Portfolio Reshaping Mid-Year 2007, Part 2

Posted on 23 June 2007 by David Merkel

Here are my current industry ratings.? Using my Bloomberg Terminal, I? ran a screen looking for cheap companies in those industries.? The result yielded eight tickers:

ACO CONN GMRK HES NSIT PDE SMRT SSI

I also added in the top 12 tickers from the last time that didn’t make it into my portfolio, and aren’t on the current list.? Here are the tickers:

ABFS [DBK GR] FINL FL GGC HERO [NGX CN] PTSI RADN SNSA URI WIRE

If you have other stock ideas for me, let me know (post a comment!).? Remember that I am a value investor.? I like them cheap.

Aside from any names that readers might give me, my list of possible replacements is done.? All that is left is to run my valuations/technicals model, and think about what to but and sell.? Early next week, I will run those models, and make the decisions by Independence Day.

Portfolio Reshaping Mid-Year 2007, Part 1

Posted on 23 June 200723 June 2007 by David Merkel

Well, the second portfolio reshaping of the year has begun. To refresh your memory on what I do here, you can review this short post. Here are the tickers from my initial stack, candidates to replace my current portfolio:

ABY ACI ACTU AFN APA ARLP ASEI BBG BHP BLX BMI BOW BTU BVN C CBE [CMB PE] CMC CNX CQB [CRY CN] CRZ CTHR CTL CVX CWEI CY DELL DNR DVN DVR EMR EOG EPEX EPL ERF ESV FCGI FCX FRD FRO FRX FSS FST FTO GIFI GMK GMR GSF GVHR GW GYI HHGP HNR IDCC IMMR IMOS INTX IO IR ITW IVAC KAR KEP LRCX LRW [LUN CN] MEOH MGS MKSI MLR MRO MTL MVC NAT NBL NBR NFX NR NRP OMM OPMR PCZ PH PRKR PTEN PVX PWE R RDC RDS RGS RIG RIO ROK RRC RSH S SHOO SPH SPI STZ SU SWKS TAP TLM TPL TSO TX TXI TYC UNT UNTD UPL WCC WDC WFC WIN XTO

If you have ideas, post them in the comment section of this post.? I’ll be running my industry model and an additional screen to generate a few more tickers, and then the comparison to my current portfolio. I should have more later today. Till then.

Supply and Demand Factors in the Equity Market

Posted on 18 June 2007 by David Merkel

My posting philosophy when doing commentary on the news is not to do “linkfests,” much as I like them, but to try to give a little more thought behind what has been written, and try to weave them into a greater coherent whole.? My career has been diverse; if I wanted to be mean I would say that I was a dabbler, a patzer, a dilettante.? A jack of all trades and a master of none.? The strength of my varied career is that I have insights into a wide number of areas in the markets, and how they interconnect.? I have always believed that understanding multiple markets helps shed light on each one individually.

So, when I comment on the news, it is my aim to give you a broader perspective on the major factors influencing our investment decisions.? That also means that I might not be commenting on what is breaking news, but on what trends are going on behind the scenes.? Today’s topic is supply and demand factors in the equity market… the true technical analysis. 😉

Let’s start with Jeff Miller at A Dash of Insight. He gives the classic case of why a management would buy back stock.? A management team is able to capture more of the excess returns that the business is earning by substituting cheaper debt for equity in their capital base.? In moderation, this is a decent strategy; it is a strategy increasingly employed because of high profit margins and low interest rates.

Now, as you go through this discussion, you will run into the term “Fed Model.”? The Fed model is a simplified version of a discounted cash flow model, where the earnings of an equity market are discounted using a common interest rate, frequently a long treasury rate, and compared to the current price, to see whether stocks are rich or cheap.? (Note: this calculation does not actually prove whether stocks are absolutely rich or cheap, but only rich or cheap relative to bonds.)? In practice, the calculation can come down to comparing the earnings yield of an index (earnings divided by market capitalization) to the yield on the long Treasury note.

Use of this model is controversial and can produce widely varying results depending on your assumptions.? Take for example, this article over at Trader’s Narrative. It draws the conclusion that the market is “extremely undervalued” at these levels.? This is true, if interest rates and credit spreads stay low, and profit margins stay high.? All three data series tend to mean revert, so how long these factors remain favorable is open to question.? Nonetheless, in the past, comparing treasury and earnings yields was a smart strategy.? Will that continue?

