How to Invest in the World's Best Hedge Funds Without Paying Any Fees

How to Invest in the World's Best Hedge Funds Without Paying Any Fees
By Porter Stansberry, founder, Stansberry Research

Inside today's Digest... an overview of one of the few true investment secrets.

Most people don't know that they don't have to settle for poorly run mutual funds or "buy everything" exchange-traded funds. There are a handful of nearly secret investment funds that trade on the public market, have excellent track records, and treat their shareholders with great care and respect. Best of all, outside of paying a one-time brokerage fee, it costs nothing to own these funds.

I am going to detail the funds you can join and the secret "backdoor" way you can buy them below. The summary is pretty simple: You can invest alongside the best and brightest investors in the world... You can gain substantial tax advantages (in some cases) by doing so... And executing these trades is no more difficult (or more expensive) than simply buying a stock...

Let's start here. Do you have any of your assets being managed by David Einhorn? What about Dan Loeb? Maybe you have cash with Prem Watsa or Carl Icahn. What about Sardar Biglari? He's one of the most talented young activist investors in the world. Do you think having at least some of your long-term savings with these guys would be a good idea?

I would argue that even if you're a professional investor and working on your portfolio full-time, it's unlikely that you're going to produce long-term results on par with these guys. They're the best in the world and they have the best analysts working for them, guys in their 20s and 30s who are blindingly smart and working 80 hours a week.

There are three reasons why more investors don't invest with these guys.

First, obviously, most people don't know how. They think they have to have millions to get into their hedge funds. They don't know that many of the most successful investors in the world offer their portfolios to public market investors.

The next problem is harder to solve: these holding companies typically have complex structures that make them very difficult to analyze and understand. I'll do what I can to show you how to make sense of them, but if you're going to invest in these firms, you really have to read their annual and quarterly reports. You should really go to the annual meetings, too. There's no substitute for looking these guys in the eye and hearing about their plans.

Finally... you have to be prepared for significant volatility. These are essentially leveraged financial firms. That means when a cold wind blows in the financial sector, these stocks are going to get "blown around." I have suggested some ways to help you deal with this problem in the past. But remember that Warren Buffett's Berkshire Hathaway saw its share price drop 50% twice during Buffett's tenure (in 1974 and 2000). Trust me when I tell you that the intrinsic value of Berkshire Hathaway didn't change much at all.

With these companies, you have to really understand what you own and what it's worth. The public-equity markets do a terrible job of pricing this kind of company.

Let's start with the most famous – Carl Icahn. There's a public vehicle that owns essentially all of Icahn's investment assets – Icahn Enterprises (IEP). The company owns his direct investments, including eight casinos and other interests in railcars, steel, packaging, and real estate.

Roughly half of the company's assets are invested in Icahn's hedge funds, which include offshore funds that don't have to pay capital-gains taxes in the U.S. He personally owns 87% of the stock, which has a market capitalization of $7 billion and holds around $8 billion in net debt. From 2004 to 2014, Icahn grew the book value of this business at an annualized rate of 18%.

Currently, the stock trades at a significant 180%-plus premium to book value.

The next most famous member of this group is probably David Einhorn. He's the founder of Greenlight Capital, a hedge fund that's value-oriented and also shorts stocks to hedge its exposure to the stock market – the same strategy I follow in my Investment Advisory.

Einhorn launched his hedge fund in 1996 with less than $1 million... and now manages around $10 billion. He launched a "captured" reinsurance company in 2004. Public-market investors can now buy shares of Greenlight Capital Re (GLRE), Einhorn's Cayman Islands-based reinsurance company. The insurance company underwrites profitably and invests 80% of its float back into Einhorn's hedge fund. Since its inception in 1996 through 2014, Greenlight returned almost 20% a year to investors. This reinsurance operation has seen its book value grow 12% a year. It currently trades at a 10% discount to book value.

Activist investor Daniel Loeb has a similar reinsurance firm set up in Bermuda. It's called Third Point Reinsurance (TPRE). From its inception in 1995 through 2014, Loeb's Master Fund returned more than 20% a year to its investors, making Loeb one of the greatest investors of this era.

