Category: Stocks

Nine Notes on Speculation

Nine Notes on Speculation

Recently I have been clipping articles, and arranging them by category, so that I can comment on them as a group more easily.? Tonight’s topic is speculation again, but these articles are all of the odd bits that don’t follow any particular theme.

 

  1. Sometimes I think that the major financial press that covers Wall Street should send chocolates to Jim Cramer for creating TheStreet.com.? Where else would they get high quality journalists the understand the markets?? Writing for RealMoney, Matthew Goldstein would occasionally e-mail me with a question.? He was the one who covered financials in the news group for TSCM.? Financials are harder to learn than industrials, and I thought he would go far. 

    Well, he has gone far, to Business Week.? The advent of hedge funds has created a great demand for shorting stock, and there are concerns on the part of some with naked shorting, where one does not borrow the shares before they are sold.? This article describes the probe into stock lending, and what may come of it.? Personally, I wonder why investment banks don’t create single-name total return swaps.? E.g., receive three month LIBOR plus or minus a spread, pay IBM total return.? That would allow the same economics of shorting, without the stock borrow, and no charges of naked shorting.? Why not?

  2. Brave new world; the uptick rule is history.? Well, that should provide more liquidity to buyers.? I’m indifferent on this one, though I would warn anyone doing a death-spiral convert that the elimination of the uptick rule means there is no way that the short sellers won’t win.
  3. Once you have derivatives, almost anything is possible.? Insider trading can be hidden through derivative instruments, because they are not publicly reported.? Now, in practice, it may not be that simple, because derivatives are a zero sum game, and the counterparty loses what the one with information wins, unless they are hedged.? Whoever bears the loss after the takeover is announced has a concentrated interest to find the one who ended up winning, because they might get back what they lost.
  4. I think it is inevitable that there will be different ways of trading large and small blocks of stock.? Most industries have different distribution methods for wholesale and retail.? Dark pools of liquidity don’t surprise me; when I was a bond trader, if I wanted to trade a large fraction of some bond deal, quietness and anonymity were crucial.? My view: have the SEC serve as trading apprentices a large equity or bond shops, and see why large trading is different from small trading.
  5. Fitch gets it, maybe.? They see why hedge funds might be weak holders during a crisis.? I’m not sure what Fitch will do with it, but that skepticism will make for a better rating agency.
  6. 130/30 seems to be coming along at the wrong time.? There is too much pressure on the borrow from hedge funds already.? My opinion is that short-selling is getting close to useless on average, given the high level of shorting.? When the bad event happens, the covering keeps the stock afloat.
  7. No more earnings guidance? Yay!!? Let analysts be real analysts, and not just take what management has fed them.? I like it when companies I follow eliminate earnings guidance, because it increases the advantage of analysts who really understand what is going on.
  8. Investing in commodities was a great idea until players started to invest in an indexed manner on the front month.? This has forced the front month to be low versus future months, and the continuing roll depresses returns.? If I were running such a fund, I would invest in a ladder of contracts similar to the pro-rata ladder of contracts currently traded; that would minimize the antiselection.
  9. Finally, be wary of funky ETFs that don’t actually own the underlying assets in a direct way.? There are too many ways for those vehicles to go wrong.? Good ETFs have direct ways of hedging that keep the prices in line with what they are trying to replicate.

 

That’s all for now.? My own investing has gone well so far this week, but who can tell what the future will bring?

Supply and Demand Factors in the Equity Market

Supply and Demand Factors in the Equity Market

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.

Nine Business Days Ago

Nine Business Days Ago

The most recent closing high in the S&P 500 was on June 4th.? Since then, we have been through a spin cycle where all that mattered were yields on the long end of the Treasury curve.? That’s why I wrote late on Thursday at the RM Columnist Conversation:


David Merkel
Bonds and Stocks Decoupling? They were only Together by Accident.
6/14/2007 4:50 PM EDT

I was somewhat skeptical when I saw bonds and stocks trading in tandem. The relationship between bond and stock earnings yields is a tenuous one operating over the long haul and on average. Using the five-year Treasury as and the S&P 500 my proxies, bond yields have exceeded earnings yields by as much as 8% in the mid-’50s, while earnings yields have exceeded bond yields by more than 4% in 1981, 1984 and 1987. On average earnings yields are 32 basis points over bond yields. If there is mean reversion in the difference between the two yields, the effect is not a strong one. At present, the relationship between earnings and bond yields seems tighter because of the large substitution of debt for equity going on, but that’s not a normal thing in the long run.

Even with all the buybacks and LBOs, it isn’t normal for stocks and bonds to trade in a tight correlated way in the short run, so, take one of your eyes off of bonds, and look at the fundamentals of the companies that you own. You’ll make more money that way, and take less risk.