John Hussman ably argues that profit margins are mean-reverting, and that the relationship of earnings yield to bond yields has been spotty at best.? I agree with both of those ideas, but with some caveats:

Profit margins could remain high for a longer time than anticipated because of increased globalization, and increased willingness to lever up.
The relationship of earnings and bond yields has gone through eras where there has been extreme greed and fear.? That earnings and bond yields do not track perfectly is not a weakness, but a strength of the model.? If they tracked perfectly, there would be nothing to game here.? At extreme differences the yield differential produces signals that will make money, and reduce risk to investors.? (Personally, I like my models to explain half of the variation or so — a good balance between there being a signal, and having significant noise to exploit.)

I expect profit margins to mean-revert, but what if they don’t do so quickly?? As an example, consider the upside surprise delivered in the first quarter.? US corporations don’t just depend on the US economy anymore; they sell outside the US, and buy resources outside of the US, even labor (outsourcing).? With a weak dollar, earnings in dollar terms surprised on the upside.? Buybacks also increased earnings per share.

Ignore Shiller when he does the 10-year average earnings.? 10-year averages are less representative of future earnings than the current year’s earnings.? There has been a lot of earnings growth for sustainable reasons.? Could earnings pull back significantly?? Yes, but not to the 10-year average, unless we get a depression.

What of rising interest rates?? Will they derail the equity market?? Some think so.? Some think not.? My view is that at around 6.50% on the 10-year Treasury, bonds would present serious competition to stocks.? Down here around 5.15%, we will continue to have the substitution of debt for equity through LBOs and buybacks.? Despite the volatility, investment grade credit spreads are still tight, and the collateralized loan obligation market is still active, allowing LBOs to be more easily financed.? Further, there is a yield hunger on the part of buyers that allows corporations to sell debt, even subordinated debt cheaply.? This will eventually change, but we need some genuine failures of investment grade companies to demonstrate the real risks of borrowing too much.

In the short run, that IPOs are being well-received is a plus to the market.? There is demand for stock.? In the long run, buying at low P/Es is also a plus (ask David Dreman).? That’s not true now, except relative to bonds, which are providing little competition to stocks.

So where does that leave me?? My view is more complex than many of the caricatures being trotted out.? Let me give you the main ideas:

Comparing earnings yields to bond yields is useful, but must be done with discretion.
Profit margins will mean-revert, but given globalization, and its effect in restraining wages, that may be a while in coming.? How much do you want to leave on the table?
Demographic trends should keep real interest rates low.? The graying of the global Baby Boomers is one of the factors keeping interest rates low.? Retirees and near-retirees want income, and that is surpressing interest rates.
Also suppressing interest rates are those that have to recycle the US current account deficit.? Until we see large currency revaluations in countries that have large surpluses with the US, rates should stay low.
Until we get a significant set of defaults in the credit markets, credit spreads should stay low.? At present, there is too much vulture capital lurking, waiting to buy distressed assets.? The distressed investing community needs to be seriously scared; then maybe valuations will head south.

So, reluctantly, in the short run I carry on as a moderate bull.? That said, the valuations in my portfolio are cheap relative to the market, and the balance sheets are stronger than average.? The names are inclined more toward global growth than US growth.? Many companies in my portfolio have buybacks on, but none are doing it to the level where it compromises their credit quality.

Trends have a nasty tendency to persist longer than fundamental investors would anticipate.? So it is with the markets at present.? Honor the momentum, but keep one eye on shifts in interest rates and profit margins.

How Do You Value an Insurance Business?

Posted on 6 June 20076 June 2007 by David Merkel

As Paul mentioned in the comments on the last post, I answered a question at Stockpickr.com today. James Altucher, the bright guy who founded the site, asked me if I would answer the question, and so I did. Here is a reformatted version of my answer, complete with links that work:

Q: Any thoughts on how to value an insurance business? What are the best metrics to use? In particular I’m looking at small cap insurers (P&C) as potential acquisition targets. Does that change the methodology?

A: That’s not an easy question, partly because there are many different types of insurance companies, and each type (or subsector) gets valued differently due to the degree of growth and/or pricing power for the subsector as a whole.

