The last several days have been interesting to me regarding National Atlantic. It started with a discussion with another person who worked for my former employer (no, not the same one as last time). It went something like this:
Friend: Did you see the filing by our old boss?
DM: Yes, but unless he files suit alleging fraud, it is unlikely to amount to much.
F: Good point. What do you think the odds are of the deal going through?
DM: The deal is more likely to go through than not, but if the deal does fail, the stock will fall to $4, and if the deal succeeds it will go to $6.25. The payoff is asymmetric. I think the odds are 65% that the deal goes through.
F: So why are you holding on if the odds are that poor relative to the rewards?
DM: Uh…
So, on Thursday of last week and yesterday, I sold away 70% of my position after voting “no” on the deal. My thoughts: it is quite possible that the deal will get voted down. Sure, it isn’t in the short term interest of stock holders to see the deal fail, but National Atlantic has so annoyed shareholders that many will vote against their short term interests because of the egregiousness of the deal.
As an aside, NAHC is the sort of stock that if you are not careful, a large order can disrupt the market; I ended up using discretionary reserve orders routing through Arca [NYSE Archipelago], which allowed me to show 100 shares with much more behind that, and have discretion to lift bids within a penny of the stated offer. I was able to sell a lot without disturbing the market.
If the deal does get voted down, I will buy back in, at much lower prices. If it succeeds, I will take the small gain and move on.
National Atlantic has filed its Preliminary Proxy Statement. I’m only going to tackle one part of it here tonight — the section starting on page 24, “Opinion of the Financial Advisor.” Those who have read me for a long time know that I am neither biased for or against any “fairness opinion.” For those who want to go back to my early days on RealMoney, you can view what I wrote on the MONY acquisition by AXA. The fairness opinion was correct, and the contesting value investors were dead wrong. Part of the problem was not understanding the insurance accounting.
With National Atlantic, I think the fairness opinion does not truly represent the value of the company. Let me go through a few critical bits of the fairness opinion:
(Page 26)
Selected Publicly Traded Companies Analysis. Banc of America Securities
reviewed publicly available financial and stock market information for National
Atlantic and the following seven publicly traded personal lines property and
casualty insurance companies with a market capitalization below $2.5 billion:
o Mercury General Corporation
o State Auto Financial Corporation
o Horace Mann Educators Corporation
o Infinity Property & Casualty Corporation
o Safety Insurance Group, Inc.
o Donegal Group, Inc.
o Affirmative Insurance Holdings, Inc.
Banc of America Securities reviewed, among other things, per share equity
values, based on closing stock prices on March 7, 2008, of the selected publicly
traded companies as a multiple of calendar years 2008 and 2009 estimated
earnings per share, commonly referred to as EPS, and as a multiple of book value
per share as of December 31, 2007 (in the case of Safety Insurance Group and
Affirmative Insurance Holdings, as of September 30, 2007).
Affirmative and Infinity do not belong in this group, because they are both nonstandard auto writers, which get lower valuations than standard writers. Donegal is mainly a commercial writer when last I looked… the rest are fine. I might have included Gainsco, Commerce Group, or Universal Insurance Holdings. In any case, it biases the calculation of the estimated price low.
Implied Per Share Equity Value Reference Ranges for National Atlantic Consideration
--------------------------------------------------------------------- -------------
2008E EPS 2007 Book Value
--------------- -------------------
$3.27 - $4.20 $5.24 - $7.85 $6.25
It also would have been better to do a scatterplot of Price-to-book versus expected ROE on compared companies. I will have to perform that analysis eventually.
(Page 27)
Selected Precedent Transactions Analysis. Banc of America Securities
reviewed, to the extent publicly available, financial information relating to
the following twenty selected transactions involving property and casualty
insurance companies with a transaction value below $500 million:
Announcement
Date Acquiror Target
- --------------- -------------------------------------------------- -----------------------------------------
2/20/08 o Meadowbrook Insurance Group, Inc. o ProCentury Corp.
1/3/08 o QBE Insurance Group Ltd. o North Pointe Holdings Corp.
4/4/07 o Fortress Investment Group LLC o Alea Group Holdings Ltd.
3/14/07 o Argonaut Group, Inc. o PXRE Group Ltd.
12/4/06 o Elara Holdings Inc. o Direct General Corp.
11/22/06 o Clal Insurance Enterprises Holdings Ltd. o GUARD Financial Group Inc.
11/13/06 o Tower Group Inc. o Preserver Group Inc.
