Brighthouse Financial (BHF – NYSE) is a provider of life insurance and annuities.
Today Brighthouse shares are changing hands for under $40 – meanwhile as of the company’s last financial filing it had a book value of $128.40.
That means that Brighthouse Financial is trading for just 31 percent of book value.
Is that cheap? Yes it is!!
While low interest rates have hurt the ability of insurance companies to generate investment income most of these companies still trade near book value. To get to book value Brighthouse shares would need to triple.
At this point what you should be asking is how is it possible that a life insurance company could be this misvalued by the market?
For an answer to that I will turn to one of the best hedge fund managers of this generation who has made Brighthouse the second largest position in his concentrated portfolio.
According To David Einhorn – GAAP Accounting Has Confused The Market
David Einhorn founded Greenlight Capital 23 years ago in May 1996. Over that time Greenlight has returned 1,367% to investors – which is the investment performance after deducting the firm’s not insignificant incentive and management fees.
Over that same time period the S&P 500 is up just 331%, so Einhorn has soundly thrashed the market over the very long term.
Brighthouse Financial was Einhorn’s second largest position as of the end of March 2019 because he believes the insurer is indeed dirt cheap.
Einhorn’s opinion on why the market has misvalued this company is because of complicated GAAP (generally accepted accounting principles).
His view is that GAAP is hiding the true profitability of this company.
As an insurance company Brighthouse’s assets include a large investment portfolio while its liabilities include a large book of equity and interest linked variable annuities that the company is committed to paying to customers over time.
Brighthouse purchases derivative products (hedges) to reduce its exposure to equity market and interest rate swings.
It is the GAAP accounting for these hedges that is confusing investors.
Here is Einhorn’s explanation from his Q1 investor letter:
Under GAAP accounting, the hedges get marked to market each quarter, but the liabilities they hedge do not. This creates a mismatch between how Brighthouse’s assets and liabilities are treated in response to market moves.
All else being equal, BHF benefits from rising equity markets and higher interest rates, as the economic gain from lower expected claims more than offsets the company’s losses on its hedges.
However, the company’s GAAP accounting indicates the opposite; while the hedges generate mark-to-market losses, there is not a corresponding reduction in GAAP liabilities.
As a result, when markets rose in the first part of 2018, BHF’s GAAP results showed losses and book value declined. The company presents adjusted earnings that correct for the perverse accounting treatment, but we believe the GAAP losses dissuaded many investors from buying the shares last year.
Some analysts even pointed to BHF’s declining book value as evidence that the company would perpetually lose money.
BHF’s fourth-quarter results and earnings call should dispel this misunderstanding. In the fourth quarter of 2018, the dynamic reversed; equity markets and interest rates fell – a negative for the business but a positive for the hedges.
The result was that BHF reported a GAAP profit of more than $12 a share for the quarter.
Obviously, we don’t believe this reflects the company’s earnings power, but it undermines the bearish argument that the company is saddled with GAAP losses. If anything, the result suggests that adjusted profits are a better indicator of BHF’s performance.
On that basis, BHF earned $7.44 per share in 2018 and we expect it will earn about $9 per share in 2019.
Understanding Einhorn’s explanation of the GAAP accounting treatment is less important than understanding who is providing you with this accounting lesson.
Over the past two decades David Einhorn has become famous specifically for his ability to read GAAP accounting better than the market.
The highest profile instance of this was in 2008 Einhorn not only told the world but also shares his specific analysis of Lehman Brothers financial statements – accusing the company of being involved in dodgy accounting practices that covered up the firm’s massive liabilities on asset-backed securities.
Einhorn was of course 100 percent correct. Lehman subsequently announced massive losses and collapsed.
The chances of Einhorn not understanding Brighthouse’s accounting seem highly unlikely. This is a man who runs a very concentrated portfolio with every position undergoing extensive due diligence and has made a career of being ahead of the curve on reading financial statements.
If Brighthouse earns $9 per share as Einhorn expects in 2019 that means that the company is trading at barely 4 times earnings.
Which again would point to a lot of upside.
The Caveat – It Might Take A Long Time For The Market To Agree
If Einhorn is correct (and who am I to doubt him given his track record for outsmarting the market) there is one problem….
There is no obvious catalyst to change how the market values Brighthouse.
And to be fair – when you look at the quarterly earnings you can appreciate the confusion.
Here is how Brighthouse quarterly earnings per share has trended without adjusting for the GAAP hedging weirdness:
Q3 2017 – EPS of negative $7.87
Q4 2017 – EPS of positive $5.57
Q1 2018 – EPS of negative $0.56
Q2 2018 – EPS of negative $2.00
Q3 2018 – EPS of negative $2.26
Q4 2018 – EPS of positive $12.03
Q1 2019 – EPS of negative $6.31
These are the incredibly volatile headline earnings numbers that the market sees which make the company look completely unpredictable. You can see the windfall like profits that the company reported in Q4 2018 when the stock market tanked – just as misleading as the losses reported in the prior quarters.
Einhorn’s point is that these numbers are MEANINGLESS because GAAP marks to market only Brighthouse’s assets and not the annuity liabilities.
Adjusted for this hedging confusion earnings per share over this period has always been positive and ranged from $1.26 to $2.36. But the market doesn’t see those numbers and may not ever pay attention to them.
I’m sure Einhorn and other Brighthouse shareholders are frustrated by the discounted valuation but there is a big silver lining here.
Brighthouse intends to repurchase $1.5 billion of stock by the end of 2021, which would be more than one-third of its market capitalization.
With that much money being plowed into share repurchases, the lower Brighthouse’s share price stays down the better. You can create a lot of value for shareholders when you are buying back shares at one-third of book value.
Over the past quarter century David Einhorn has proven that he is smarter than the market. If he is reading the Brighthouse financial statements better than the market there could be an easy three-bagger right here.
Maybe the stock market won’t figure that out, but an acquirer of this business might.
Editor, Investing Whisperer