Now, typically what I do as a first pass is graph Price/Book versus return on equity for the subsector as a whole, and fit a regression line through the points. Cheap companies trade below the line, or, are in the southeast corner of the graph.

But then I have to make subjective adjustments for reserve adequacy, excess/noncore assets, management quality, pricing power on the specific lines of business that write as compared to their peers, and any other factors that make the company different than its peers. When the industry is in a slump, I would have to analyze leverage and ability of the company to upstream cash from its operating subsidiaries up to the parent company.

Insurance is tough because we don’t know the cost of goods sold at the time of sale, which requires a host of arcane accounting rules. That’s what makes valuation so tough, because the actuarial assumptions are often not comparable even across two similar companies, and there is no simple way to adjust them to be comparable, unless one has nonpublic data.

My “simple” P/B-ROE method above works pretty well, but the ad hoc adjustments take a while to learn. One key point, focus on management quality. Do they deliver a lot of negative surprises? Avoid them, even if they are cheap. Do they deliver constant small earnings surprises? Avoid them too… insurance earnings should not be that predictable. If they become that predictable, someone is tinkering with the reserves.

Good insurance managements teams shoot straight, have occasional misses, and over time deliver high ROEs. Here are three links to help you. One is a summary article on how I view insurance companies. The second is my insurance portfolio at Stockpickr. The last is my major article list from RealMoney. Look at the section entitled, “Insurance & Financial Companies.”

Now, as for the small P&C company, it doesn’t change the answer much. The smaller the insurance firm, the more it is subject to the “Law of Small Numbers,” i.e., a tiny number of claims can make a big difference to the bottom line result. Analysis of management, and reserving (to the extent that you can get your arms around it) are crucial.

As for takeover targets, because insurers are regulated entities, they are difficult to LBO. Insurance brokers, nonstandard auto writers, and ancillary individual health coverage writers have been taken private, but not many other insurance entities. State insurance commissioners would block the takeover of a company if it felt that the lesser solvency of the holding company threatened the stability of the regulated operating companies. The regulators like strong parent companies; it lets them sleep at night.

One more note: insurance acquisitions get talked about more than done, because acquiring companies don’t always trust the reserves of target companies. Merger integration with insurance companies has a long history of integration failures, so many executives are wary of being too aggressive with purchases. That said, occasionally takeover waves hit the insurance industry, which often sets up the next round of underperformance, particularly of the acquirers.

How to Sell a Securitization

Posted on 4 June 2007 by David Merkel

In securitizations, a series of assets, typically ones with well defined payoffs, such as fixed income (bonds and loans) and derivatives of fixed income get placed in a trust, and then the trust gets divided up into participations of varying riskiness. The risks can be ones of cash flow timing (convexity) and/or credit. Regardless of what the main risk is, the challenge for those issuing the securitization is who will buy the riskiest participations.

When the market is hot, and there are many players gunning for high income, regardless of the risk level, selling the risky pieces is easy, and that is what conditions are like today, with the exception of securitizations containing subprime loans.? When the market is cold, though, selling the risky pieces is hard, to say the least.? If market conditions have gotten cold since the deal began to be assembled, it is quite possible that the will not get done, or at least, get done at a much smaller profit, or even a significant loss.

In that situation, hard choices have to be made.? Here are some options:

If there is balance sheet capacity, keep the risky parts of the deal, and sell the safer portions.? Then if the market turns around later, sell off the risky pieces.
If there is a lot of balance sheet capacity, hold all of the loans/bonds and wait for the day when the market turns around to do your securitization.
Sell all of the loans/bonds off to an entity with a stronger balance sheet, and realize a loss on the deal.
Reprice the risky parts of the deal to make the sale, and realize a loss.

The proper choice will depend on the degree of balance sheet capacity that the securitizer has.? Balance sheet flexibility, far from being a waste, is a benefit during a crisis.? As an example, in 1994, when the residential mortgage bond market blew up, Marty Whitman, The St. Paul, and other conservative investors bought up the toxic waste when no one else would touch it.? Their balance sheets allowed them to buy and hold.? They knew that at minimum, they would earn 6%/year over the long haul, but as it was, they earned their full returns over three years, not thirty — a home run investment.? The same thing happened when LTCM blew up.? Stronger hands reaped the gains that the overly levered LTCM could not.