10/31/06 o American European Group, Inc. o Merchant's Group Inc.
10/6/06 o Affordable Residential Communities Inc. o NLASCO, Inc.
10/3/06 o Affirmative Insurance Holdings, Inc. o USAgencies, L.L.C.
9/28/06 o Arrowpoint Capital Corp. o Royal & Sun Alliance Insurance
8/16/06 o QBE Insurance Group Ltd. o One Beacon Insurance Group, Ltd.
8/4/06 o Delek Group, Ltd. o Republic Companies Group, Inc.
7/19/06 o Inverness Management L.L.C. o Omni Insurance Group Inc.
11/4/05 o General Motors Acceptance Corp. o MEEMIC Insurance Company
5/22/03 o Liberty Mutual Holding Company Inc. o Prudential Financial Inc.
5/22/03 o The Palisades Group o Prudential Financial Inc.
3/26/03 o Nationwide Mutual Insurance Co. o Prudential Financial Inc.
11/1/00 o American National Insurance Company o Farm Family Holdings, Inc.
10/25/00 o State Automobile Mutual Insurance Company o Meridian Insurance Group, Inc.
The only deal here that would truly be a “comparable” might be Republic Companies. It was a company that was mainly a personal lines company, unlike many of the rest of these deals which are for commercial insurers and reinsurers (I am not familiar with all of them). Republic was sold significantly over its book value. And, where is Commerce Group? I know it is too big to meet the cutoff, but there is a sale of a single state insurer. I would think that valuation would be relevant.
Implied Per Share Equity Value
Reference Ranges for National Atlantic Consideration
------------------------------------------ ------------------
2008E EPS 2007 Book Value
---------------- -------------------
$5.36 - $6.30 $8.51 - $9.82 $6.25
So, I think these values are low as well. There is far more certainty to the valuation of the reserves of a short-tailed insurer, which usually deserves a higher valuation.
(Page 28)
Discounted Cash Flow Analysis. Banc of America Securities performed a
discounted cash flow analysis of National Atlantic to calculate the estimated
present value of the standalone unlevered, after-tax free cash flows that
National Atlantic could generate during National Atlantic's fiscal years 2008
through 2012 based on the National Atlantic management forecasts. Banc of
America Securities calculated terminal values for National Atlantic by applying
terminal forward multiples of 7.0x to 9.0x to National Atlantic's fiscal year
2013 estimated GAAP earnings and of 0.40x to 0.70x to National Atlantic's
estimated 2012 year-end book value. The cash flows and terminal values were then
discounted to present value as of March 7, 2008 using discount rates ranging
from 15% to 17%. This analysis indicated the following implied per share equity
value reference ranges for National Atlantic as compared to the Consideration:
Implied Per Share Equity Value
Reference Range for National Atlantic Consideration
----------------------------------------------- --------------------------
$5.42 - $7.42 $6.25
I’d like to see them spill the guts of the calculation, and the other calculations above as well. Using “0.40x to 0.70x to National Atlantic’s estimated 2012 year-end book value” and “discount rates ranging from 15% to 17%” is too severe. This is a company with no debt. It’s marginal cost of capital, using the “pecking order” theory is low. Also, short-tail P&C companies under competent management teams don’t retain valuations below 0.8x book.
Run-off Analysis. Banc of America Securities also performed a run-off
analysis of National Atlantic to calculate the net present value of dividends
that would be paid to shareholders over the remaining life of the company
assuming that it serviced its existing policies without writing any additional
policies or renewing any existing policies. Based on the assessment of National
Atlantic management that the company would not be permitted to pay annual
dividends by the New Jersey regulators, this analysis calculated the net present
value of the final dividend available for distribution to shareholders after all
payouts on loss reserves and losses on unearned premium reserves, estimated to
be approximately $88.0 million payable in 2016. Banc of America Securities
applied a sensitivity analysis to assess a range of values if the loss reserves
were inadequate by up to 10% or were overstated, showing a redundancy of up to
10%. The range of final dividend distributions were then discounted to present
value as of March 7, 2008 using discount rates ranging from 13% to 17%. This
analysis indicated the following implied per share equity value reference ranges
for National Atlantic as compared to the Consideration:
Implied Per Share Equity Value
Reference Range for National Atlantic Consideration
----------------------------------------------- --------------------------
$1.36 - $3.60 $6.25
Again, the discount rate is too high. Beyond that, they make the fatal assumption that the company can’t close its books until 2016. If National Atlantic stopped writing policies today, then, one year from today, it would receive its last premium. The company would operate with a skeleton staff for one more year, after which, the remaining book could easily be sold to a company specializing in run-offs. You wouldn’t get your money in 2016. It would be more like 2010. Six years of interest discount at 13-17% makes a huge difference in the price.
