Those who have read me for a long time know that my favorite insurance company is Assurant.  I’m not writing tonight about how they had great first quarter earnings, or how their investment portfolio suffered less than their competitors.  Rather, it springs from a Bloomberg article that is not available on the web.  It seems Assurant is talking to Countrywide about purchasing their Balboa Insurance Group.

What makes for an intelligent acquisition?  Two things: don’t overpay, or flub the integration.

On overpaying, it helps if you are buying:

  • part of a business rather than the whole company
  • a noncore asset of the target
  • and offering noneconomic benefits (e.g. joining Berkshire Hathaway, because Warren doesn’t change the culture…)
  • through a negotiation, not an auction (think of MetLife buying Traveler’s Life)
  • something where you can get significant expense savings
  • and you are known to be prudent and fair as an acquirer

On integrating, it helps if:

  • you are integrating a business that differs from your business in at most one or two ways
  • corporate cultures are similar
  • the differences in technology are small
  • you gain new markets or technologies that you can use in the rest of your business

Assurant has done very well through small in-fill acquisitions where they pick up a new line of business that they can grow organically.  They also have done well in occasionally buying scale in areas where they are already strong, for example, when they bought the pre-need (funeral) insurance business of Service Corp International (a very concentrated niche business line).

With Balboa Insurance Group, Assurant would deepen its penetration into lender placed homeowners insurance.  Assurant is #1, and Balboa I think is #2 because of its business with Countrywide.  Assurant has efficient systems — they will be able to take out costs, and deliver even better service to Countrywide / Bank of America.

Now, if Countrywide is interested in selling, it is likely that the best bid would come from Assurant, not because they will overpay, but because they can offer the best service, and take out the most in expenses.  Bank of America would likely find Balboa to be a small noncore asset, so their interest in retaining it would be low.

Here’s small excerpt from the Bloomberg piece:

“Certainly that is a business we would be interested in,” Assurant Chief Executive Officer Robert Pollock said today in a conference call with investors. “Until things between Bank of
America and Countrywide close, I don’t think that’s going to be a focus” for Bank of America.

Countrywide, based in Calabasas, California, reported a first-quarter loss of $893 million earlier this month, its third straight quarterly loss, as late mortgage payments and home
foreclosures rose. Bank of America said April 21 that its purchase, which would make the Charlotte, North Carolina-based bank the largest U.S. mortgage lender, remained on course for
completion in the third quarter.

“Even in that case though, we still have to evaluate what we would have to pay for that business versus our ability to win” Balboa, Gene Mergelmeyer, president of Assurant’s specialty
property business, said in the call.

So, I look at this as a possible plus for both Bank of America and Assurant.  Balboa will be most valuable in Assurant’s hands.  Put it this way, why would another insurer want to buy Balboa when it is up against much superior competition?

PS — From the “don’t give a sucker an even break” file, Bank of America may not guarantee the debt of Countrywide.  This should not be a surprise.  They aren’t required to guarantee the debt, and Countrywide bondholders should just be grateful for the equity infusion.  If things get bad, though, Bank of America could walk away from Countrywide, and give it to the bondholders.

Full disclosure: long AIZ

Just a quick note on how my equity investing is doing — in April I was slightly ahead of the S&P 500, and year-to-date, things are quite good. This is not to say that I haven’t had my share of failures… Deerfield Capital, YRC Worldwide, Jones Apparel, National Atlantic, and Vishay Intertechnology have hurt. But in a portfolio of 35 stocks, even large percentage whacks get evened out if the stock picking on the remainder has been good enough. And, for me it has, though the successes are not as notable as the failures.

As an investor, I am a singles hitter, but my average is high, and strikeouts low. I have my failures, but the eight rules, which are my risk controllers and return generators, protect me. At least it seems that way for the last 7.7 years, but I know enough that even if the principles are right, they are no guarantee for the next day, year, or decade. “The markets always find a new way to make a fool out of you,” and so I encourage caution in investing. Risk control wins the game in the long run, not bold moves.

So, I keep plugging on, adapting to what I think the market will reward in the future, and ignoring the past for the most part.

Full disclosure: long VSH YRCW NAHC JNY

The Fundamental IndexThe books keep rolling in; I keep reviewing. Given that I am a generalist, perhaps this is a good task for me. Before I start for the evening, though, because I know the material relatively well, I skimmed the book, and read the parts that I thought were the most critical.