In this era of substituting debt for equity, maintaining balance sheet flexibility is a quaint luxury to most.? There will come a time in the next five years where it goes from being a luxury to a necessity.? Companies that must securitize will have a hard time then.? Those that can self-finance the assets they originate will come through fine, to prosper on the other side of the risk cycle.? Be aware of this factor in the financial companies that you own, and be conservative; it will pay off, eventually.

Going Through the Research Stack

Posted on 31 May 200731 May 2007 by David Merkel

Once every two months or so, I go through my “research stack” and look at the broad themes that have been affecting the markets. Here is what I found over vacation:

Inflation

Commodity prices are still hot, as are Baltic freight rates, though they have come off a bit recently. Lumber is declining in the US due to housing, but metals are still hot due to global demand. Agriculture prices are rising as well, partly due to increased demand, and partly due to the diversion of some of the corn supply into ethanol.
While the ISM seemingly does better, a great deal of the increase comes from price increases. On another note, the Implicit Price Deflator from the GDP report continues to rise slowly.
Interest rates are low everywhere, at a time when goods price inflation is rising. Is it possible that we are getting close to a global demographic tipping point where excess cash finally moves from savings/investment to consumption?
At present, broad money is outpacing narrow money globally. The difference between the two is credit (loosely speaking), and that credit is at present heading into the asset markets. Three risks: first, if the credit ignites more inflation in the goods markets which may be happening in developing markets now, and second, a credit crisis, where lenders have to pull back to protect themselves. Third, we have a large number of novice central banks with a lot of influence, like China. What errors might they make?
The increase in Owners Equivalent Rent seems to have topped out.

International

Global economy strong, US is not shrinking , but is muddling along. US should do better in the second half of the year.
The US is diminishing in importance in the global economy. The emerging markets are now 29% of the global economy, while the US is only 25%.
Every dollar reserve held by foreigners is a debt of the US in our own currency. Wait till they learn the meaning of sovereign risk.
Europe has many of the problems that the US does, but its debts are self-funded.
The Japanese recovery is still problematic, and the carry trade continues.
Few central banks are loosening at present. Most are tightening or holding.
There is pressure on many Asian currencies to appreciate against the dollar rather than buy more dollar denominated debt, which expands their monetary bases, and helps fuel inflation. India, Thailand, and China are examples here.

Economic Strength/Weakness

We have not reached the end of mortgage equity withdrawal yet, but the force is diminishing.
State tax receipts are still rising; borrowing at the states is down for now, but defined benefit pension promises may come back to bite on that issue.
Autos and housing are providing no help at present.

Speculation, Etc.

When are we going to get some big IPOs to sop up some of this liquidity?
Private bond issuers are rated one notch lower in 2007 vs 2000. Private borrowers in 2007 are rated two notches lower than public borrowers, on average. Second lien debt is making up a larger portion of the borrowing base.
Because of the LBOs and buybacks, we remain in a value market for now.
Volatility remains low ? haven?t had a 2% gain in the DJIA in two years.
Hedge funds are running at high gross and net exposures at present.
Slowing earnings growth often leads to P/E multiple expansion, because bond rates offer less competition.
Sell-side analysts are more bearish now in terms of average rating than the ever have been.
There are many ?securities? in the structured securities markets that are mispriced and mis-rated. There are not enough transactions to truly validate the proper price levels for many mezzanine and subordinate securities.

Comments to this? Ask below, and I’ll see if I can’t flesh out answers.

One Dozen More Compelling Articles Around the Web

Posted on 11 May 2007 by David Merkel

1)? Picking up where I left off last night, I have a trio of items from Random Roger.? Is M&A Bullish or Bearish?? Great question.? Here’s my answer: at the beginning of an M&A wave, M&A is unambiguously bullish as investors seize on cheap valuations that have gone unnoticed.? Typically they pay cash, because the investors are very certain about the value obtained.

From the middle to the end of the M&A wave, the action is bullish in the short run, and bearish in the intermediate term.? The cash component of deals declines; investors want to do the deals, but increasingly don’t want to part with cash, because they don’t want to be so leveraged.