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I have more work to do here, but my fundamental view is not changed. I will be voting against the deal, and encouraging others to do the same. Should the deal succeed, I will likely file for appraisal rights. As I have noted before, I believe that I have meritorious arguments for a better price.
Given the furor of the day, I thought I might have to abandon the National Atlantic Teleconference call.? I didn’t miss the call.? The transcript is here (thanks, Seeking Alpha).? Let me quote my portion of the call.
=-=-=-==-=-=-=-=-=-=-=-=-==-=-=-=-=-=-=-=-=-
Operator
Thank you, sir. Today?s question-and-answer session will be conducted electronically. (Operator Instructions). We?ll go first to David Merkel of Finacorp Securities.
David Merkel – Finacorp Securities
Hi, Hello.
James V. Gorman
Good morning, David.
David Merkel – Finacorp Securities
Very good. I wanted to ask a little bit about the, you had a number of parties go over your reserves, three and all I believe and how, I would assume at this point you are rather certain that you have been able to clean up most of reserving problems particularly given what was happening in your claim department prior to, I guess September 2007? Can you walk us through that one more time?
James V. Gorman
Yes, we have taken a very hard look at the claim review process, within the claim department. We have modified the procedures, we have updated our diaries. And when you go through a change like this, your historical information and your typical loss development patterns are no longer appropriate to use.
David Merkel – Finacorp Securities
Right.
James V. Gorman
In estimating alternates. So, we had to rely heavily on projecting the open, ultimate number of claims that will be paid and the severity associated with those clients. And I think our review that was done as well as that done by our external auditors have focused on looking at average claim cost as opposed to looking at normal loss development methods.
We continue to look very closely, as part of our quality control process to make sure that the adjusters are in fact keeping claims up to date that we are managing them affectively and that we are in fact putting in place an aggressive settlement policy to move these claims off of our balance sheet. So, we are cautiously optimistic that we have our arms around, our ultimate liabilities. But, obviously there is no guarantee but we have scrubbed this thing it from many different angles.
David Merkel – Finacorp Securities
Great, well that?s good. The re-insurance recoverable change, it was $3.1 million or something like that? What was that about?
James V. Gorman
While we project our direct loses, we also project how much is going to commend in ceded loses and you know based upon our current retention as a company we?ve retained the first 500,000 of loss the emergence of ceded losses is very slow to develop.
David Merkel – Finacorp Securities
Right.
James V. Gorman
And we have looked more carefully at our projected reinsurance recoverables and determined that we are not going to be in a position to collect as much as we had previously thought. This is not connected at all to any reinsurance recoverable on paid clients.
David Merkel – Finacorp Securities
Yes got it.
James V. Gorman
This is based on projected losses.
David Merkel – Finacorp Securities
Okay. Last question, do you have side of your balance sheet, you know, there is a decent amount of turmoil out there now, with respect to various types of AAA structured product and I know you didn?t do that much with subprime or anything like that. But, what are you experiencing if anything on the asset side of your portfolio at present, I assume that it?s just ordinary payments of cash flows from your mortgage bonds and other assets, because you have a fairly high quality portfolio we use the way the rating agencies rate them. Are you experiencing any difficulties there at all?
James V. Gorman
Well, I?ll start that answering your question David and then I?ll turn it to Frank, but from the investments, I would like to just further assure our investors that we have absolutely no subprime exposure. In addition, any bond that we have is A or better on its own merits without the effective any MBIA or AM backed insurance less to the rating, further we have no equities in our portfolio. So, on the investment side, I think that we are pretty planned and pretty solid and we had a great yield in ?07 given all of the decrease in interest, average interest rates. Frank can you add anything to that on the balance sheet.
Frank Prudente
I think you well covered it I may I think we felt for a long time, we have a conservative portfolio and with a disruption we?ve seen in the market it?s evident it?s conservatism by us not having any issues.
David Merkel – Finacorp Securities
Well, thank you gentlemen. I appreciate it and I will be looking forward to any releases that describe the logic for the $6.25 purchase price. So, I thank you both.
James V. Gorman
Thank you, David.
David Merkel – Finacorp Securities
Take care.
=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-
Okay, why did I ask those questions?? Why not bluster about the huge discount to book that they are selling the company at?
