Category Archives: Investment-Gurus

AerCap Holdings NV (ISIN NL0000687663) – How good is Einhorn’s new favourite ?

A friend forwarded me the latest presentation from “guru” David Einhorn where his main long pick was AerCap, an Airplane leasing company.

To shortly summarize the “Long case”:

– AerCap is cheap (P/E 9)
– they made a great deal taking over IFLC, the airplane leasing division of AIG which is several times AerCap’s original size
– they have great management which is incentivized along shareholders
– The business is a simple and secure “spread business”
– major risks are according to Einhorn mostly the credit risk of the airlines and residual value risk of the planes

There are also quite obvious reasons why Aercap is cheap and trades at lower multiples than its peers:

– share overhang: AIG accepted new AerCap shares as part of the purchase price and owns 45,6%. They want to sell and the lock up is expiring
– following the IFLC/AIG transaction, the company was downgraded to “Non-investment grade” or “junk” and has therefore relatively high funding costs compared for instance to GE as main competitor

What kind of business are we talking about?

Well, Airplane leasing is essentially a “special purpose lending business” without an official bank license, one could also say it is a “shadow bank”. What Aercap essentially does is to loan an airplane to an airline.

In order to make any money at all, they have to be cheaper than the simple alternative which would be the airline gets a loan from a bank and buys the airplane directly. As Airlines are notoriously unprofitable and often thinly capitalized, they often need to pay pretty high spreads even if they borrow money on a collateralized basis.

As any lessor funds the plane mostly with debt, the cost of debt is one important factor to make money compared to competitors. It is therefore no big surprise that GE with its AA+ Rating is the biggest Airplane leasing company in the world and that ILFC thrived while AIG was still AAA and had comparably low funding cost.

Airplane buying is tricky business

A second aspect is also clearly buying power. Planes have to be ordered many years in advance and the two big manufacturers want to be sure that they are getting paid. I assume a reliable bulk buyer gets better access to the most sought after planes and maybe even better prices. Prices for planes at least in my experience are notoriously intransparent. Nobody pays the official list prices anyway. I found this interesting article in the WSJ from 2012.

When Airbus and Boeing Co. announce orders at the Farnborough International Airshow this week, they will value the deals based on the planes’ catalog prices—which no one pays. Airline executives, when pressed for details, will probably say they got “a great deal.” But actual terms will remain guarded like nuclear launch codes.
The aviation industry’s code of silence on pricing is notable in this era of information overload. Thousands of people world-wide are involved in airplane purchases, yet few numbers spill out. That yields much mystery and speculation.

Discounts are large:

But there are ways to estimate the range of discounts. An analysis of public data by The Wall Street Journal and interviews with numerous industry officials yielded this: Discounts seem to vary between roughly 20% and 60%, with an average around 45%. Savvy buyers don’t pay more than half the sticker price, industry veterans say. But deal specifics differ greatly.

But no one wants to talk about it:

One reason for the secrecy surrounding all this, say industry officials, is psychology: Less-experienced plane buyers like to think they got a bargain and don’t want to be embarrassed if they overpaid. The safest approach then is silence. More-seasoned plane buyers also know that bragging about discount specifics would anger Airbus, Boeing or other producers and hurt the chances of striking a sweetheart deal again.

Clearly, as a large “quasi broker”, Airline leasing companies seem wo have a chance to make some money in such a intransparent market. But it is really hard to pin down real numbers. It reminds me a little bit about how you buy kitchens in Germany where the system is pretty much the same. Everyone gets a discount, but no one knows what the “true” price looks like.

But this also leads to a problem:

With the current funding costs, AerCap would not be competitive in the long run. Let’s take as a proxy the 10 year CDS spread as a proxy for funding costs and compare them across airlines and competitors (more than 50% of AerCaps outstanding debt is unsecured):

10 year senior CDS Rating
     
AerCap 215 BB+
     
     
Clients    
Air France 96  
Singapore Airlines 105 A+
Southwest 109  
Lufthansa 195 BBB-
Thai Airways 240  
Delta 256 BB
Emirates 257  
Jet Blue 362 B
     
Competitors    
GE Capital 72 AA+
Air Lease 175 BBB-
ICBC 194 A
CIT 229 BB-

So purely from the funding cost perspective, AerCap at the moment has a problem. Someone like Air France could easily fund a loan for an airplane cheaper than AerCap, so cutting out the middle man is basically a no brainer and even the smaller competitors could easily under price AerCap when they bid for leasing deals. On top of that, a lot of non-traditional players like pension funds and insurance companies want some piece of the action, as the return on investments on those leases are significantly higher than anything comparable. Even Asset managers have entered this market and have created specific funds for instance Investec.

AerCap does have a positive rating outlook, so there is a perspective for lower funding costs. Just to give an indication of how important this rating upgrade is: On average, 10 year BB financial isuers pay 2,4% p.a. more than BBB financial issuers at the moment. The jump from BB+ to BBB- will not be that big but it would increase the investor universe a lot for AerCaps bonds.

The biggest risk for AerCap

So although I am clearly no match for David Einhorn (*), I would argue that the biggest risk for AerCap is not the residual value of the planes or the credit quality of the Airlines but quite simply the refinancing risk. AerCap has to fund a significant amount going forward and if for some reasons, spreads move against them, they will be screwed. Just a quick reminder what happened to ILFC in 2011:

Credit-default swaps on the company climbed this month as global stocks tumbled and speculative-grade debt issuance all but evaporated. The cost reached as high as 663 basis points on Aug. 11, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market. The contracts have held at prices that imply ILFC’s debt should be rated B2, according to Moody’s Corp.’s capital markets group.

However if they manage to to get an investment grade rating and lower their funding cost, then it could be an interesting investment as funding is cheap and they do have access to a lot of new and sought after aircraft. Again, borrowing from Warren Buffett, with any leveraged company, management is extremely important.