My advice: watch two things. One, the cash component of deals, and two, the reaction of the market as deals are announced.? Here’s a quick test: good deals increase the overall market cap of the acquirer and target as a whole.? Bad deals decrease that sum.? Generally, deal quality by that measure declines over the course of an M&A wave.

2) Ah, the virtues of moderation, given that market timing is so difficult. This is why I developed my eight rules, because they force risk control upon me, making me buy low and sell high, no matter how painful it seems.? It forces me to buy when things are down, and sell when things are running up.? Buy burned out industries.? Reshape to eliminate names tht are now overvalued.? These rules cut against the grain of investors, because we like to buy when comapnies are successful, and sell when the are failures.? There is more money to be made the other way, most of the time.

3) From Roger’s catch-all post, I would only want to note one lesser noticed aspect of exchange traded notes.? They carry the credit risk of the issuing institution.? As an example, my balanced mandates hold a note that pays off of the weighted average performance of four Asian currencies.? In the unlikely event that Citigroup goes under, my balanced mandates will stand in line with the other unsecured debtholders of Citigroup to receive payment.

4) Bespoke Investment Group notices a negative correlation between good economic reports and stock price performance.? This should not be a surprise.? Good economic news pushes up both earnings and bond yields, with the percentage effect usually greater on bond yields, making new commitments to bonds relatively more attractive, compared to stocks.

5) From a Dash of Insight, I want to offer my own take on Avoiding the Time Frame Mistake.? When I take on a position, I have to place the idea in one of three buckets: momentum (speculation), valuation, or secular theme.? What I am writing here is more general than my eight rules.? When I was a bond manager, I was more flexible with trading, but any position I brought on had to conform to one of the three buckets.? I would buy bonds of the brokers when I had excess cash, and I felt the speculative fervor was shifting bullish.? If it worked, I would ride them in the short run; if not, I would kick them out for a loss.

Then there were bonds that I owned because they were undervalued.? I would buy more if they went down, until I got to a maximum position.? If I still wanted more, I would do swaps to increase spread duration.? But when the valuations reached their targets, I would sell.

With bonds, secular themes don’t apply so well, unless you’re in the mid-80s, and you think that rates are going down over the next decade or two.? If so, you buy the longest noncallable bonds, add keep buying every dip, until rates reach your expected nadir.? Secular themes work better with equities, where the upside is not as limited.? My current favorite theme is buying the stock of companies that benefit from the development of the developing world.? That said, most of those names are too pricey for me now, so I wait for a pullback that may never come.

6) I’ve offered my own ideas of what Buffett might buy, but I think this article gets it wrong.? We should be thinking not of large public businesses, but large private businesses, like Cargill and Koch Industries.? Even if a public business were willing to sell itself cheap enough to Buffett, Buffett doesn’t want the bidding war that will erupt from others that want to buy it more dearly.? Private businesses can avoid that fracas.

7) And now, a trio on accounting.? First, complaints have arisen over the discussion draft that would allow companies to use IFRS in place of GAAP.? Good.? Let’s be men here; one standard or the other, but don’t allow choice.? We have enough work to do analyzing companies without having to work with two accounting standards.

8) SFAS 159?? You heard it at this blog first, but now others are noticing how much creative flexibility it offers managements in manipulating asset values to achieve their accounting goals.? My opinion, this financial accounting standard will be scrapped or severely modified before long.

9) Ah, SFAS 133. When I was an investment actuary, I marveled that hedges had to be virtually perfect to get hedge treatment.? Perfect?? Perfect hedges rarely exist, and if they do, they are more expensive than imperfect ones.? Well, no telling where this one will go, but FASB is reviewing the intensely complex SFAS 133 with an eye to simplifying it.? This could make SFAS 133 more useful to all involved… on the other hand, given their recent track record, they could allow more discretion a la SFAS 159, which would be worse for accounting statement users, unless disclosure was extensive. Even then, it might be a lot more work.

10) ECRI indicates better growth and lower inflation coming soon.? I’ll go for the first; I’m not so sure about the second, with inflation rising globally.