Rather than do it that way, I asked about the two least certain items on their balance sheet — their loss reserves, and the value of their assets.? If they express confidence in those two numbers, then it will be hard to back away from an adjusted book value north of $10.? Why does this have value?? Well, there are many other investors bigger than me in the company, and this gives them a reason to vote down the deal.? NAHC has no debt; there is no solvency crisis here, so a large discount to book is not warranted.? With a short-tail P&C company you could hire a specialist to inexpensively run the book off, and after a year or so, sell of the tail of the company.? We would definitely realize a price north of $6.25.
But what if the deal goes through?? In that case, I might not tender my shares, but file for appraisal rights.? I would show the judge the management’s answers to my questions, demonstrating the confidence that they had in the asset values and reserving, immediately after the deal announcement.? It is rare that the judges allow deals to go out at less than tangible book value, particularly on short-tailed P&C companies with little insolvency risk.
So, that’s why I asked those questions.? Now to see what happens.
I have to be careful as I write this post, because I have agreements with my former employer. I will stick with what is publicly understood, and avoid internal knowledge of what my former employer thought when I last worked with them.
Today, after the close, Hovde Capital filed a 13D, seeking to own more than 17% of National Atlantic, and asking for seats on the board of directors. Now, what I want to say to my readers might agree with what Hovde Capital might want. Don’t make too much out of this. First, the New Jersey Department of Banking and Insurance might turn Hovde down. Second, realize that any party acquiring 10% or more of any publicly traded company has to file two days after making any trade. That is the signal that I would be looking for.
National Atlantic is my largest holding, and I am aware of other parties considering buying National Atlantic, but they fail the urgency test for me. There’s lots of talk but no action. Don’t take any action off of Hovde’s SEC filing. There are too many uncertainties here, and wise investors will wait for favorable levels for investing.
Photo Credit: acciarini ||Sometimes a good conversation elucidates a matter…
Q: What defines a safe asset?
A: My, but that is a broad question. Do you have something more specific that you are trying to answer?
Q: Well, I’ve heard that the wealthy often invest their excess assets in real estate. It seems perfect. As Twain said, “Buy land, they aren’t making any more of it.” It provides income, and protects against inflation.
A: Do you own the land free and clear, or did you have to borrow to own it?
Q: I don’t own any land, aside from my house, and yes, I have a mortgage there. Why are you asking this?
A: Do you remember the financial crisis 2008-2011?
Q: Yes, but why does that matter?
A: Many people had paid a lot for their homes, and were stretched in making mortgage payments. Then one of the Ds hit.
Q: My, but he is a piece of work. So, houses aren’t a safe asset?
A: Well, most of the time they are, particularly if don’t have any debt on them. But there are situations where housing prices have been bid up to where the prices don’t justify the cash flows if you are borrowing to own it and are renting it out.
Q: What do you mean?
A: No asset’s price can survive if the implicit net rent is negative. I.e., if you have to feed the property to hold it.
Q: Huh?
A: Imagine that instead of living in your home, you borrowed money to buy the house, and have rented it out. What I am saying is that when those that do this are losing money, the price of the house is too high. They are relying on price appreciation to bail them out, and no one can control that.
Q: Is there a simpler way to say this?
A: When you have to give up money to hold onto an asset, you are in a weak position, and it means you should sell, particularly if many people are having to do the same thing. Properly priced assets produce cash; they don’t consume cash. If on net it is cheaper to rent than borrow and own, then it is probably better to rent.
Q: Are you just saying that risk is a function of the price of the asset? An overpriced asset is risky, and an underpriced asset is not?
A: I am saying that, but there is more to say as well. An asset could be priced below its fair market value, and it could still be risky if it is misfinanced. Take for example the insurance company General American back in August 1999.
Q: Huh?
A: Old news, I know, and most people don’t follow insurers. But they had written a lot of floating rate GICs terminable at par in 7 days if they got a ratings downgrade. What was safe if it had only been 5% of their assets became toxic at 25% of their assets. The amount they were selling ballooned because money market funds could treat the assets as short-term paper.
Once the downgrade came, there was no way to raise that much money so fast. They ended up selling out to MetLife for 50% of their net worth. MetLife picked up control of one of their subsidiaries, RGA, in the process. They made exceptionally good money on that purchase.
It’s like crossing a stream that is 3 feet deep on average, but there is a spot in the middle that is 20 feet deep. If you can’t swim, don’t cross it.
