While looking at General Electric some days ago, I remembered that I had the IPO/Spin-off GE Capital Credit Cards which is now Synchrony Financial on my research list for quite some time.
Company Background
This is from the 2016 annual report explaining how Synchrony was separated from GE:
Background:
Home Capital Group is a Canadian bank/mortgage lending company founded in 1986 and run by the same CEO for 30 years, which came into the spotlight over the past few months. It ran into trouble, almost imploded and then got saved by no one other than Warren Buffett (and Ted Weschler).
There is good coverage following this link. The story in short:
Home Capital wanted to aggressively expand into insured mortgages. However at least one underwriter collaborated with mortgage brokers to get mortgages approved without proper documentation. At some point regulators reigned in but management did not tell shareholders about it. Then the regulator got tough and management had to go. In the meantime, short-term financing was pulled and the company got into real liquidity troubles.
To sum it upfront: In my opinion there was nothing “really new” or spectacular in Buffett’s 2016 letter.
Operationally, 2016 was not such a good year for Berkshire, operating profit was flat and book value gain lower than the S&P. Nevertheless Berkshire’s stock price outperformed the S&P 500. Comprehensive income however was very good, around 50% better than 2015 (which was not very good).
Net tangible assets declined to around 170 bn from 186 bn mostly due to the Precision Cast Part acquisition which added more than 40 bn in intangibles.
I made some notes which might be interesting to some reader (or not).
Berkshire share repurchases:
The most interesting part from my side was where he writes about share repurchases in general and Berkshire in particular. I actually know some investors who treat the “Buffett put” at 120% of NAV as a real one, assuming that the stock price can never go below that level. This is what Buffet says:
Following my Old Mutual “sum of parts” valuation I saw the following Ira Sohn presentation of Exor Spa, the Agnelli family holding (FiatChysler, CNH etc.) as a potential “Sum of part” value investment.
To summarize the presentation in my own words:
The study sees a potential upside of several times the current share price. They forecast a 150 EUR NAV per share (vs. ~50 EUR now and 30 EUR share prices), driven by a quadrupling in value of the FCA and the CNH stakes.
Everyone who has read Thorndikes book “The Outsiders” clearly knows that capital allocation& capital management is one of the most important factors in creating long term shareholder value. After I watched Thorndike give a briliant talk at Google on this topic, I decided to write down my own thoughts on the topic.
What is CAPITAL ALLOCATION & CAPITAL MANAGEMENT anyway ?
CAPITAL ALLOCATION is simply what you do with your profits/cash inflows once they are in your account. You can do a lot of things with it. Thorndike in the talk above uses 5 uses, I would add another 2 (in bold)
1. Reinvest: Maintain your existing assets/infrastructure/operations
2. Grow organically: Expand your business by buying more machines/outlets/opening stores etc.
3. Expand your business by M&A
4. Pay back liabilities (debt, payables, pension liabilities etc.)
5. pay dividends
6. buy back shares
7. just leave the cash on your account and wait for better opportunities
In late 2014 I started looking into oil related companies. I have looked at a couple of energy related companies like explorer Peyto, LNG liquification terminal Cheniere , Consol Energy and Gaztransport. I only bought Gaztransport which I then sold 6 weeks later. As I am still interested in the Energy sector, I will cover some stocks from time to time.
Kinder Morgan, the US pipeline owner/operator looks like another typical potential contrarian “Value investment”.
What I liked at first sight: Read more
Executive summary: Although American Express looks cheap based on their historic profitability, the company is subject to rapid technological change and fierce competition in the payment industry. To me it is not clear how this will work out going forward, so for the time being I will not invest but look deeper into the industry.
American Express is well known in value investment circles because Buffett owns ~15% of the company and made a lot of money with it.
Recently the stock price came under pressure mainly because:
The stock price clearly has suffered and is down more than -40% from its peak in late 2014 /early 2015:
One general remark upfront: The 2015 annual report wasn’t that exciting in my opinion. Actually, I didn’t plan to write a post on it. However, after reading a couple of posts on the topic, I though maybe some readers are interested because I haven’t seen those points mentioned very often elsewhere.
GEICO had a pretty bad year in 2015. The loss ratio (in percent of premium) increased to 82,1% (from 77,7%), the Combined ratio increased to 98% and the underwriting profit fell by -60%. Buffett talks about the cost advantage a lot in the letter, but the only explanation forthe increase in loss ratios are found in the actual report:
After bashing David Einhorn for his Consol Energy WACC assumption last week, by chance I read at the very good 25iq blog an article on how Buffett and Munger publicly speak about those things.
Indirectly, this is clearly a slap in my face because even the headline already says it all:
Why and how do Munger and Buffett “discount the future cash flows” at the 30-year U.S. Treasury Rate?
The post summarizes what Charlie and Warren have said over the years with regard to cost of capital and discounting. I try to summarize it as follows:
So if Buffett doesn’t use more elaborated methods why should any one else ? Was I wrong to beat up David Einhorn because he used a pretty low rate for Consol Energy ? Add to this Mungers famous quote “I’ve never heard an intelligent cost of capital discussion” and we seem to waste a lot of time here, right ?
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.
value and opportunity 