11) What nation has more per capita housing debt then the US?? Britain. (And its almost all floating rate…)? With economics, it is hard to amaze me, but this Wall Street Journal article managed to do so.? Though lending institutions bear some blame for sloppy underwriting, it amazes me that marginal borrowers that are less than responsible can think that they can own a home, or that people who have been less than provident in saving, think that they can rescue their retirement position by borrowing a lot of money to buy a number of properties in order to rent them out.? In desperate times, desperate people do desperate things, but most fail; few succeed.? We have more of that to see on this side of the Atlantic.

12) I am not a fan of what I view as naive comparisons to other markets and time periods.? There has to be some significant similarity in the underlying economics to make me buy the analogy.? Thus, I’m not crazy about this comparison of the current US market to the Nikkei in the late 80s.? Japan was a much more closed economy, and monetary policy was far more loose than ours is today.? I can even argue that the US is presently relatively conservative in its monetary policy versus the rest of the developed world.? So it goes.

Four Interesting Things I Have Seen Around the Web

Posted on 10 May 200710 May 2007 by David Merkel

1) In Grad School, one of my Ph. D. fields was econometrics. In general, I agree with this piece by Jeff Miller on the payroll survey, but I have a few things to add. My main problem with the birth-death model is that they use an ARIMA model. We only use ARIMA models when we don’t have sufficient cofactors to try to explain something structurally. At best, an ARIMA model is the reduced form solution to the broader structural model for which we do not have data. Second, I would simply add that the true error bonds on the month-to-month change are large, and I would advise everyone to look at year-over-year changes to get a better sense of the trend in the economy. As Morganstern showed over fifty years ago, economic data has so much noise that noise swamps signal until you look at year-to-year changes.
2) From the ever excellent Daniel Gross at the NYT, comes his piece questioning how important the US is the US to the global economy at present. I have written about the same thing over at RealMoney. With the US accounting for a shrinking fraction of global trade, it is hard to see how the role of the US is not diminishing here. We need to get used to the idea that we are “first among equals,” and make our policy requests as a part of coalition building among the nations that trade.
3) In general, I like John Hussman; I have learned a lot from him. We even live in the same city. That said, his commentary on share buybacks needs some clarification. Once a buyback is completed, the economics of the buyback are reflected in the diluted EPS. One should not count it as a dividend; the increment to book value reflects the change in value. But after the announcement, but prior to the buyback itself, investors analyze whether a management team is credible on the announcement. Does management follow though? Can the balance sheet handle it? Credible management teams can make the stock price rise with the mere mention of a buyback.

4) Calling John Henry and his modern counterparts: can traders be replaced by computer algorithms? Average traders, yes. The best traders, no. Good trading relies on a variety of factors that are difficult to turn into math. I learned that as a corporate bond manager/trader. Sensing when the speculative nature of the market is turning is touchy. There are many aspects of that that I think would be difficult to teach to a machine. It’s one thing for a computer to beat us at chess, which is a relatively simple game, but when will one beat us consistently at poker?

I have more, but I will publish now, and bring the rest back tonight.

A Half-Dozen Comments on the Current Market Environment

Posted on 5 May 20076 May 2007 by David Merkel

Here’s my take on a large part of what is going on it the markets now.

Bond market implied volatility is low. Tony Crescenzi comments about that on the Treasury market, but it is also true of the agency and swap markets. Less true of corporates, because rumored LBOs are making market players jumpy, but spreads are still pretty tight. People are too complacent…
What did well in the first four quarters of this year? Borrowing from Merrill Lynch, in terms of sectors, it would be utilities and materials, follow by healthcare and energy. In terms of quality, low quality continues to win, which is a function of tight credit spreads. Growth strategies are working — low PEG ratios, small caps, and high ROE are doing well so far in 2007.
China may take the global economy over the edge. Between tightening interest rates and raising deposit requirements, they are moving to slow their economy. One thing that fights against them is the currency; much stimulus comes from keeping the yuan low.
One factor that helps to keep oil prices high is the inefficiency of the average state-owned oil company. Venezuela, Iran, and Indonesia are great examples of the damage that can be done by negligent government-sponsored companies tha don’t reinvest enough in their businesses.
Fascinating to see copper and gold up, Baltic freight up and timber prices down. US housing is damaging timber, but demand outside of the US is driving the rest at the margin.
Even more amazing is the foreign buying of Treasuries, which proceeds unabated to recycle the shrinking current account deficit.