Q: I heard you wrote to Cramer about General American at the time.
A: Yes, that was my first email to him, and I explained the situation in such detail that he republished the email for readers. That was my introduction to Cramer.
Q: So, you are saying there are two things to safety — price and financing?
A: That’s all I’ve said so far, but there are a few other things. The character of management matters. Remember my piece, Dead as a Severed Horse?s Head?
Q: Oh, the zinc miner that sided with the bondholders against the shareholders?
A: Exactly. With better management, they could have skated through the troubles, and perhaps sold the company to a larger base metals miner like BHP.
Q: Well, I read your confession pieces on both of them.
A: It still hurts, but faithful are the wounds of a friend.
Q: Proverbs 27:6, I like it.
A: I still remember the stress and the losses.
Q: Then is that all? Price, leverage, and management?
A: Pretty much. There are some secondary matters to those who do not want to do the hard work. Companies that pay dividends and buy back stock are shareholder friendly, and that is good so long as they don’t borrow too much to do that.
Also, there are the issues of operating leverage — companies with low fixed costs are safer. But that’s about it, unless you want to talk about investments other than stocks.
How I did a bad job for Hovde on Scottish Re and National Atlantic Holdings.? Also, what I did to mitigate the errors.? (And I am supposed to be really good with insurance companies…)
On why the Consolidated Audit Trial [CAT] is a bad idea.? Preventing “flash crashes” is not a desirable goal; they teach people not to use market orders, and to be careful.? The market is a place for big guys, not little guys.
Some academic literature implicitly treats risk premiums as “free money” if you hold it long enough.? But there’s the problem: can you hold it long enough?? Also, sometimes the extra returns are so small that they are not worth the risk.
Some things aren’t meant to be highly liquid, and it is foolish to worry about the lack lack of liquidity.? The second article covered some good questions that I got asked, including bonds that are predominantly “bought and held,” and the limitations on investment banks to hold inventory post-crisis.
What do you recommend when stocks and bonds are likely to return the same amount over the next ten years?? I leaned toward the bonds, which so far has been the wrong call.
How to analyze the cycles that investment ideas go through.? People think about it linearly, which helps lead to the booms and busts.? The second article gives 16 practical applications of the idea to illustrate the general theory.
In this article, I argue that China has been indirectly encouraging its banks to run huge risks by financing illiquid assets with liquid liabilities.? Again, the risk hasn’t materialized yet.
I discussed the unwillingness of Doubleline to cooperate with Morningstar to analyze certain Doubleline funds, and why it was reasonable in some ways for Doubleline to refuse, and Morningstar to not give favorable ratings.? That said, I concluded that Morningstar should apologize to Doubleline.? This article earned me polite calls from both sides, and one request to take the article down voluntarily.? I politely refused.
It is a fatal attraction, but if you are going to write about investing, you will have to make some predictions about markets.? Just try to keep them from being too outlandish.
This was the first of what was going to be sixteen articles.? I was thinking of turning it into a book.? Things have been too busy for that.? This article is about figuring out what you want to do in life.
Many amateur investors give up on a strategy just as it is about to start succeeding, and choose a strategy that has performed well, only to watch it underperform.
I give you at least five reasons why you should bid out your personal insurance policies every three years or so.? Underwriting rules and premiums change, and some companies take advantage of loyalty.
Six years ago, I reviewed a book?The Club No One Wanted To Join. ?It was a poorly done book written by a bunch of people who were swindled by Bernie Madoff. ?Now, I?didn’t want to be unsympathetic — after all, they were cheated. ?But they missed many signals that tipped off others, and could have tipped off them to the fraud. ?Worse, they tried to argue that since many top-performing mutual funds had total returns similar to that of Madoff, there was no way anyone could have figured out that it was a scam. ?They neglected to note that Madoff’s returns were ultra-smooth, while the returns of the mutual funds were not. ?Big difference.
There’s one more thing: many of them gave in to the idea that they had found a hole in the system. ?Far from it being “The Club No One Wanted To Join,” rather, it was their own secret private club that they were smart enough to join when fate smiled on them, and they got their opportunity.
Tonight, I am talking about a different sort of scam that sucked in a different class of people. ?This scam was a corporation where the management took a?firm into bankruptcy that could easily pay its debts, at least in the short-run. ?The management likely conspired with the bondholders against its shareholders, seemingly in an effort to gain a greater reward from the bondholders who would own the firm post-bankruptcy than they could from operating the firm outside of bankruptcy. ?The name of this firm is Horsehead Holdings [ZINCQ].
