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David Einhorn Owns $179 Million Of This Small-Cap Stock

Chad Tracy

David Einhorn is not your average investor.

The billionaire founder and president of Greenlight Capital has managed to earn an average of 20% per year for investors since he started the hedge fund in 1996.

Twenty percent -- that's Warren Buffett territory.

A high annual rate of return isn't the only thing he has in common with the Oracle of Omaha. The two also share a fondness for one type of business in particular -- insurance.

In 2004, Einhorn founded the company Greenlight Capital Re (GLRE) and set up shop in the Cayman Islands. Greenlight Re is a reinsurance company, which means it primarily sells insurance policies to insurance companies. Almost all insurance companies have a reinsurance program to mitigate risk.

One of the big reasons investors like Buffett and Einhorn love the insurance business is the access it gives them to huge chunks of other people's money, which they can borrow without interest and use to invest. In the insurance industry, this money is called the float.

Considering Einhorn's success in the reinsurance field, it wasn't a big surprise to discover that he also owns an enormous stake in a similar company.

Most investors may have never heard of Aspen Insurance Holdings (AHL), but this $2.4 billion market cap company is one of Einhorn's favorite small-cap stocks.

Greenlight Capital is currently Aspen's largest institutional shareholder, with a stake of nearly 5 million shares. This represents more than 7% of the total shares outstanding, and a total investment of $179 million at today's prices.

His most recent purchase of the stock came in the fourth quarter of 2012, when he increased his stake by 875,182 shares.

As usual, his timing was spot-on. Since bottoming out in the middle of November at just below $30 a share, the stock has shot up more than 22%, hitting record highs of $39 before settling back down to the $36 range.

So, after this big run-up, is the stock still a buy?

Let's begin by looking at one of the most important ratios used to value an insurance company: the combined ratio, which measures underwriting profitability. Despite what many people may believe, most insurance companies don't earn a profit from underwriting. In other words, they are forced to pay out more in claims than they collect in premiums.

Buffett noted this in his letter to Berkshire Hathaway shareholders last year:

"In most years, the insurance industry as a whole operates at a significant underwriting loss. For example, State Farm, by far the country's largest insurer and a well-managed company besides, has incurred an underwriting loss in eight of the last 11 years. "

If we can find an insurance company with a combined ratio below 100, it means we have found a company that makes money on underwriting, instead of losing money. Insurance companies that are consistently able to report combined ratios below 100 are the cream of the crop.

Aspen Insurance fits the bill. In the first quarter, the company reported a combined ratio of 90%. While the company doesn't always reach this goal -- in last year's fourth quarter, for instance, the combined ratio was 108% -- it succeeds more often than not, and far more often than the majority of its peers.

There are two other areas in particular where Aspen excels in comparison with its competition.

Aspen boasts an operating margin of 16%, compared with an industry average of just 1% over the past 12 months. Operating margin is a good measure of profitability because it indicates how much of each dollar in revenue is left over after both costs of goods sold and operating expenses are considered.

The company's return on equity (ROE) ratio is 9 times higher than the industry average. ROE is a good measure of efficiency because it measures a company's ability to generate a profit without needing as much capital.

Aspen pays a small but stable dividend of nearly 2%, and so far the company is making good on a recent promise to aggressively buy back shares. As CEO Christopher O'Kane noted during the company's most recent conference call, Aspen has repurchased $230 million worth of shares so far this year and expects to buy back another $300 million worth of shares by year's end.

Amy Calistri, a StreetAuthority expert and author of the popular Stock of the Month and The Daily Paycheck newsletters, has been a close observer of Einhorn's investing strategy over the years. In her October issue of Stock of the Month, she explained why:

"Much like I do here in Stock of the Month, Einhorn employs a simple strategy. He's not a day trader: He tries to hold both his long and short positions for as long as they are fundamentally sound. Like me, he prefers to spend most of his time researching the very best opportunities. He doesn't hold a lot of positions -- just the best short and long positions he can find."

True to form, Einhorn has maintained a position in Aspen Insurance for years. Considering the company's excellent track record and recent focus on shareholder-friendly policies, investors looking to add exposure to the financial sector might be wise to do the same.

Risks to Consider: Insurance companies can be subject to huge deficits from claims that arise out of unforeseen events. For example, after purchasing General Re for $22 billion in 1998, Buffett's Berkshire Hathaway experienced dramatic losses after the events of Sept. 11, 2001. The company's total underwriting loss for that year was $4.3 billion.

Action to Take--> With a price-to-earnings ratio of 9 and a price-to-book ratio of 0.7, Aspen appears to be fairly priced relative to its industry peers. Investors in search of a bargain may want to be patient. Share prices have experienced what I think is a short-term correction after hitting record highs in May. The 200-day moving average for the stock is $34 per share. Should share prices dip below $34, I recommend jumping in with both feet and treating the stock as a long-term holding.

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