PS: if the ten-year crosses 5.50%, go ahead and look at bonds again, and maybe allocate some more money to fixed income. Repeat the process each 0.5% up, should we get there. Equilibrium for stocks and bonds on a valuation basis is a 6.50 10-year. We’re not there yet, so I expect the substitution of debt for equity to continue, albeit at a slower pace.

Sometimes I think investors and the media search for an easy target on which to pin their fears or hopes.? In this case, it was the bond market.? Don’t get me wrong, the bond market is important, and usually ignored by investors to their peril.? But using the bond market to make short term equity trading decisions is just plain silly.

Now, when actual volatility rises, my methods usually do well against the broad averages.? One of the things that I have tried to achieve in my adaptive approach to the markets is to create a system does does well in calm markets, but does relatively better in volatile markets.? Volatile markets scare inexperienced investors into making the wrong moves.? My methods are geared toward allowing ordinary investors to benefit from volatility in a rational way.? As I stated in the CC on Friday:


David Merkel
Rebalancing Trades
6/15/2007 11:55 AM EDT

Wow. Nice rally over the last chunk of time, and it’s time to “ring the register” and lighten on a few names that have run nicely. I do this primarily for risk control purposes. Here are the names that I trimmed: Noble Corp (NE), Cemex (CE), Lyondell Chemicals (LYO), and Tsakos Energy Navigation (TNP). They are now back at their target weights in my portfolio. My rebalancing discipline is a way of:

  1. Lowering risk on companies that are more expensive, and thus more risky than when I last bought them.
  2. Raising exposure on names that are cheaper, and thus less risky than when I last bought or sold them.
  3. Capturing swings in sentiment in industries, companies and the market as a whole, without becoming a momentum trader.
  4. Lowering my market impact costs by leaning against the wind (selling into a rise, buying into a fall), and
  5. Forcing a review process at certain price levels
  6. Taking the emotion out of selling and buying
  7. Making an additional 2% to 3% a year on my portfolio.

You can only do this with a high quality portfolio; don’t try this with companies that have a non-zero chance of a severe drop. For more information, review my “Smarter Seller” article series.

Position: long NE LYO TNP CX

Since 6/4, my broad market portfolio has outperformed the S&P 500 by roughly 1%.? My methods are designed to be able to cope with volatility and some back smiling.? Why can I go on business trips or vacation and not worry about the markets?? Why don’t I get scared by many of the negative macroeconomic situations out there?? First, I trust in Jesus; my life is not just the markets.? But beyond that, my eight rules are design to deal with the volatility that the market serves up, and adapt to what is undervalued in the present environment.

My plan for the next three weeks on the blog is to go through another portfolio reshaping.? You’ll get to see how I make choices in my portfolio.? Beyond that, I have one big article on the Fed Model coming, and continuing coverage of the major factors driving the markets.? Have a great weekend.

Full Disclosure: long CX TNP LYO NE

Private Equity: Short Term versus Long Term Rationality

Private Equity: Short Term versus Long Term Rationality

Until you learn to accept it, it is painful for many fundamentally driven investors to accept trends that are short-term rational, but long-term irrational. (And, much as it hurts my fingers to type this, technicians don’t have that problem… they have other problems though.) 😉

Tonight’s topic is private equity. There has been a cascade of bits and bytes splattered across the web on this topic, so I thought I would try to give a well-rounded picture, together with my views on the topic. Let’s start with the bull case:

Who better to start with than my colleague Jim Cramer? Two articles:

  1. Fear Not the Private Equity ‘Bubble’, and
  2. Five Reasons Private-Equity Deals Keep Going.

Let’s take the latter article. What were his five reasons?

Funny; it [DM: the private equity wave] will end. But not before many things happen, including these five:

  1. Interest rates on the long end going to at least 6%-7%. At that point, I believe it will get too risky.
  2. The equity market being closed to the IPOs of the companies that need to be flipped. It’s wide open right now.
  3. Not one, not two, but maybe three or four, or even five deals going bust. Can’t we wait for even one to go belly-up before we get too nervous?
  4. Valuations ramping up more. With the S&P 500 selling for about 17.5 times next year’s earnings, there is plenty of room to keep buying.
  5. Private equity funds running out of money. Very unlikely.

He has made the case exceptionally well as to why Private Equity should continue to be a factor in the market in the short-to-intermediate run. Here are two other pieces that make a similar case, which can be summarized like this: if there is a positive spread between the forecast earnings yield of a company, and the interest rate at which we can finance the purchase of the company, then it is rational to take the company private.
It’s at times like this that my inner actuary comes out and says, “Hey, what about a provision for adverse deviation?” That is, how much can go wrong, and still make this deal work? My inner financial analyst asks a slightly different question, “Will you need additional financing later, even if it is selling off the company? What if financing or selling is not available on today’s advantageous terms?”