His insurance company will underwrite profitably (although it hasn't yet) and invest its float in Loeb's funds, which are hedged with short positions... again, like in my newsletter. There's a very short operating history here, as the reinsurance company only went public in New York last year. But so far, Loeb has grown its book value 35% annually. Currently, Third Point Re trades right around book value.

These first three investors are well-established and have proven their "chops" in a wide variety of markets and investments. The next investor I'd like to introduce you to hasn't done that... yet. I believe he's on his way to becoming a financial titan, and it may well pay huge dividends to hop on the boat before he's as big as an Einhorn or a Loeb. His name is Sardar Biglari. His company is Biglari Holdings (BH).

Like Buffett, Biglari holds an annual meeting worth attending every year that features a tough Q&A session that lasts for hours. He, like Buffett, also writes annual letters that are brilliant. But unlike Buffett, he's known for being arrogant and doesn't suffer fools gladly... at all. Naturally, I like him.

Whatever you think of his personality, his track record is among the best in the world. He used a private investment fund to take over and turn around fast-food chain Steak & Shake, a move that required tremendous financial risk-taking and true operational excellence.

Biglari is one of the few executives who can operate at a high level both on the financial side and on the business side – something that Sears Holdings CEO Eddie Lampert, for example, has failed to do so far. Biglari began to funnel Steak & Shake cash flows into activist campaigns (against fellow restaurant Cracker Barrel) and, more recently, he bought his first insurance company (First Guard Insurance).

Out of all the young guys in finance these days, Biglari is the most fascinating... and I believe he will become the most successful. The company is still very small – its market cap is less than $1 billion. It holds very little net debt. From 2004 to 2014, Biglari grew the firm's book value nearly 12% annually. I believe, as his insurance operations ramp up, this figure will grow substantially, pushing annualized results up to 16%-18% annually. Currently, Biglari Holdings trades at a 75% premium to book value.

The last "secret" fund I'd like to show you isn't a secret at all. It's a well-known insurance company – Fairfax Financial (FFH.TO) – headquartered in Toronto. What makes Fairfax unusual is that, like Buffett's Berkshire Hathaway, the company invests most of its insurance float in value stocks. Its chief investment officer – Prem Watsa – is one of the world's leading value investors.

As an example of the contrarian ideas Watsa follows, he's among the largest holders of Blackberry stock – the totally out-of-favor cell-phone company...

From 2004 to 2014, Fairfax Financial grew its book value 10% annually. Currently, Fairfax Financial is trading at a 33% premium to book value.

What should you do with this information? I have a few suggestions. First, read whatever you can from these companies' public filings. Fairfax Financial, for example, has to report its positions in a 13F each quarter, giving you a free look at what one of the world's best value investors is buying. Right now, there's one stock that makes up 25% of his U.S. equity portfolio. Sure, I could tell you the name of the stock, but there's no such thing as teaching. There's only learning. Just Google "Fairfax Financial, 13F." Figure it out yourself. You'll learn something.

And obviously, I recommend buying shares of these firms. I believe there's a near certainty that they will grow their book value at a faster rate than you will grow your overall portfolio. Nothing is certain, of course... but the odds favor these investors in a massive way.

Here's a tip: From time to time, these shares trade for less than book value. That's because most investors don't understand insurance stocks, or because, in Biglari's case, most investors simply think he's going to fail in his efforts to turn around or take over new businesses.

I don't think you should buy these stocks today. Financial stocks and financial operators have had huge runs higher. What you should do is wait, read, meet, and learn. By that, I mean watch the stocks carefully. Read their quarterly and annual reports. Attend their annual meetings. (Buy one share so you can attend.)

Learn what makes these businesses work... and when you feel confident that you really understand what they do and why, begin to invest. Do your best to buy when other investors won't. And try to pay less than book value. You might also wait to see when these financial gurus – Einhorn, Loeb, Watsa, Biglari, etc. – begin to buy their shares. If you're patient, you'll get those opportunities.

Regards,

Porter Stansberry