The Religious War Over Indexing

Passive investors are often passionate investors when it comes to what they think is right and wrong. For market cap or float-weighted indexers:

  • The market is efficient!
  • Keep expenses low!
  • Don’t trade fund positions!
  • Fundholders buy and hold!
  • Tax efficiency!
  • Weight by market cap or float!

For fundamental indexers:

  • The market is inefficient (in specific gameable ways).
  • Keep expenses relatively low.
  • Adjust internal fund positions as valuations change!
  • Fundholders buy and hold!
  • Relative tax efficiency!
  • Weight by fundamental value!

Some of the arguments in Journals like the Financial Analysts Jounrnal have been heated. The two sides believe in their positions passionately.

For purposes of this review, I’m going to call the first group classical indexers, and the second group fundamental indexers. The first group asks the following question: “How can I get the average return out of a class of publicly buyable assets?” The answer is easy. Buy the same fraction of shares of every member of the class of assets. The neat part about this answer, is everyone can do it. The entirety of shares could be owned in such a manner. Aside from buyouts and replacements for companies bought out, the turnover is non-existent. Net new cash replicates existing positions.

The fundamental indexer asks a different question, namely: “What common accounting (or other) variables, relatively standard across companies, are indicators of the likely future value of the firm? Let’s set up a portfolio that weights the positions by the estimated future values.” Estimates of future value get updated periodically and the weights change as well, so there is more trading.

Now, not all fundamental indexers are the same. They have different proxies for value — dividend yield, earnings yield, sales, book value, cash flow, free cash flow, etc. They will come to different answers. Even with the different answers, not everyone could fundamentally index, because at some point the member of the asset class with the highest ratio of fundamental weight as a ratio of float weight will be bought up in entire. No one else would be able to replicate the fundamental weightings.

So, why all of the fuss? Well, in tests going back to 1962, the particular method of fundamental indexing that the authors use would beat the S&P 500 by 2%/year. That’s worth the fuss. Now, I have kind of a middle position on this. I think that fundamental indexing is superior to classic indexing, so long as it is not overdone as a strategy. Fundamental indexing is just another form of enhanced indexing, tilting the portfolio to value, and smaller cap, both of which tend to lead to outperformance. It also allows for sector and company-level rebalancing changes from valuation changes, which also aids outperformance. In one sense fundamental weighting reminds me of Tobin’s Q — it is an attempt to back into replacement cost. Buy more of the assets with low market to replacement cost ratios.

But to me, it is a form of enhanced indexing rather than indexing, because everyone can’t do it. Fundamental Indexing will change valuations in the marketplace as it becomes a bigger strategy, wiping out some of its advantages. The same is not true of classic indexing, which just buys a fixed fraction of a total asset class.

Though the book is about fundamental indexing, and the intellectual and market battle versus classic indexing, there are many other topics touched on in the book, including:

  • Asset Allocation — best done with forward looking estimates of earnings yields (another case of if everyone did this, it wouldn’t work.. but everyone doesn’t do it. Ask Jeremy Grantham…)
  • The difference to investors between dollar vs time weighted returns by equity style and sector. (Value and Large lose less to bad trading on the part of fund investors… in general, the more volatile, the more fund investors lose from bad market timing.)
  • A small section on assumptions behind the Capital Asset Pricing Model, and how none of them are true. (Trying to show that a cap-weighted portfolio would not be optimal…)
  • And a section on how future returns from stocks are likely to be lower than what we have experienced over the last half century.

One more note: I finally got how fundamental weighting might work with bonds, though it is not explained well in the book. Weight the bond holdings toward what your own models think they should be worth one year from now. That’s not the way the book explains it, but it is how I think it could be reasonably implemented.

The Verdict

I recommend the book. The authors are Bob Arnott, Jason Hsu, and John West. At 260 pages of main text, and a lot of graphs, it is a reasonable read. The tone is occasionally strident toward classic indexing, which to me is still a good strategy, just not as good as fundamental indexing. (It sounds like Bob wrote most of the book from a tone standpoint… but I could be wrong.)

Who should buy this book? Academics interested in the debate, and buyers of indexed equity products should buy the book. It is well-written, and ably sets forth the case for fundamental indexing.

Full disclosure: If you buy anything from Amazon after entering Amazon through any link on my leftbar, I get a small commission. It is my version of the tip jar, and it does not increase your costs at all.