And one should clearly compare AerCaps valuation and risk/return to banks and not to the currently much higher valued corporates. AerCap is much more similar to a bank than anything else. This general valuation disconnect seems to be also one of major reason why GE announced the massive reorganization just 2 weeks ago. However, as far as I understood tehy will keep the leasing business as this is unregulated.

Summary:

Although I slightly disagree with the risk assessment of Einhorn’s case, I still think AerCap could be an interesting case and is worth to dig deeper. I don not have a problem investing into financial companies and I do like those “share overhang” situations. However, I will need to dig deeper and especially try to figure out how good AerCap’s management really is.

(*) I did disagree with David Einhorn already once with Dutch Insurer Delta LLyod which was Einhorn’s long pick of the year 2011. Overall in this case I would put the score of MMI vs. Einhorn at 1:0 as Delta LLoyd did not outperform.

Why on earth is Seth Klarman investing 1,7 bn USD in Cheniere Energy (LNG) at 7x P/B ?

In my book review “The Frackers”, I mentioned one of the stories in the book was about Cheniere Energy:

Finally, there is a fascinating side story about the guy who is running Cheniere Energy, Charif Souki. His great idea was to import natural gas into the US and he raised several billion USD to build a huge gasification plant on the gulf coast. He clearly did not see fracking coming and his investment was worthless. Nevertheless, he was able to raise another few billion bucks and retool the facility in order to export natural gas.

This “double or nothing” gamble seems to have paid off. Seth Klarmann by the way, has just doubled its stake in Cheniere, making it their biggest public listed position at around 1,7 bn USD.

Seth Klarman

Seth Klarman is a famous value investor running Baupost Group a 25bn USD hedge fund. In contrast to Buffett, Klarman very seldom gives interviews and his fund commentaries are hard to get. Hi is considered to be the “heir” of Benjamin Graham and still sticking to the “cigar butt” approach of deep value investing. Two years ago in a Charlie Rose interview, Klarman made the following comment:

Baupost’s leading man says that he buys “cigar butts” at cheap prices. Warren Buffett used to also do this. The difference between the two legends is that Klarman stayed focused on cigar butts while Buffett’s process morphed into buying great companies at great prices and then into paying so-so prices for great companies.

Klarman does many things ordinary investors can’t do, like buying defaulted Lehman stuff etc. Not many of his investments are public and not all of his public investments are successes. Nevertheless it is clearly interesting to look more deeply into his biggest public position, Cheniere Energy.

Cheniere Energy

Cheniere’s stock chart shows the “unusual” history of the company:

Just as a side remark, somehow this chart reminds me of this funny animal:

Looking at Cheniere’s latest quarterly report, we can clearly see that Seth Klarman’s days as Graham style “net-net” investor seem to be over. Cheniere has currently around 7,5 bn net debt and 2,3 bn equity. Based on a market cap of around 17 bn USD, this is a P/B of roughly 7 times so hardly a bargain investment based on this metrics.

On top of that, the company never made a profit in its life as this table with EPS since 2004 clearly shows:

      EPS
02/21/2014 FY 13 12/13   -2,2
02/22/2013 FY 12 12/12   -1,6
02/24/2012 FY 11 12/11   -2,6
03/03/2011 FY 10 12/10   -2,3
02/26/2010 FY 09 12/09   -3,8
02/27/2009 FY 08 12/08   -6,0
02/27/2008 FY 07 12/07   -3,6
02/27/2007 FY 06 12/06   -1,5
03/13/2006 FY 05 12/05   -0,9
03/10/2005 FY 04 12/04   -0,6
N.A. FY 03 12/03   -0,4

So the question is clearly: What does Seth Klarman see to make this his biggest publicly disclosed investment ?

The best analysis I found was the one at Value Investor’s Club (accessible with guest login) from 2013, where the stock was trading at a third of the current price (Klarman bought between 60-70 USD). There is also a good article in Forbes from 2013 about the story behind Cheniere from 2013.

I try to summarize the case in a few bullet points:

– natural gas is very cheap in the US due to fracking and multiple times more expensive especially in Asia
– despite high costs, it is a pretty good business to liquify natural gas in the US and ship it to Asia in order to earn the spread
– Cheniere is in the process of finishing its first gasification plant by the end of the year 2015 and will then start to produce reliable cash flows as it has already contracted out its full production capacity for 20 years to major energy companies

The most important point is however the following quote from Forbes:

Cheniere’s Sabine Pass facility got its approval from the Department of Energy to export to any country in the world two years ago. It is so far the only facility to be cleared to export to countries that do not have a Free Trade Agreement with the U.S. And getting a non-FTA permit is a make-it-or-break-it approval for these projects, because there’s only one big gas-importing country (South Korea) with a free trade deal with the U.S. Unless a facility can export to the likes of Japan, China and India, the economics likely won’t support a multibillion-dollar build-out.

Cheniere had the luck to be the first to get this license. Later on, mostly due to the pressure of US based energy users, the US Government declined to issue further LNG “non FTA” export licenses for some time. According to Cheniere’s latest investor relation presentation, in 2014 two more “non FTA” licenses have been granted but Cheniere clearly has a head start.

Many more export facilities in the US would lead to higher prices in the US and to lower spreads compared to Asia, but for the time being, Cheniere’s primary LNG facility could be viewed as the typical “toll bridge” for US natural gas on its way to off shore destination as the other two licensed projects are still to be completed in several years time.

Cheniere itself is trying to further expand its current facility by 50% and they are projecting another site, but both projects have not yet received their license.

Valuation:

Replacement value

Despite buying at 7 times book, the question is: Could it be that Klarman is buying below replacement value ? I think it is unlikely. EV is around 25bn, stated book value of the assets is around 8 bn. Liquification facilities are not that hard to construct. all you have to do is to call someone like Bechtel and sign a turn-key project. Ok, you need the land and the permission, but overall this seems to be manageable in the US. So without going into more detail, we can assume that the current valuation of Cheniere is clearly above replacement value.

Valuation based on future cash flows

The VIC author estimates around 4-6 USD per share distributions for Cheniere’s shareholders going forward based on the first 4 trains of the initial liquification project. I have not double checked this but I will assume this number of being correct.

