Monthly Archives: August 2014

Bilfinger SE (DEDE0005909006) – Opportunity or Falling knife to be avoided ?

Background:

Bilfinger is a traditional German and international construction company with a history going back to 1880. As many of its peers, it tried to diversify away from the risky large-scale construction business into concessions and services. 3 years ago, Bilfinger surprised many by naming the the former German politician Roland Koch as new CEO. In 2011, Swedisch activist fund Cevian disclosed a 10% position and has increased this to 20% making them Bilfinger’s largest shareholders. Under Koch many of the traditional construction subsidiaries were sold and many new services companies were acquired. I counted 13 acquisitions in 2012 and 2013.

Up until early 2014, the strategy seemed to have worked well, margins and ROE/ROIC increased and the stock price hit an all time high of 93 EUR in April 2014.

Current situation

However since then, it seems that the “wheels went off”. Koch had to lower the guidance for 2014 2 times with quite significant impact on the share price as we can see in the chart:

Quite surprisingly for a traditional German company, he left the office on the very same day with his predecessor becoming his successor. There is some speculation in the press why this happened so fast but I think that activist investor Cevian was most likely also involved in this decision. Interestingly, Koch was buying shares for his personal account in July, so even he seems to have been surprised to a certain extent.

Falling knife vs. opportunity

I am a big fan of the saying “never catch a falling knife”. In the Bilfinger case we have a lot of risks:

– some of the many acquisitions could lead to further write downs, especially if a new CEO comes in and goes for the “kitchen sink” approach
– especially the energy business has some structural problems
– fundamentally the company is cheap but not super cheap
– often, when the bad news start to hit, the really bad news only comes out later like for instance Royal Imtech, which was in a very similar business. I don’t think that we will see actual fraud issues at Bilfinger, but who knows ?

On the plus side however we do have also a couple of arguments:

+ Bilfinger still has only a low amount of debt outstanding, so I don’t thin we will see a “Royal Imtech scenario”
+ Cevian will not sit back and watch. They have board members and a proven track record. They are usually in for the long-term but act quickly if things go wrong
+ Bilfinger does not have a majority owner and could be an M&A target
+ Bilfinger is a traditionally well-managed company
+ Analyst sentiment is already pretty bad (lowest quarter of the HDAX)

Especially the Cevian involvement looks interesting. The final target is pretty clear: By shifting the business mix more into engineering/service, they want to realise higher multiples than what traditionally is associated with “real” construction companies. Especially companies like Arcadis or Atkins trade at EV/EBITDA multiples of 8x-10. Bilfinger currently trades at around 6x EV/EBITDA, 10x EV/EBIT and 11 times earnings based on the reduced 2014 estimates. So there is clearly some potential here if they manage to stabilize the company.

On the other hand, Cevian clearly didn’t see that coming either. They actually increased their position in May when the stock traded north of 85 EUR. I would estimate that they paid around 70 EUR per share for their whole position.

Also, when we look at other comparable situations for instance Suedzucker, we can clearly see that the “knife can fall” a very long way down:

Clearly Suedzucker is not comparable to Bilfinger but it shows that one can easily lose 2/3 or more within a relatively short period of time if things og bad.

So what to do ?

Despite the lure of a “bargain” I will not invest now. For now I will stick to my principles and not catch a falling knife

What could make me change my mind ? For instance a new CEO who does not need to start with an accounting bloodbath……

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.

Book review: “Only the paranoid survive” – Andy Grove

Andy Grove was senior manager and CEO at Intel for a very long time and was one of the architects of the spectacular rise of Intel as microprocessor powerhouse. The book was written by Andy grove in 1997, one year before he stepped down as CEO of Intel.

He outlines how he dealt with what he called “inflection points” at Intel. An inflection point is in his definition a point where business changes so profoundly that either the business changes as well or the company will be killed by competitors. For Intel, this was the case when in the 1980ties, the Japanese suddenly were able to produce better and cheaper memory chips which were until then Intel’s main business.

Grove managed then to shut down the memory business and concentrate the efforts on the microprocessor business which was until then only a small part of the business. His first person (CEO) perspective is very interesting to read as change doesn’t come naturally to large and succesful companies.

I also found the book especially interesting because Intel is one of the famous cases for a “size moat” in Bruce Greenwald’s “Competition demystified”. Greenwald there argues that Intel’s success in microprocessors was more or less given because they had such a size advantage compared to AMD, their major competitor. Reading the book, I got the impression that Prof. Greenwald greatly simplified this. There seemed to have been several junctions on the way where Intel easily could have went “of course”, such as the rise of the RISC processors or the question at that time if multimedia will be won by PCs or TV sets. For me, one of the lessons o f the book is that Moats, at least in technology are always “weak moats” as the development is just too dynamic.

The most powerful concept of the book in my opinion is the following concept from Andy Grove: If you see someone coming up with a new idea or a competing product, then you should ask yourself the question: Is this a thread to the business if this gets 10 times bigger or better or faster ? His theory (and paranoia) was that if it is a thread at 10x bigger/better/faster than the probability of this actually happening is very big and you have to do something about it. And fast…

If I use this concept for instance for electrical cars, then as a traditional car manufacturer I should ask the question: What if electrical cars have 10 times better reach, 10 times more charging stations, charge 10 times quicker then now ?. Would I have a problem with this ? The answer would clearly be yes.

