The Greenlight Capital funds (the “Partnerships”) returned (14.3)%,1 net of fees and expenses, in the third quarter of 2015, bringing the year-to-date net return to (17.1)%. During the third quarter, the S&P 500 index returned (8.2)%, bringing the index’s year-to-date return to (5.3)%.
Given our results this quarter, this is a good time to discuss our process. First, we are value investors. This means that we buy what we believe are misunderstood companies at low valuations relative to their underlying assets and future cash flows. This involves spending many hours analyzing a company’s reported financial statements, then making adjustments to them based on our perception of the economics of the business.
Sometimes we determine that a listed or perceived asset is actually a liability; other times we find value that gets missed because the company has done a poor job explaining itself. We find that the more misunderstood a company is, the greater the likelihood of a dislocation between value and price, and the more we tend to like it.
Second, we run a concentrated portfolio. Our philosophy is to invest the most capital in ideas where we have the most conviction. The core of our process for both finding stocks and sizing our investments has not changed and has historically served us well.
[drizzle]Unfortunately, a good process does not prevent mistakes, nor does it guarantee good outcomes, especially on a short-term basis. Because we look for investments that have a healthy margin for error, a misjudgment of analysis is rarely a disaster. We don’t need much to go right in order to make money, and in many cases we can get a lot wrong and still break even. When we are very wrong, however, we are going to lose money. And although large losses don’t occur often, in a punitive environment we can have more than one in a short period of time.
With any large loss, we reassess the position to evaluate whether our thesis is busted or the losses are overblown. Depending on what we determine, we either add, hold, trim or exit. Sometimes, patience is in order and sometimes it’s not. Just as the summer began, we ran into significant problems in rapid succession in three of our largest positions. One has played itself out; the other two are still in their middle innings.
CONSOL Energy (CNX), SunEdison (SUNE) and Micron (MU) all performed abysmally this quarter. In the case of CNX and SUNE, the complicated financials that make these companies misunderstood are contributing to their declines. In both instances, a superficial financial analysis does not inspire confidence. It takes time, diligence, and possibly even some directed guidance for new investors to get up to speed. Lacking a strong incentive to dig through the numbers, some investors simply see a falling knife and look no further. This is what we see from here forward.
CNX is an Appalachia-based coal and natural gas production company. From its most recent high of $33.34 on May 8, the shares traded down gradually to $9.80, where they ended the quarter. There was no single moment where the shares fell sharply; it was essentially an orderly collapse. Yes, coal and natural gas prices both fell modestly during the decline. Yes, the company’s effort to bring its coal assets public in a separate vehicle was greeted coolly by the market. Yes, there is an oversupply of natural gas in the region, which has caused local realizations and quarterly earnings to fall below plan. We could have mitigated a portion of our loss by hedging natural gas, but with the price already near a historical low, we made the incorrect decision not to hedge the commodity risk.
However, CNX has had plenty of overlooked good news. The company went through a significant cost-cutting effort and cut its capital spending budget aggressively. In July it reported fantastic drilling results and a significant success at a test well in the Utica Shale. Ordinarily, the market responds favorably to positive drilling news. In the current environment, it has responded more like a child receiving socks as a birthday present, “Gee, just what I always wanted … more, cheap natural gas.” We believe the market has undue concern about the near-term prospects for Appalachian coal and natural gas, leading it to discount the company’s long-term resource value far beyond anything we anticipated.
CNX’s financials do not lend themselves to easy analysis. Right now, CNX is transitioning from one of the country’s biggest coal producers into a natural gas company. CNX’s financial statements combine both operations, which makes it challenging to properly analyze either of them. Gas analysts looking at CNX could see a low-cost, growing natural gas business with enormous resources combined with a worthless legacy coal business. Coal analysts aren’t looking at CNX – they’re looking for new jobs. Having dissected the financials, we see two businesses with significant upside.
Even at lower commodity prices, capital discipline, cost cutting and much more efficient drilling economics should enable CNX to be cash flow breakeven or better from here on out, which is a significant improvement from our original expectations of about $1 billion of cash burn through 2017. In 2016 we expect CNX to generate cash while growing its production and proved developed reserves. There are very few midsize energy companies achieving similar success. And yet, CNX trades as if it is at the cusp of financial distress. Of course, we wish we were entering the position now rather than at the higher prices we paid.
For the first part of the year SUNE was by far the fund’s biggest winner. The shares rallied from $19.51 to a peak of $32.13 on June 23 before collapsing to $7.18 by September 30. SUNE’s business is to develop solar and wind projects for major utilities and commercial customers that agree to buy the power over a very long term, often 20 years. These projects have purchase contracts from highly creditworthy counterparties and produce an average unlevered return on capital of 10% and 13% in developed and emerging markets, respectively. SUNE makes money by selling the projects at a premium to investors seeking safe, long-term income.
Given the low-rate environment, SUNE thought it could make even more money if it created its own related yield vehicles to buy the projects and dividend the income to shareholders. It created TerraForm Power (TERP) for its developed markets projects and TerraForm Global (GLBL) for its emerging markets projects. Initially this worked very well, and in July 2014, SUNE successfully brought TERP public. This July it brought GLBL public with much less success.
In the weeks before the GLBL initial public offering, SUNE was at its highs and we contemplated trimming the position. Since we expected the IPO would trigger a further advance in the shares, we decided against it. Around this same time, oil and gas prices renewed their declines, causing the values of energy master limited partnerships to justifiably fall. We believed that TERP and GLBL would not be impacted, as neither is subject to commodity risk. We were wrong. Because the SUNE yield vehicles were relatively new to investors, the market did not distinguish them from other energy dividend flow-through structures. In mid-July,