Reading through the roughly 15 pages of risk factors in Cheniere’s 2013 report, I would not call this a risk free business.There are still a lot of moving parts and operational risks even if the whole facility is up and running. Cheniere’s public bonds in the operational subsidiary trade at around 5,5% yield p.a. So discounting equity cash flows at the HoldCo level should be higher than that.

A) Existing facility and licence & contracted cash flows only

Cheniere has fixed contracts for 20 years. In the following table I have calculated NPS for the above mentioned EPS range and different discount rates, based on the assumption that one gets those earnings for 20 years and after that nothing (for instance any future earnings have to be applied to retire the debt):

eps/discount rate 4 5 6
6,50% 44,07 55,09 66,11
7,50% 40,78 50,69 60,83
8,50% 37,85 46,73 56,08
9,50% 35,25 43,17 51,81
10,50% 32,92 39,96 47,95
11,50% 30,84 37,05 44,46

We can clearly see, that the contracted amounts at the existing facility will not be enough to justify the current valuation of around 70 USD.

B) Existing facility, indefinite cashflows

This is the table with an indefinite stream of earnings at various discount rates:

eps 4 5 6
6,50% 61,54 76,92 92,31
7,50% 53,33 66,67 80,00
8,50% 47,06 58,82 70,59
9,50% 42,11 52,63 63,16
10,50% 38,10 47,62 57,14
11,50% 34,78 43,48 52,17

Even with an indefinite time horizon, Cheniere does not look like a “bargain stock”.

C) Existing facility + 50% capacity increase, contracted cash flows only

eps/discount rate 4 5 6
6,50% 66,11 82,64 99,17
7,50% 61,17 76,03 91,24
8,50% 56,78 70,10 84,12
9,50% 52,87 64,76 77,71
10,50% 49,39 59,93 71,92
11,50% 46,26 55,57 66,69

D) Existing facility +50% capacity increase, indefinite cash flows

eps 6 7,5 9
6,50% 92,31 115,38 138,46
7,50% 80,00 100,00 120,00
8,50% 70,59 88,24 105,88
9,50% 63,16 78,95 94,74
10,50% 57,14 71,43 85,71
11,50% 52,17 65,22 78,26

The 4 scenarios show relatively clearly that only with including future non-contracted cashflows and additional, not yet approved capacity, the stock looks interesting. In order to satisfy the return expectations of Klarman, which should be 15-20% p.a.based on his track record, he must assume further cash flows for instance from the second site Cheniere wants to contruct at some point in the future in Corpus Christi. Plus, there should be no dilution etc. from raising the rquired gigantic amounts of capital.

Maybe he is betting that the stock will trade like a bond if the company starts paing dividends ? Or is he leveraging the investment with addtional debt ?

In any case, he seems to be paying a lot for future, uncertain cash flows, which contradicts his “we still do cigar butts” statement. This is not that different from what Buffett is doing when he is paying rather expensive prices for great companies. At least for a guy with a portfolio size like Seth Klarman, the time of “cigar butt” investing seems to be over. Even he must feel th pressure that you cannot charge 2/20 for holding cash.

So to answer the question from the beginning:

Why on earth is Seth Klarman investing 1,7 bn USD in Cheniere Energy (LNG) at 7x P/B ?

I have no real idea but it might be the case that Klarman somehow need to put money at work and he expects this investment to be uncorrelated to general market as he has been quite pessimistic on equities for some time.

Summary:

For me, Cheniere at current prices is clearly one for the “too hard” pile. Klarman of course can spend a lot of money and time to fully analyze the energy markets etc. although as we know now, most energy experts have a hard time to make meaningful forcasts. But still it doesn’t look like a bargain and clearly no “cigar butt” or “net-net” kind of investment.

Funnily enough, analyzing Cheniere makes me much more confident in my Electrica investment. At least to me, the risk/return relationship there is some magnitudes better than for Cheniere. I think I will upgrade this to a full position over the next few days.

P.S.

Some other stories I found about Cheniere
http://www.alternet.org/fracking/how-powerful-friends-and-cozy-relationships-helped-cheniere-energy-cash-natural-gas-exports
http://www.octafinance.com/baupost-group-doubled-stake-cheniere-energy-still-bullish-us-lng/
http://www.mailtribune.com/article/20150125/Opinion/150129835

Harvesting the archives (1): AS Creation, Medtronic, Netflix

Introduction:

Keeping track of all the companies one has ever looked at is pretty hard. It is pretty easy to update the companies which are in the current portfolio, but in my case, I often forget about the companies which I have looked a couple of years ago but didn’t buy for one reason or another or sold them. One of the great things of blogging is that you can easily look at everything you have ever written. Especially in the current environment, where good value investing ideas are pretty hard to find, it might make sense to look back at companies one has researched sometimes ago and either sold or not bought. Maybe they have become interesting again ? For me it is a lot easier to update myself on a stock I have looked 3-4 years ago compared to looking (and digging) into a completely new stock.

So in this new series, I will look into stocks I have written about and either sold or rejected and try to find out if something has changed or if some lessons could be learned.

AS Creation

AS Creation was the first detailed stock analysis on the blog in December 2010 (in German). The company back then looked cheap: Single Digit P/E, historically a single digit p.a. grower, 30% market share in Germany and the potential upside of a Russian JV (Russia was supposed to be a growth market back then). After some quite significant ups and downs, the stock was sold in August 2013 because the margins didn’t mean revert and the Russian JV was already in some trouble under “non crisis” conditions.

Looking back, the decision to sell in June 2013 at ~34 EUR looks smart if we consider the chart although in between the stock went up to 40 EUR again:

Operationally, AS Creation was hit by several negative events: First, the bankruptcy of Praktiker impacted them in the German core business, secondly, their French subsidiaries suffered and finally, the Russian JV which had to suffer from delays has been clearly hit by by the current crisis. With regard to the German business I have the impression that they never really rebounded to their historical average, maybe they did profit from some kind of anticompetition arrangements, for which they were fined. An interesting detail: They were convicted to pay 10,5 mn EUR in 2014, but they seem to have appealed the decision. To my knowledge, no appeal was ever succesful.