I’m not writing about?this to give a blow-by-blow description of how the bondholders and management cheated shareholders out of their ownership interests, though I will touch on that at points. ?I am writing about this to respond to those who wrote to me in the midst of the bankruptcy trial to try to gain some coverage of what was going on.
Over 20 people wrote to me and almost 100?journalists/media in an attempt to create “viral” coverage of the trial, and if nothing else, bring public attention to the travesty that was the bankruptcy process. ?As it is, I wrote one paragraph on the matter, but I didn’t see anything from any major publication until after the trial completed. ?I did mention to a number of the writers that efforts to get coverage would not affect the outcome of the bankruptcy court; it is relatively insulated from public opinion, as it should be.
(As an aside: if you write such a letter to journalists, or me, try to stay on topic. ?It is not relevant to call the bondholders “greedy,” that they are a hedge fund, or talk about their prior dealings with Collateralized Debt Obligations that failed during the recent financial crisis.)
Aleph Blog is mostly about risk control. ?As I read the letters from the shareholders who were watching their ownership rights be destroyed, I noted a few things that might have enabled some of them to avoid much of the unfavorable outcome:
Buying a levered highly cyclical company.
Relying on the insights of bright investors who buy concentrated stakes ?in a few companies.
Not diversifying enough.
Let me take these in order:
Buying a levered highly cyclical company
If you look at the risk of owning a single company, there are two ways where a company can affect the degree to which a change in sales can raise the profits of the company. ?The first way is to choose a production method that has high fixed costs and low variable costs, which is typically true of cyclical companies. ?The second way is to borrow money. ?Both methods magnify returns, right or wrong.
Typically, you only do one at a time. ?Supermarkets are stable, so they often borrow more to lever up returns. ?Mining companies, among other industries that require heavy capital investment, are anything but stable booms and busts are common and follow product prices.
Horsehead Holdings had a high degree of leverage from both debt and being in a cyclical industry. ?It ran into a scenario where the price of its main product, zinc, fell hard. ?At the time before they filed for bankruptcy, management could legitimately say to themselves, “If the price of zinc remains this low we will shortly be insolvent, particularly if our new processing plant doesn’t work out.”
Now, the bankruptcy code is a rather flexible beastie. ?It allows for a management team to file before things are at their worst so that they can try to preserve a better outcome for the company. ?My suspicion is that management’s motives were mixed when they filed — they wanted the best deal they could get for themselves, but may have assumed that there wasn’t much life left to the equity anyway. ?Who could have predicted that the price of zinc would rally back so much, such that the company could have survived in its pre-bankruptcy state?
Now, has this ever happened to me? ?Not exactly, but there are other ways that managements can dispose of a company to the detriment of the stockholders. ?I lost money on C. Brewer Homes when management did a leveraged buyout when the stock price was unduly depressed. ?Enough stock was in the hands of arbs that the deal went through. ?Oh, and if you want another one, there was the loss on National Atlantic Holdings which I described in ugly detail in this article.
The main point is this: don’t assume that management will act in the interests of stockholders, particularly in a stressed situation. ?The leverage and cyclicality of Horsehead Holdings set up the possibility of that occurrence, and the fall in the price of zinc triggered it.
Relying on the insights of bright investors who buy concentrated stakes ?in a few companies
I respect both Mohnish Pabrai and Guy Spier. ?They are bright guys, and from what I can tell at a distance, ethical too. ?They were big holders of Horsehead Holdings, and I’m sure they had good reasoning behind their decisions. ?But, even excellent investment managers aren’t infallible. If you are just picking one of their ideas, that could be a rocket to the sky — or the ground, while their portfolio as a whole might do well.
Also, they will make their decisions with some lead time over you if the data shifts. ?Any investment advisor you mimic is not required to tell you when they change their mind, aside from required filings with the SEC… which are delayed, and sometimes don’t cover everything.
Has this happened to me? ?Yes it has. ?I have sometimes invested partly ?on who is invested in a company, though never to the point of not?doing my “due diligence.” ?But aside from some early failures 20+ years ago, it never hurt me much because I was never guilty of:
Not Diversifying Enough
A number of the people emailing me said they put more than half their savings into Horsehead Holdings. ?If you are going to engage in such risky behavior, you need to know more than everyone else investing in the stock. ?No exceptions. ?I agree with investing in a concentrated way, but?my view of that for average people is no positions larger than 5% of your capital. ?That is plenty concentrated enough.