I have more, but I am tired, and will post more on Monday.

Why Financial Stocks Are Harder to Analyze

Posted on 28 April 200720 June 2017 by David Merkel

One of my readers, Steve Milos, asked me the following question:

Free cash flow is a metric that I like to use when judging investments in most types of companies. However, I?m not sure how to apply it to insurance companies, or even how to calculate it, given the uncertainty of claims. Do you use it? How do you calculate it? Currently, I?ve used P/E, P/Book, dividend yield, combined ratio as metrics for insurance companies instead.

Before I start, for those that have access to RealMoney, I would refer you to the following two articles:

Parsing the Financials of the Financials, and

Time to Get Personal with Insurers (free at TSCM).

Quoting from a recent article at RealMoney:

The free cash flow of a business is not the same as its earnings. Free cash flow is the amount of money that can be removed from a company at the end of an accounting period and still leave it as capable of generating profits as it was at the beginning of the accounting period. Sometimes this is approximated by cash flow from operations less maintenance capital expenditures, but maintenance capex is not a disclosed item, and changes in working capital can reflect a need to invest in inventories in order to grow the business, not merely maintain it.

And quoting from the first article that I cited above: The cash-flow statement is of great use in gauging the health of industrials and utilities, but it tells us next to nothing about financials. One of the best values of cash-flow statements is that they enable one to attempt to derive estimates of free cash flow (the amount of cash that a business generates in a year that is left over after it has paid all of its expenses, including capital expenditures to maintain its existing business). Deducting maintenance capital expenditure from EBITDA often approximates free cash flow.

However, cash-flow statements for financials can’t 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 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 isn’t disclosed anywhere in a typical 10K. Even the concept of required capital can change depending on what market the financial institution is in and what entity most closely controls the amount of operating and financial leverage it is allowed to take on.

Federal or state regulators sometimes impose the biggest constraints on leverage — this is particularly true for institutions that interact closely with the public, i.e., depository institutions and life and personal-lines insurers. For companies that raise capital in the debt markets or do business that requires a strong claims-paying-ability rating, the ratings agencies may lay on the tightest constraints.

Finally, in rare instances of loose regulatory structures, the tightest constraint can be the company’s calculation of how far it can push its leverage before it blows up. Again, this is rare; many companies estimate the capital required for business, but regulatory or rating agency standards are usually tighter.

Actuaries have their own name for free cash flow. They call it distributable earnings. It is equal to earnings less the change in capital necessary to support the business. When sales are growing, typically distributable earnings are less than earnings. When sales are shrinking, typically distributable earnings are more than earnings.

As pointed out in the second quotation above, the hard part is knowing what entity requires the most capital to be held against the business. Is it the regulators, the rating agencies, or the company itself? The tightest constraint determines the capital that is required.

The second part of what makes it hard is that the capital standards for the rating agencies are dimly known to outsiders. Internal company capital standards are not known to outsiders either. Finally, the regulatory standards for capital are known but complex. The formula is known, but not all of the data that goes into the calculation is public. A further difficulty is that different companies run at different percentages above the minimum capital standards, and typically, that is not disclosed.

Aside from that, there is the problem of whether the reserves are fairly stated, but the nuances of that are beyond this discussion. What can an insurance analyst do to get something near free cash flow?

Ask questions on leverage policy. Ask the company how they decide what the maximium amount of business they could write next year is. Premiums-to-surplus? Statutory net income/loss limits? How much more could you borrow at the holding company at your current rating? Questions like this cut through the clutter of what you don’t know, and allow you to estimate how much capital they will have available to increase dividends, buy back stock, or buy other strategic assets. You can also read reports from the ratings agencies, since they focus on this.

In practice, I have a “back of the envelope” feel for how loose or tight capital is at firms that I analyze. I spend more time on pricing power, since it correlates better with stock price performance in normal situations. I look for the sustainability of underwriting margins. I also graph Price-to-Book versus Return on Equity, looking for companies that earn a lot on their net worth, and have a reasonable chance of sustaining those earnings.

I hope that helps explain how to analyze insurance companies, approximating some aspects of free cash flow. If you have a question, pose it below so others can benefit from your question and my answer.