In any case, I don’t think AS Creation is interesting at the current level of 30 EUR. At a 2014 P/E of 15-20 (before any extra write-offs on Russia) there seems to be quite some turn around fantasy being priced in.

From my side there were 2 important lessons:
1. Mean reversion on single stock basis is nit guaranteed
2. If you buy cheap enough, you don’t lose much if things go wrong.

Medtronic

Medtronic was introduced (in German) on December 31st 2010 and then kicked out in August 2011 because I didn’t feel comfortable with a large cap US stock.

Looking back, this clearly doesn’t look like the smartest decision I ever made. Back then, I sold Medtronic at a loss of around -19%. Since then, the stock showed a total return of 167% in EUR. One of the interesting things about Medtronic is that a lot of the performance came from multiple expansion.

When I sold the stock at around 32 USD, the stock was trading around 10 times trailing earnings (3,27 USD per share 2010). 4 years later, reported earnings 2013/2014 have been ~20% higher per share at 3,80 USD, but Medtronic is now trading at around 18,5 times trailing earnings.

What is even more interesting than that is the fact that in absolute terms, 2013/14 earnings are at exactly the same levels as 2010/2011. Profit margins are even lower than back then. What happened ? Well, as in many cases for US stocks, the company bought back shares aggressively. Still, both ROE and ROIC declined but shareholders don’t seem to bother.

So despite the big run up of the share price, I don’t think that selling the shares has been a mistake. From a fundamental view the company looks worse than back then, however investors seem to be so happy about buyback driven EPS gains that they are willing to pay a pretty high valuation for this.

You could have speculated on such an outcome but as a fundamental investor, this would not have been in line with my investment philosophy. And clearly, You cannot increase the value of the company forever just by reducing the share count.

Stand-alone I would argue that Medtronic is clearly overvalued, based on the stagnating profit and deteriorating profitability. However with the current Healthcare “merger mania” I would not want to short the stock either.

Netflix

I briefly considered to skip the whole Netflix episode but then decided against it. Looking back, this clearly shows that one can do stupid things and still make money….

I shorted Netflix in January 2011 after a short thesis from Whitney Tilson. Luckily I was able to cover the short with a gain in September 2011.

Looking at the chart, we can see that despite extreme volatility, Netflix is now trading 3 times higher than when I covered the position:

The lessons here were pretty simple:

1. Don’t short “hot stocks” based on fundamentals. It is too volatile and just not worth it-
2. Stay away from whatever Whitney Tilson is recommending

Fundamentally, Netflix is on my “too hard” pile. I do think streaming is a big thing and will be even bigger in the future. However I have no idea how much money Netflix will actually be able to make.

Lancashire Group (ISIN BMG5361W1047) – The UK equivalent of Buffett’s National Indemnity ?

While I was writing this post which I do normally over 1-2 weeks, the excellent WertArt Capital blog has released a very good post on Lancashire a few days ago. I higly recommend to read the post as it contains a lot of usefull information.

This saves me a lot of time and I only need to summarize the highlights:

– Lancashire is a specialist insurance company which insures mostly short tail “Excess loss” type of risks. It was founded by Richard Brindle, an experienced underwriter

– Since founding & IPO in 2009, the company has shown an amazing track record. No loss year, 59% average combined ratio and 19,5% ROE is simply fantastic.
– the company has a very disciplined underwriting focused business model, investment returns are negligible
– focus in on capital allocation and efficiency. If rates are not good, Lancashire returns capital to shareholders
good alignment of management and shareholders (majority of bonus depends if ROE hurdle of 13% + risk free is hit)
– The company looks cheap at ~8,5x P/E and 1,3 x P/B

For non-insurance experts a few quick explanations of insurance terms:

“Short tail” insurance business:

“Short tail” means that one is only insuring stuff where you pretty quickly see if there is a loss or not. For instance a “plane crash” insurance will be good for 1 year and if a plane crashes, the insurer will pay. After that 1 year there are no obligations for the insurer.

“Long tail” in contrast is an insurance policy which again covers a calendar year but where the damage can come up much later. A good example is D&O (director and officers) insurance. Often, when a big company goes bankrupt, some fraud etc. was involved at management level. Until a jury finally makes a verdict, many years can pass by but still the insurance company which has underwritten the policy remains liable. A good example is for instance the recent Deutsch Bank /Kirch trial where insurers will have to pay 500 mn EUR for something that happened 12 years ago.

Long tail has the advantage that the “float” can be invested long-term and illiquid, on the other hand the risk if a significant miss-pricing is much higher.

Excess Loss contracts

Excess loss contracts are contracts where the insurer only pays above a normally quite high threshold. This means that in normal cases, one does not need to pay but as a result premiums are lower than with normal contracts or “lower attachment points”. These kind of contracts are also often called “catastrophe risk” or “Cat Risk”. If such an event hits, then the hit will be big. Lancashire initially expected to make a loss 1 out of 5 years but up to now they had no loosing year. A company which has many excess loss contracts will report very good results in some years but very very bad in others.

What is the connection to Warren Buffett ?

Lancashire and Co. are relatively similar to Buffet’s National Indemnity Insurance, maybe the most overlooked part of his insurance empire after GEICO and Berkshire/General Re. Buffet has commented several times on National Indemnity and the competitive advantages of this company. The major competitive advantage of this business according to him was the ability NOT to write business if premiums are too low. The problem with this approach is of course that if you write less business, cost will be higher and the all important “Combined Ratio” (costs+claims divided by premium) will go up and investors will get nervous.

I wrote down this quote from last’s year Berkshire AGM from Buffett:

“I prefer the underwriters playing golf all day instead of underwriting risks at the wrong price. I don’t care of combined ratios grow well above 100% in such years.” For normal Insurance companies this is almost impossible to achieve as investors want to see increasing sales and profits any year and so most Insurance companies will underwrite no matter what the price is just to maintain the premium.

