hikes have risen, as inflation (and the Fed’s intent in fighting it) has increased in recent months.
At this point, we believe that current market expectations roughly match our own. As a result, we have all but exited this investment.
We wrote about TWTR in our last letter even though we purchased it in the third quarter. It appreciated to $43.84 per share at quarter end. This still represents a sizable discount to the stated deal price of $54.20.
Gold fell from $1,807 to $1,661 an ounce. Sometimes in a bear market, investors simply want cash. Further, high short-term interest rates provide competition for gold. Nonetheless, we remain concerned that the current inflation problem could evolve into a currency and/or sovereign debt crisis.
Accordingly, we maintain our gold position, despite the possibility for continued near-term weakness.
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In a correction, “buy-the-dip” gets promptly rewarded. In a bear market, not so much. We haven’t had a bear market since 2008-2009. Our strategy is to remain positioned bearish and to gradually stockpile dry powder, enabling us to make new investments as opportunities present themselves.
It isn’t entirely clear whether we are, or are not, in a recession. The first two quarters of 2022 had negative GDP growth, which usually marks a recession. Even so, the politicians are debating the definition of a recession, which isn’t surprising, as we appear to be in a postfactual world. Strange times.
Whether we are in a recession or not, it’s clear that the Fed wants to deflate the stock market. After Chair Powell’s speech in Jackson Hole, one Fed governor said he “was actually happy” with the stock market’s negative reaction. Again, strange times.
It seems the Fed believes that inflation is caused by a difference between supply and demand. If this were the case, there would be two possible approaches: try to increase supply or to try to decrease demand. To increase supply, we would need productive investment. This would add to wealth and improve living standards.
To decrease demand, we would reduce income and wealth, thereby lowering living standards. Our policy makers, who have delegated inflation fighting to the Fed,3 have chosen the latter. There is no discussion about how to increase supply.
In fact, higher interest rates reduce investment, and therefore, supply. The most glaring area might be in housing, where higher rates lead to reduced supply despite widespread shortage. All told, this policy might make inflation worse rather than better.
As we wrote a decade ago in our Jelly Donut monetary policy thesis, the relationship between interest rates and the economy is non-linear; the Fed does not appear to understand this. Again, very strange times.
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Of course, we believe that inflation is only partly caused by a difference between supply and demand. It’s also caused by the creation of money. We just went through a period where we had aggressive fiscal policy financed by newly created money. Unfortunately, fiscal reform is not on the table at this point.
Portfolio Changes
To that end, we have reduced our gross long exposure substantially this year. Further, our investment in TWTR is inherently short-term. As such, we expect to have additional dry powder after exiting that investment upon resolution (and we hope completion) of its sale.
In addition to AAWW, we also exited Change Healthcare (BMV:CHNG), Chemours (NYSE:CC), International Seaways (NYSE:INSW), the Playboy Group (NASDAQ:PLBY) and Warner Brothers Discovery (NASDAQ:WBD).
CHNG completed its sale to UnitedHealthcare. We made a 40% IRR over a 32-month holding period.
We exited CC due to our concern about the deteriorating economic cycle. While the company could release substantial value by separating its commodity-driven titanium dioxide business from its rapidly growing ESG-friendly refrigerant business, we do not believe that management is currently interested in pursuing a separation. As such, we exited our 3-year investment with a mid-single digit IRR.
Shortly after we purchased International Seaways Inc (NYSE:INSW), a strategic investor bought a large stake in the company. We became concerned about possible falling oil prices and exited with an almost 40% gain over half a year.
Finally, we sold unsuccessful investments in Plby Group Inc (NASDAQ:PLBY) and Warner Bros Discovery Inc (NASDAQ:WBD). We thought both companies were going through substantial corporate transformations. PLBY failed to execute on its strategy and we exited with a 50% loss on our investment.
We sold WBD as it faces a more challenging path to executing its integration plan than we expected. It also has a sizable amount of debt. We are trying to avoid levered equities in the current economic environment. We lost approximately 40% on WBD in half a year. Both positions were small.
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Best Regards,
Greenlight Capital, Inc.
Read the full letter here.