Grove also observes that you only have a chance to survive such inflection points if you start early, so when the old stuff is still selling well. Once the company is in real trouble, then change is much much more difficult.

The final chapter in the book deals with how Grove thought about the internet. One should remind that this book was written in 1997, but it is fascinating how Grove already identified industries which would be badly effected by the internet. He already was aware that for instance a lot of ad revenues would flow from print into the internet. One should not forget that this book was written a year before Google was even founded !!!

Another interesting aspect was that at that time Apple was considered by Grove a failed company as they did not change their vertical business model to a “Horizontal” one. Clearly , mobile was not on his radar screen at that time. As a final observation: Without the great run up in the stock price this year, Intel’s stock would have been more or less flat against the time when Grove stepped down as CEO in 1998. So even a great company as intel might not be a great investment at any price….

Anyway, in my opinion this is a truly great book. I think both, investors and managers can profit a lot from this book. I do like “first person perspective” books a lot, especially if you can compare them against articles and theories about the same company written by other people.

Performance review July 2014 – Comment “Anchoring”

Performance:

In July, the Benchmark (Eurostoxx50 (Perf.Ind) (25%), Eurostoxx small 200 (25), DAX (30%), MDAX (20%)) lost -4,5%. This is actually the biggest monthly loss since May 2012. The portfolio lost “only” -2,6%, an outperformance of +1,9% for the month. YTD, the score is +7,4% for the portfolio against -0,5% for the benchmark, a relative outperfomance of +7,9%..

Interestingly, especially the German part of the benchmark is struggling, with the MDAX down almost -6,5% for the year. My cautious stance towards German shares seems to have been justified so far.

The biggest looser in %terms in the portfolio were not surprisingly Sistema with -19,4% and Sberbank (-15,9%) followed by Trilogiq with -12,5%. Portugal Telecom would have been even worse with -39,7% but thankfully I sold that one early. Winners were few, among them Koc with +7,6%, TFF +4,7% and Gronlandsbanken +4,2%.

My Emerging Markets “Basket” has clearly added some volatility but on the other hand I think it was a good idea to diversify and only invest small amounts in risky stuff.

Current portfolio & Transaction

In July, I sold my small position in Portugal Telecom at a loss after the connection to Banco Espirito Santo became public. My relatively quick reaction saved me from much steeper losses. Sometimes it pays to react quickly.

Additionally I sold Vetropack as my investment case was clearly not fully valid anymore. The only new position was the Sky Deutschland “special situation”, which is a relatively low risk low upside investment. Finally I scaled down the Draeger position from 6,7% to 5% as the multiple against the pref shares increased to 6 times.

Cash at month end was around 12,4%, with a further 10% (Depfa LT2, MAN, SkyD) invested in special situations which I would consider close to cash. So the portfolio should be quite well prepared for any more significant corrections.

The current portfolio can be seen here.

Comment: “Anchoring”

During the month, I faced 2 situations where I was confronted with one of the most common but also most dangerous behavioural biases: Anchoring. On Stockopedia I found a pretty good description:

The concept of anchoring draws on the tendency to attach or “anchor” our thoughts to a reference point – even though it may have no logical relevance to the decision at hand.

The first situation this month was the case of Portugal Telecom (PTC). PTC announced quite surprisingly that they had extended almost 1 bn EUR to the now bankrupt Espirito Santo Group. When I had time to look at this, the stock dropped already significantly and I was already down -30% compared to my purchase price. For a short time I was tempted to speculate on a rebound as I hated to realize such a “loss”, especially as there were some positive news like potential collateral from ESF etc. But then I realized that I was “anchored” on my purchase price. Even at a loss, the risk/return relationship for the stock had worsened significantly. Instead of a speculation on a Brazilian merger, the situation had changed to a potentially corrupt management, unreliable financial statements and a speculation of Espirito Santo not going bankrupt. If the fundamentals of an investment change so much, being anchored on the purchase price is one of the worst things that can happen. It is much sfer to sell first and then sit back and think about if you would buy the stock again at the current price.

The second instance was Vetropack. Vetropack was one of my original investments. During the 3,5 year holding period, at one time the stock price had been almost 2000 CHF, a nice round numbers. Again, when I reviewed the business case and found some significant flaws compared to my own case, I was tempted to keep the position, speculating that it may reach 2000 CHF again and then sell at least at a small profit. But being anchored on previous higher prices is as bad as being anchored on the purchase price.

Those biases are also quite common in the business world. Selling a subsidiary at a loss, despite how bad and desperate the situation is, is very often an absolute “no go” for most senior managers. Only when the old managers are getting kicked out, the successors then finish the job because it was not “their” purchase price. For me, this is by the way a sign for good capital allocation if the management of a company sells a subsidiary at a loss or closes it down if they can’t turn around the business themselves as this is clearly not easy for any management. Much more often you see companies throwing good money after bad in those situations. The argument is often: “If we sell now, we lose everything we have invested before”. This “sunk cost” fallacy is extremely common and very hard to argue against.

So how can an investor protect against this anchoring ?

An easy solution would be just to forget purchase prices. In practice, this is not that easy as you usually see your purchase price in each and every broker statement.

What works best for me is also very simple: Writing down the original investment thesis and comparing the positions on a regular basis against this thesis. If something has changed significantly to the worse, then sell independent of the purchase price or previous highs. If nothing has changed and the case is still valid, then hold.

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