On the web I found similar quotes from him on the National Indemnity (NICO) which the bought in the 80ties:

Nevertheless, for almost all of the past 38 years, NICO has been a star performer. Indeed, had we not made this acquisition, Berkshire would be lucky to be worth half of what it is today.

What we’ve had going for us is a managerial mindset that most insurers find impossible to replicate.

and:

Most American businesses harbor an “institutional imperative” that rejects extended decreases in volume. What CEO wants to report to his shareholders that not only did business contract last year but that it will continue to drop? In insurance, the urge to keep writing business is also intensified because the consequences of foolishly-priced policies may not become apparent for some time. If an insurer is optimistic in its reserving, reported earnings will be overstated, and years may pass before true loss costs are revealed (a form of self-deception that nearly destroyed GEICO in the early 1970s).

Additionally, Buffett is already participating in the London/Lloyd’s market via another structure. Last year, he underwrote a socalled “side car” deal with Aon. The deal is still controversial but indicates a change of how things are being done at Lloyds. Funnily enough, Lancashire CEO Richard Brindle called the Buffet/Aon deal “foolish” in an interview last year.

Why is the company cheap ?

1. In general, all the socalled “London market” insurers are cheap. Let’s look at the “London” peer group:

Name Est Price/Book Current Yr P/E P/E FY1 Current Div. Yld (%)
         
LANCASHIRE HOLDINGS LTD 1,24 8,76 8,77 8,26
HISCOX LTD 1,62 10,47 13,48 8,21
BRIT PLC 1,23 #N/A N/A 8,59 #N/A N/A
BEAZLEY PLC 1,55 8,11 9,55 10,00
AMLIN PLC 1,36 7,94 11,13 6,07

Compared to those London players, all European P&C Insurance peers trade on average at~ 2,2 x book and 12 x earnings. So why are the London insurers so cheap ? In my opinion, the answer lies in the cyclicality of the business similar to Admiral. The “London market” is even more cyclical as it is primarily an institutional price driven market. The London market specialises in large and complex risks with “natural catastrophe” exposure. Despite the headline news, in the last years there were very few NatCat events which really led to large insured losses. In those times, profit margin increase and there is big pressure to lower premium. As companies accumulate capital, the appetite for risk increases, which further lowers premiums. This works as long as either a large NatCat event happens or capital markets crash and the insurers then have to raise premiums in order to restore their capital levels.

2. Management and strategy change

Lancashire so far has shown excellent underwriting discipline and outstanding an outstanding ability to allocate capital. However in the last few months a couple of things have changed:

a) The founder & CEO has “retired” in April at an age of 54. I haven’t found out why. Since 2005 I would guess that he has earned 50+ mn GBP, maybe he thought that this is enough ? At least he got an extra 10 mn package according to this article. He has been selling shares before his retirement.

b) In a change of strategy, Lancashire bought at the end of 2013 a Lloyd’s syndicate called Cathedral for ~200 mn GBP. Although the Lloyd’s business is not necessarily bad business, it is clearly a change. Lloyd’s underwriting is often reinsurance in contrast to Lancashire’s direct insurance. In their previous reports they claimed that their strategy of insuring directly was a competitive advantage. The Lloyd’s market on the other side is mostly reinsurance and more vulnerable.

c) Finally, after having been invested in short-term no-risk bonds since their IPO, they suddenly disclosed beginning at year-end 2013 that they now invest also into stocks and “Low volatility” hedge funds. Most likely not a good idea at this point.

For me, the cyclicality of the business itself would be no problem. But the combination of Management change and strategy change is very hard to swallow. I would happily invest if there would be EITHER a management change OR a strategy change but not both.

Summary:

To quote Donald Rumsfeld, those two changes lead Lancashire into the “unknown unknowns” territory. Sure, the new CEO is at Lancashire since 2007 and an underwriter, but overall I am not sure if the superior capabilities of the forme CEO have been “institutionalized” in the 8+ years of company history. Having three platforms instead of one sounds great, but it can also mean a loss of focus. So at the moment, Lancashire for me is not a “buy” as I do not have a clear idea how and if they can replicate their past results. T

However in general, the business model is attractive and the “London Insurers” could become interesting, especially if the market softens further so I will try to look into the others at some point in time.

Edit: I have just seen via the “Corner of Berkshire and Fairfax” board a link to an “Insurance Insider” article which states that the former CEO has completely sold out and is expected to launch a new company. A reason more not to rely on past results as this business is very dependent on the persons and the old CEO wil be a pretty tough competitor if he starts over again.

The German Dax at 10.000 – looking back

Following Mr. Draghi’s speach on Thursday, the German Stock Index DAX hit the 10.000 mark for the first time in history soon thereafter. Many major publications directly came out with headlines along the line “DAX 10000 – what’s next” and speculated where the DAX might go.

In contrast to that and only for reasons of personal entertainment, I want to take a look back into the DAX history. The DAX was introduced 26 years ago in July 1988 by the German Stock Exchange in order to introduce a modern, performance based stock index. The linked Wikipedia site gives a great overview on the history of the DAX and the change in constituents. Mathematically, the DAX times series was based on 31.12.1987 with a starting value of 1.000 although there exist some “Virtual” time series going back much further.

Just a few interesting facts about the DAX:

– only 15 of the original constituents are still in the DAX
– 3 (or 10% of the original 30) actually went bankrupt
– the best years since 1987 have been 1993 with +46,71% and 1997 with +47,11%
– the worst year were 2002 with -43,94% and 2008 with -40,37%
– the biggest cummulative loss was the 2001-2003 period with a cumulative loss -58,9%
– the Dax rarely ends up pruducing single digit returns over a full calender year. Only 5 out of the last 26 years produced “single digit” returns. So yes, long term stock returns might be single digits but short term single digit returns are an exception

Neverthess, the 10.000 level represents an annual return of ~9,02% over 26,5 years (from December 1987 until May 2014). This compares with around 10,1% for the S&P 500 (in EUR).

