The following was published at RealMoney in March 2006:
When you are a corporate bond manager, one of the lessons that you learn early is that financial companies (or, financials) are different from industrials or utilities. Why? First, the novice manager wants to buy a lot of financials, because they yield more at equivalent ratings. Second, you have a staff of analysts, and you realize that only a few of them can do financials, whereas almost all of them can do industrials or utilities. Again, why? Here are a number of related reasons:
- Tangible assets play only a small role in a financial company. What constrains the growth of an industrial company? The fixed assets (plant and equipment) limit the technical amount of product that can be delivered in a year. With services, workers… Finally, demand is the ultimate limiting factor, but this affects financial, industrial, and services businesses alike. With a financial company, sometimes the limits are akin to a service business (“If only we had more trained sales reps!”), but more often, capital limits growth.
- The cash flow statement plays a big role with industrials and utilities, but almost no role with financials. One of the great values of the cash flow statement is the ability to attempt to derive estimates of free cash flow. Free cash flow is the amount of cash that the business generates in a year that could be removed, and the business is as capable of functioning as it was at the start of the fiscal year. Deducting maintenance capital expenditure from EBITDA often approximates free cash flow. Cash flow statements for financials cannot in general be used to derive estimates of free cash flow because when new business is written, it requires capital to be set aside against the risks. Capital is released as business matures. In order to derive a free cash flow number for a financial company, operating earnings would have to be adjusted by the change in required capital.
- Sadly, the change in required capital is not disclosed anywhere in a typical 10K. Depending on the market environment, even the concept of required capital can change, depending on what entity most closely controls the amount of operating and financial leverage that a financial institution can take on. Sometimes the federal or state regulators provide the most constraint; this is particularly true for institutions that interact closely with the public, i.e., depositary institutions, life and personal lines insurers. For entities that raise their capital in the debt markets, or do business that requires a strong claims paying ability rating, the ratings agencies could be the tightest constraint. Finally, and this is rare, the probability of blowing up the company could be the tightest constraint, which implies loose regulatory structures. Again, this is rare; many companies do estimates of the economic capital required for business, but usually regulatory or rating agency capital is tighter.
- Financial institutions are generally more highly regulated than non-financial institutions. There are several reasons for this: the government does not want the public exposed to financial risk, systemic risk, guarantee funds are typically implicitly backstopped by the government (think FDIC, FSLIC, state insurance guaranty funds, etc.), and defaults are costly in ways that defaults of non-financials are not. The last point deserves amplification; in a credit-based economy, confidence in the financial sector is critical to the continued growth and health of the economy. Confidence can not be allowed to fail. Also, since many financial institutions pursue similar strategies, or invest in one another, the failure of one institution makes the regulators touchy about everyone else.
- Rapid growth is typically a negative; financial businesses are mature, and there is a trade-off between three business factors: price, quantity and quality. In normal situations, a financial institution can get only two out of three. In bad times, it would be only one out of three.
- Because of the different regulatory regimes, financial institutions tend to form holding companies that own the businesses operating in various jurisdictions. Typically, borrowing occurs at the holding company; the regulators frown at borrowing at the operating companies, unless the borrowers are clearly subordinate to the public served by the operating company. This makes the common stock more volatile. In a crisis, the regulators only want to assure the safety of the operating company; they don’t care if the holding company goes bust, and the common goes to zero. They just want to make sure that the guaranty funds don’t take a hit, and that confidence is maintained among consumers.
All of these factors together lead to the following conclusion: financials are more complex than other types of companies, and are not correctly analyzed in the same way as non-financials. Earnings quality is hard to discern, and growth is not always a positive thing. Bankruptcies are rare, but when they happen, recoveries are poor for common stockholders and holding company debtholders. Finally, management conservatism and competence are paramount, given the less certain nature of accrual accounting at financial companies, and the inability to calculate free cash flow with any precision.
In part 2 of this two-part series, I will give my approach to analyzing a sector of the insurance space in order to demonstrate some of these ideas.