I have one holding that is 13% of my assets — a private company that I know exceptionally well. ?My house is another 13%. ?After that, my next largest holding is 3% of my assets. ?I believe in the assets that I buy, but I concentrate enough by only owning individual stocks, and very little in the way of pooled investment vehicles.
Again, my sympathies to those who lost on Horsehead. ?I can’t do anything about those losses. ?At least you have the opportunity to sue the?management of the company. ?It certainly seems like the management team cheated the stockholders, though I can’t say for sure.
What I can help are future investors, and my counsel is this: Diversify! ?You are your own best defender, so don’t merely mimic bright investors; do your own due diligence. ?Be wary of investing in cyclical companies with high debt levels. ?Don’t implicitly trust that management teams will act in your interest. ?And finally, diversify, as it protects against failures in other areas.
PS — I looked through my notes of the past. ?I did look at Horsehead Holdings, and I passed on it. ?That said, I don’t know why… hopefully it was for a good reason, though I expect that I didn’t have room for another cyclical company, and not another one in base metals.
Let me start at the beginning. ?NAHC was an insurer with a niche presence in New Jersey. ?They competed only in personal lines, which usually is easy to analyze. ?New Jersey was a tough but not impossible state to operate in, and NAHC was a medium-sized fish for the size of the pond that they were in.
Chubb was not in NewJersey at that point in time, and so they wanted to insure autos, homes, and personal property, particularly that of wealthy people.
I thought it was an interesting company, trading slightly below tangible book, with a single-digit multiple on earnings, good protective boundaries, and a motivated management team. ?The CEO owned over 10% of the firm, which seemed to be enough to motivate, but not enough to ignore shareholders.
In 2005, we bought a 5%+ stake in the company, which in 2006 became 10%+, and eventually topped out at 17%. ?We might have bought more with the approval of the NewJersey Department of Insurance, which was easy at lower levels, and harder at higher levels, which was an interesting anti-takeover defense.
The company showed promise in many ways, but always seemed to have performance issues — little to medium surprises every few quarters. ?The stock price didn’t do that much bad or good. ?When I left Hovde at the end of July 2007, the position was at a modest gain. ?Hovde had a hard time finding long names in that era, so the performance up to that point wasn’t that bad.
If you want to see my original logic for buying the stock after I left Hovde, you can read it here.
Here was the stock price graph from May 2007 to May 2008:
My old employer Hovde owned 17%. ?I eventually owned 0.15%, at the prices you see there, at an average cost of $6.67 for me. ?I eventually sold out at an average price of around $6.10. ?(In the above graph, “Exit” was not a sale, but where I cut off the calculation.) ?This wasn’t my worst loss by any means, but it cost my former employer badly, and it was my fault, not theirs.
What Went Wrong?
Their competitive position deteriorated as companies that previously avoided New Jersey entered the state.
They announced that they had reserving errors, and reported moderate?losses as a result.
They announced a sale to Palisades Insurance, a private New Jersey insurer for $6.25/sh, valuing the company at less than 60% of tangible book value. ?The fairness opinion was a bad joke. ?The company would have been worth more in run-off.
Really, the management team was weak.
The first problem would be a tough one to solve. ?On the second problem, I never got a good answer to how the loss reserves got so cockeyed, and somehow no one was to blame for it. ?This is personal lines insurance — the reserves validate themselves every year.
But the third problem made me think the management was somewhat?dishonest. ?A larger company could have paid a higher price for NAHC, but that probably would have meant that management would lose their jobs. ?They gave shareholders the short end of the stick for the good of management, and perhaps employees.
My biggest error was giving too much credit, and too much patience to the management team. ?I met far better management teams in my time as a buy-side analyst, and they were on the low end of the competence scale. ?I let cheapness and a strong balance sheet blind me to the eroding competitiveness, and weak ability to deal with the problem.
Ultimately, Hovde found itself in a weak position because it could not file for appraisal rights, a fraud case would have been weak, and the NJ Department of Insurance would not let them acquire enough to block the deal. ?Besides, once arbs got a hold of over 40% of the shares, the deal was almost impossible to block.
As I often say, risk control is best done on the front end. ?On the back end, solutions are expensive, if they are available at all.
The front end for you can be learning from my errors. ?Wise men learn from the mistakes of others. ?Average men learn from their own mistakes. ?Dumb men never learn.
In closing, be conservative in investing, and be wise. ?I thought I was being both, so seek the counsel of others to check your logic.