For me personally, the implementation of the Dax coincidently equals almost exactly when I bought my first stock. The first Stock I bought was a company called Hoesch in September 1987. I remember this so well because just a few weeks later, the “Black october of 1987” hit me with full force. I had used half of my earnings from a vacation job. As I wanted to increase my position after the crash, the people at the bank refused to take my order because they said that stocks are only for gamblers. As I was not yet of legal age back then, I had to come again with written permission of my parents to buy stocks.

This leads to another question:

Was this huge 26 year rally predictable or not ?

3 years ago I had reviewed the original “Market Wizards” from Jack Schwager which contains interviews with many then famous traders and hedge fund managers. Overall, one year after th 1987 crash, the sentiment was very very negative.

As I did not find historical P/Es for the Dax in 1987/1988, let’s look at this table of historic P/Es for the S&P 500:

P/E
31.12.1973 12,3
31.12.1974 7,3
31.12.1975 11,7
31.12.1976 11,0
30.12.1977 8,8
29.12.1978 8,3
31.12.1979 7,4
31.12.1980 9,1
31.12.1981 8,1
31.12.1982 10,2
30.12.1983 12,4
31.12.1984 9,9
31.12.1985 13,5
31.12.1986 16,3
31.12.1987 15,6
avg 10,8

Someone like John Hussmann might have said that stocks have nowhere to go as the P/E even after the 1987 crash was ~50% higher than the preceeding 15 year average. At the and of 1987, 10 30 year US Treasuries were yielding around 9%, another argument why stocks didn’t look that “apetizing” at that point in time. Why bother with stocks if you can earn double digits with corporate bonds any time ?

What followed

Looking back, it is easy to point out some of the events which led to this remarkable run especially for the DAX over the last 26 years:

– Communism broke down (“Peace dividend”)
– the Eurozone was created, stimulating cross border trading, increasing competition
– technology change (PC, Internet, Mobile)
– Corporate taxes in Germany went down form >50% to ~30%
– interest rates declined for now 25 years in a row
– old crossholding structure (“Deutschland AG”) dissolved, more professional management, foreign investors
– the BRIC story unfolded, further possibilities to export “core competency” goods like machinery and cars

In 1987/1988, few market pundits did even predict a single one of those factors. That’s why I think that just looking into the rearview (valuation) mirror should not be the only tool in the investing toolbox. Past P/Es will not predict future seismic shifts. On the other hand, one should not rely on such evcents happening over and over again and boosting share prices further. Clearly, interest rates and taxes will not fall that much lower and the effect of the end of Communism will not repeat itself.

For me the major conclusion is the following: Do not rely on any one system which tries to predict the future and/or future returns. Keep an open eye on everything, from valuations to macro economic factors and political shifts. Be prepared for surprises. Inthe long term, many surprises turned out to be positive for the economy and stock return.

Some musings on the Dax constituents

Just for fun, I created a table with the long term performance of the 15 “surviving” Dax constituents. Unfortunately I only got performance numbers back to 1992, but the p.a. Performance of the DAX was quite similar. lets look at those 15:

1987 Still in DAX Comment LT Perf (08/1992) p.a.
DAX     545,14% 8,95%
Allianz * 1   177,55% 4,80%
BASF * 1   3650,23% 18,12%
Bayer * 1   1598,15% 13,90%
BMW * 1   1723,82% 14,28%
Commerzbank * 1   -70,14% -5,40%
Continental 1   1962,28% 14,92%
Daimler-Benz (*) 1   90,50% 4,22%
Deutsche Bank * 1   89,57% 2,98%
Deutsche Lufthansa * 1   615,84% 9,47%
Henkel * 1   1200,08% 12,51%
Linde * 1   699,66% 10,03%
RWE * 1   308,71% 6,68%
Siemens * 1   742,92% 10,29%
Thyssen (*) 1   89,98% 4,32%
Volkswagen * 1   1690,10% 14,18%

Not surprisingly, financial stocks do not look good here. Overall, companies which are considered “well managed” did quite well such as Henkel, Bayer, BMW, Linde. Surprising for me is the fact that Lufthansa actually outperformed the DAX as well as Siemens.

Now let’s take a quick look at the new stocks. If I didn’t have returns from 1992, I made a comment:

    Total p.a. Perf. Since
Adidas 1   896,84% 13,23% 1995
Beiersdorf 1   1658,99% 14,09%  
Deutsche Börse 1   335,79% 11,74% 2001
Deutsche Post 1   103,80% 5,41% 2000
Deutsche Telekom 1   62,22% 2,80% 1996
EON 1   485,63% 8,46%  
Fresenius 1   4651,42% 19,42%  
Fresenius Medical Care 1   174,05% 5,90% 1996
HeidelCement 1   242,80% 5,83%  
Infineon 1   -80,66% -10,95% 2000
K&S 1   3084,30% 17,24%  
Lanxess 1   302,98% 16,11%  
Merck 1   555,53% 10,64% 1995
Munich Re 1   300,42% 7,24% 1994
SAP 1   3502,32% 19,98%

Not surprisingly, the best “newcomers” also lead the total Dax performance. Smaller companies which grow big are always the best investments, although it is often hard to identify them before.