In hindsight, I’m not happy about what I wrote August-October 2007.? As the bubble built I criticized it in fainter ways than it deserved.? Given the implosion of money markets, I should have been more bearish.? Part of that faintness stemmed from the stigma that came to bears in that era.? But here are articles from that era:
Subprime was getting blamed, but there were many areas where markets were very speculative at the time.? I call them out here, and I was not often wrong.
I got a lot of publicity over this one.? I may do another one in 2011.? It is important to understand that those on the FOMC are not geniuses.? They are bright, but slaves to a view of the world that is not accurate.? The Fed drinks their own Kool-aid.
As the markets declined, there were a lot of signs of the oncoming trouble that were ignored.? Following market liquidity was an aid to avoiding some of the crisis that was to come.
I get some publicity for being a little ahead of the crowd in suggesting that Minsky was correct in the way he viewed economic cycles.? I also anticipate what will happen one year later.
In this article, I attempted to estimate what variable drove stock market performance in aggregate ten years out.? I discovered:
My Upshots
Note that it was a bullish period, and that stocks did not lose nominal money over a ten-year period to any appreciable extent.
Stocks almost always beat bonds over a ten-year period, except when inflation and real interest rates 10 years from now are high.
Investing in stocks during low interest rate environments can be hazardous to your wealth.
Watch for inflation pressures to protect your portfolio. Stocks get hurt worse than bonds from rising inflation.
Inflation and real rate cycles tend to persist, so when you see a change, be willing to act. Buy stocks when inflation is cresting, and buy short-term bonds when inflation is rising
I argued that if many hedge funds had mismarked assets, then many investment banks would as well.? Definitely worked out that way, but bigger than I expected.
This was a forty minute talk that I gave to the Society of Actuaries at their Annual Meeting.? Very big picture, and very prescient.? Worth a look if you have 15 minutes sometime.? I put a lot of work into this one.
Every now and then, some crank like Bill Clinton comes up with the idea that “all we gotta do is invest the Social Security trust funds in the stock market, and the funding problem will go away.”? This is the antidote to that malarkey.
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But, as the markets approached their recent highs during this period, I was skeptical, but insufficiently skeptical.? Further, I blew it on Deerfield, National Atlantic, and my view of how FOMC policy would evolve.? So for this era of my blogging, I have my regrets — I should have done better, even though I got some interesting things right.
Three notes on the blog itself.? 1) I will be guest-blogging for one post at another site on Thursday.? Won’t say where, but watch for “The Fundamentals of Real Estate Market Bottoms.”? It will be reposted here Thursday evening.? 2) I can’t paste certain bits of code in my blog because of a WordPress limitation introduced in version 2.5.? As of now, that won’t be remedied until version 2.9, which as far as I can tell, is a huge update, and is at least half a year off.? 3) I have not left RealMoney, though I have not posted there in a while.? I started this blog so that I would have a site with my own distinct voice, and so that I could have greater creative freedom to write about things dearer to me that I felt would not fit the RM audience.? Also, I felt that I had run out of articles to write, simply because I held myself to a higher standard, and didn’t want to write articles just for the sake of putting something into print.? RM readers deserve better.? I will come back to posting at RM, I just don’t know when, amid my current busy-ness.
For a six-week period, that ‘s a decent number of trades, at least for me.? My methods are designed to try to not trade frequently, but to trade to minimize risk and maximize return in a majority of situations.? For those not familiar with my rebalancing trades, I keep a fixed set of target weights in a largely equally-weighted portfolio.? When a security gets more than 20% away from its target weight, I buy (after review) to bring it back to target weight, or sell to bring it back to target weight (take some money off the table).
There have been three other actions during this time. 1) National Atlantic’s merger went through.? A loss for me, but I ain’t missing them at all.? 2) After the buyback announcement, I traded my holdings in Anadarko for holdings in Devon Energy.? I like the valuation, and the Natural Gas exposure better at Devon.? 3) I tendered all my MetLife shares for shares in RGA.? I like RGA a lot here and am willing to make it a double-weight in my portfolio. In the current tender offer, I should get approximately 10% more value in RGA shares for my MetLife shares, subject to a number of conditions listed in the prospectus.? Also, RGA is a unique company that makes its profit mainly from mortality, which is not correlated with other financials.? It is a well-run company, and deserves to be valued at a significant premium to book value.
Full disclosure: long RGA MET DVN SCVL GPI SFD JNY IRF OMX UAM XEC VLO CHIC AIZ IBA CX NTE ESV