Finally one other table. Let’s look at some of the best performers and their historical P/Es:

FRE SAP HEN3 BEI BAS
31.12.1992 28,6 24,4 19,6 18,9 11,4
31.12.1993 35,2 25,8 25,7 22,8 28,0
30.12.1994 19,4 36,7 15,0 20,6 14,6
29.12.1995 33,0 55,2 18,4 18,9 7,8
31.12.1996 64,4 52,1 25,9 28,7 14,4
30.12.1997 49,2 61,1 29,5 46,8 12,0
30.12.1998 30,8 71,5 32,8 30,4 11,8
30.12.1999 27,1 83,7 26,2 32,5 25,3
29.12.2000 37,7 60,0 21,7 41,9 23,6
28.12.2001 183,3 78,5 18,3 38,1 20,7
30.12.2002 10,8 46,3 20,0 31,3 13,9
30.12.2003 23,0 38,1 17,1 27,3 27,5
30.12.2004 18,2 30,9 5,3 21,9 14,5
30.12.2005 20,1 31,5 16,2 23,7 11,3
29.12.2006 23,5 26,2 18,9 16,7 11,6
28.12.2007 21,5 22,3 18,1 27,2 12,1
30.12.2008 21,2 15,5 54,7 16,8 8,9
30.12.2009 14,2 22,3 26,4 27,8 28,2
30.12.2010 16,3 24,9 18,1 29,7 12,0
30.12.2011 16,9 14,0 16,7 39,8 8,0
28.12.2012 16,3 25,8 18,3 31,6 13,6
30.12.2013 19,7 22,3 23,1 31,3 14,7

We can easily see that quality and growth NEVER is cheap. I am not sure if that Henkel 2004 P/E of 5 is incorrect data, but the solid “quality stocks” always traded “richly” and nevertheless delivered outstanding long term performance. Only BASF, as a “quality cyclical” company has been available at single digit P/Es at some years.

So after all, this is wat Warren B. likes to tell us: In the long term, quality does seem to beat anything else, especially if you factor in taxes, trading costs etc.

Summary:

So what does this all tell us ? I am afraid that I cannot come up with some “Magic Formula” to identify future winners. Nevertheless, I think the look back emphasizes three of Warren Buffet’s main points:

1) over the long term, stocks have been a unbeatable compounding machine. A return 10 times the original inevstment in 26 years despite several devasting crashes speaks for itself

2) over such a long time horizon, it seems that “quality buy and hold” seems to be at an advantage at least for large caps. Yes, introducing a backtested system (market timing, EV/anything) could generate fantastic returns as well, but just buying and holding well managed companies did produce spectacular returns

3) Just buying the index and sitting on one’s ass would have beaten almost all active strategies. To be fair although, the first DAX index funds were available mid/end 90ties…..

P.S.: To finish the story: What happend to my first stock, Hoesch AG ? Hoesch was taken over by steel company Krupp which itself merged with Thyssen. If I would held it all the time, it would have been a pretty weak investment……

The Warren and Charlie Show

This year I fulfilled myself a long dream: I joined the pilgrimage to Omaha in order to listen to these 2 elderly Gentlemen

Ähhhh sorry,that was the wrong picture, I actually listened to those 2 Gentlemen

I guess you can easily find transcripts and quotes of the meeting in many places for instance here, or here.

So instead of doing this once again (and by the way a I did not take notes….), I will just make a few random observations:

1. I didn’t expect any “actionable investment ideas” and there were none

2. As a “first timer”, I found the event genuinely entertaining. They make a very good show. The movie was great and the 2 guys are really funny.

3. The questions from the audience were a lot better than in any other shareholder meeting I have been

4. Doug Kass as the evil short seller was relatively tame. He mostly asked about the obvious succession issue

5. In general, the meeting was a lot about succession, Buffet said many times “when I will be gone”

6. Buffet thinks there is no need to split the company. Berkshire’s “culture” will prevail.

7. However he indicated that Berkshire would be prepared to buy a lot of stock back at the right price

8. Sometimes the answers were a bit shallow. For instance when someone asked why Iscar is better than Sandvik (i.e. which moat), the answer was “better management” or when asked about the moat of IBM he talked about a pension problem. Buffet surely knows better but I guess he is not sharing everything with his shareholders.

9. The exhibition of the Berkshire companies looked liked a flea market to me. Maybe its my European taste but i found that they sold quite crappy products.

10. Buffet was slightly subdued about growth in America for the next few years (“New Normal” anyone ?)

11. Some Omaha restaurants behave like cafes at the St. Marcus place in Venice, Italy. One night we went to the “Chophouse“. “Unfortunately” the cheapest wine at 60 USD/bottle (!!!!) was not available any more, the second cheapest was already 100 USD …..additionally they tried to talk us into ordering magnum bottles at 295 USD … DON’T GO THERE.

The two Buffet quotes I wrote down were those:

Interest rates are to asset prices what gravity is to the apple. With such low interest rates there is not a lot of gravity for asset prices.

For many companies book value has almost no correlation to intrinsic value

Would I go there again ? I have to admit that for the shareholders meeting alone I am not sure. The whole trip is quite expensive and time consuming. However I had the privilege to attend a 2 day (invitation only) value investing conference just before Saturday in Omaha which was absolutely fantastic !!!

I met a lot of very nice people who to a large extent were very good or even outstanding value investors. Many ideas were shared and interesting discussions were made.

The whole package (conference + shareholder meeting) is definitely worth the trip.

What were my take aways ?

The “hard” take aways were:

and of course these:

And I might have some posts about some ideas which have been discussed soon……

“The death of value investing”

There was a quite provocative article with the same headline “The death of value investing” on Business Insider a few days ago.

Why should one take such a Business Insider article serious at all ?

Well, at first, this was not written by some lowly paid BI staff but from Marc Andreesen and Ben Horowitz, two venture capital legends with currently 3 bn under management. Andreesen by the way was one of the creators of MOsaic, the first web browser and founded Netscape.

Let’s look at their article:

Most of the best investors in the world are considered value investors. Well, times are changing — the destructive power of technology is starting to break down companies faster than ever.
Value investing is an investment philosophy that evolved based on the ideas that Ben Graham and David Dodd started teaching at Columbia Business School in 1928. Since I started my career as an investor, value investing was the holy grail of investing.

Hmm, I am not sure about that one. I always thought that value investing is rather a minority strategy…but ok.

There are many interpretations of what value investing is, but the basic concept is as follows: essentially you want to buy stocks at a discount to their intrinsic value. Intrinsic value is calculated by taking a discount to future cash flows. If the stock price of a company is lower than the intrinsic value by a “margin of safety” (normally ~30% of intrinsic value), then the company is undervalued and worth investing in.

That part is OK although I am not sure where have the 30% “margin of safety”. But then it gets interesting:

Generally, value stocks are companies that are in decline but the market has overreacted to their situation and the stock is trading lower than their intrinsic value.

Hmm, that is in my opinion only true for the original Graham “Cigar Butts”, but lets move on:

The classic case is Research in Motion (RIM). In January 2007, RIM was trading at a high 55x PE multiple. Over in Cupertino, a computer company called Apple had reinvented itself as an MP3 player company and was now unveiling a new phone set to launch in the summer. By the end of December 2009, market share for Apple’s iPhone iOS as a percentage of US smartphone OS was 25% while RIM had increased from 28% to 41% in that same period. Though RIM had grown market share, fears of iOS growth had toppled the PE multiple to ~17x.

Many traditional, value investors sat back and thought, “Well, RIM is holding up pretty well compared to the iPhone, yet their PE multiple is getting destroyed.” It’s trading at near the historical average S&P 500 PE multiple of 15x. Apple hasn’t historically been strong in the enterprise, so maybe iPhone will just be a consumer phenomenon that doesn’t break through to business users. Android is irrelevant with 5% market share. The smartphone market is growing rapidly and RIM is the clear leader. RIM is still growing north of 35% and generating nearly $2.5B in net income. I think RIM looks cheap!
Two years later, RIM was trading at a 3.5x PE multiple and topline growth had screeched to a halt. Market share for RIM had contracted to 16% while iOS and Android combined for 77% market share. In fact, in 2012, RIM posted a net income loss of $847mm. Investors lost a ton of cash and were left scratching their heads.
How did this happen so quickly? Why did net income fall off a cliff? Why now?

They then go on to explain that technology changes faster and faster, mostly because of

1. Technology adoption accelerating
2. Internet way of life
and what they call: 3. Software Eating the World

Their final verdict is clear:

With technology upending markets, remaining a value investor is a death sentence. In the case of RIM, the company thought that their scale was defensible and stopped innovating on the operating system, favoring battery life instead. Apple’s iPhone operating system and associated software was an order of magnitude better than RIM and attracted consumers. Interestingly enough, Apple is dangerously close to losing their own software battle to Google with mobile versions of Google Maps, Gmail and Google voice being far better than their iOS counterparts.

While there may still be opportunities for value investing, you need to be cautious of businesses that appear to be on a slow decline. With the rate of technology adoption accelerating, Internet being a way of life and software consuming the world, businesses who refuse to embrace or adapt don’t just slowly decline; they fall off a cliff and take their cash flows with them.

The final statement in my opinion is both, partly wrong and partly very important for value investors.

What A&H describe is what is known to value investors as a Value Trap. A superficially cheap stock, which however for different reasons is in terminal decline. This is clearly not restricted to technology stocks, although there it is quite obvious.

Even the most famous value investors are not immune against this, as Seth Klarmann’s unsuccessful investment in Hewlett Packard showed.

Interestingly, short seller Jim Chanos (who I consider to be one of the best value investors ever) basically says the same thing:

You have to be very careful, because we looked at our returns over the past 10 years, and, particularly since the advent of the digital age, some of our very best shorts have been so-called value stocks. One of the differences in the value game now versus, say, 15 or 20 years ago, is that declining businesses, while they often throw off cash early in their decline, find that cash flow actually reaches a tipping point and goes negative much faster than it used to.

I think this is a very important point here: Low valuation (low P/E, low P/B) and/or high FCF yields based on past data are by no means a guarantee for superior investment returns. He directly confirms A&H in this paragraph:

The advent of digitization in lots of businesses also means that the timing gets compressed, meaning that you need to move quickly or you are roadkill on the digital highway. That’s true whether you look at companies like Eastman Kodak, or Blockbuster, or the newspapers. Value investors have been drawn to these companies like moths to the flame, only to find out that the business has declined a lot faster than they thought and that the valuation cushion proved to be anything but.

I think this is also one of the reasons, why many of the older “Quantitative Value strategies”, such as Dreman’s or O’Shaugnessey don’t work so well any more.

To summarize it bluntly up to this point: If you think value investing is only about buying low P/E and/or low P/B or low P/FCF stocks, then you will most likely be in for a quite nasty surprise, especially if you invest in anything that is subject to the technological changes as described above. Many of thse companies will drop off much more quickly than in the past and reversion to the mean will not happen.

On the other hand, I don’t think that value investing is dead, but it has rather evolved. If you look at Warren Bufft (and Todd Combs and Ted Weschler of course), Buffet style value investing looks of course very different. He invests at much higher P/Es and P/B, however still with a lot of margin of safety as he is able to factor in the value of potential “moats”.

Other value investors like Seth Klarmann for instance go into other asset classes or “special situation” investing where “margins of safety” are created via forced selling of market participants.

Funnily enough, when I was googling “The death of value investing”, an article with exactly the same title popped up from 2008, written by the quite famous author Edward Chancelor.

He refers to mistakes made by some “value investors” at that time:

The housing bubble, however, changed many facts. But some of the world’s leading investors appeared not to have noticed. First, several prominent names piled into housing stocks when they were selling at around book value. This proved a disastrous move as falling land prices and slowing sales generated massive losses for homebuilders. Then, some of the same investors charged into banks, figuring they were cheap. That also turned out to be a poor idea.

As we know now, Value investing made it at least another 5 years and 2008 and 2009 provided the best opportunities for open minded value investors in a generation.

Summary:

Clearly, Value Investing is not dead. It was not dead in 2008 and it is not dead now. But as the A&H well describe, “simple value” investing, i.e. just buying low P/E and P/B stocks is much more dangerous now that it was in the past.

For the “Normal” value investor, this means to put more effort in to identifying potential value traps. There is strong support to the thesis that declining companies, especially those subject to technological change, will “drop over the cliff” much faster than ever. So buying HP/Apple/ Micrososft/Intel/Solar/Media because it is so cheap at single digit trailing P/E minus cash should not considered to be a value investment unless you are really sure that sales and profits will not drop off similar to Nokia and RIM.

Value investing willneed to further evolve, but buying investments at a discount to a (carefully) determined intrinsic value will always be a good investment startegy.

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