The private equity folks will say that the high debt levels force success; there is no room for error, so we will work like crazy to make it work. As for financing, there are always windows of opportunity within a reasonable time span. There is no reason to worry.

Now not all deals work out, despite the best efforts of the new private owners. Most are marginal with a few celebrated home runs. During mania times, buyers definitely overpay. As an example, you can see how badly Daimler Benz did in its purchase of Chrysler. Will Cerberus do as well? I am not as bullish as the BW article, but it is clear the Cerberus does not have as much at risk as Daimler. Where I differ is that it will be harder to shed liabilities and reduce costs than the article implies.

At present there aren’t a lot of hot problems in private equity deals. There are financing difficulties, like KKR finding it hard to get additional private equity investors. Institutional investors like to be diversified, which always makes it tough for the biggest players in any asset class to get financing. Aside from that, the risks from doing deals are in the future.

At present, there is a lot of cash to finance private equity for both debt and equity commitments. Today it is rare to find assets that cannot be refinanced. There are more vultures than carrion. There have also been many articles pointing out that amid the flood of financing, the leverage has been going up, and the interest coverage down.

These are not the problems of today, so bulls ignore it and bears get frustrated. These will be problems, just not yet. What if real interest rise? Well, that will affect the ability to re-IPO the company, but it won’t absolutely stop a deal today. What if interest rates rise simply due a bond bear market, whether due to inflation, or global competition for capital? That will affect new deals, making it harder for them to get done, and sale multiples will fall on companies that the private equity folks try to sell.

Perhaps the effects are reversed here. Maybe private equity troubles will be a harbinger of the next junk bond bear market. Could be; after all, one weakness of being private is that tapping the public equity markets is not an easy option, much as that can be valuable when times are about to get tight.

Here’s my verdict. In the short run, almost anything can work. When debts go bad, it typically occurs because the company chokes on paying the interest, not the principal. Private companies that can pay the interest will likely survive to make some money for their private equity sponsors. But many will over-borrow, and in a recession, or in an industry or company downturn, will find that they no longer have enough cash to make the interest payments, and possess limited options for refinancing. Multiple defaults will happen then; think 2009, give or take a year.

But maybe it takes until 2012. If so, perhaps this letter from the future will seem prescient in hindsight. Private equity is not a bubble today; history may judge it to be a mania. To my readers I say be careful, and stick with higher quality bonds and stocks.

A Brief Note on Tsakos Energy Navigation

A Brief Note on Tsakos Energy Navigation

Doing estimates of private market value is often difficult. Recently while reading through the annual report of Tsakos Energy Navaigation, the CEO mentioned how much the ships were worth on the open market compared to the value on the books. After running a few calculations, I came to the conclusion that the private market value of Tsakos was around $75/share, a premium to the current quote.

Now, what can go wrong here? A lot:

  1. Protectionism could erupt, and diminish the amount of oil shipped across our oceans.
  2. Too many new boats could be built, eroding the value of existing boats.
  3. I could have done the math wrong.
  4. The CEO may have overstated his case.

I like Tsakos from both a strategic and valuation standpoint, but it is not a risk free investment; like most cyclicals, it relies on the robustness of the global economy, and the willingness of economies to buy oil from overseas. Given the uneven distribution of oil across our world, I would expect that oil shippers will be in a good spot for a while, but one can never tell for sure.
Full disclosure: long TNP

?Note: this note has been edited to remove two material errors.? First, the word “discount” has been changed to “premium” in the first paragraph.? Second, my four points only indicate areas where my analysis could go wrong.? Point four has been clarified, because I meant that you can never tell with any CEO whether everything was stated correctly, not that I thought it was incorrect here.? Rather, I trust their representations.

What Brings Maturity to a Market

What Brings Maturity to a Market

Some housekeeping before I start. My post yesterday was meant to be a “when the credit/liquidity cycle turns” post, not a “the sky is falling” post. Picking up on point number 4 from what could go wrong, I would refer you to today’s Wall Street Journal for two articles on LBOs that are not going so well, and the sustainability of private equity in the current changing environment. Please put on your peril-sensitive sunglasses before reviewing the credit metrics.

In the early 90s, as 401(k)s came onto the scene, savings options were the hot sellers to an unsophisticated marketplace. Because of the accounting rules, insurance contracts could be valued at book, not market, and so Guaranteed Investment Contracts [GICs] were sold to 401(k) and other DC plans.

The difficulty came when companies that issued contracts failed, like Executive Life, Mutual Benefit, Confederation, and The Equitable (well, almost). A market that treated all contracts equally was now exposed to the concept that there is such a thing as credit risk, and that the highest yielding contract is not necessarily the one that should be bought.

In the mid-90s, that was my first example of market maturation, and it was painful for me. I was running the Guaranteed Investment Contract desk at Provident Mutual, and making good money for the firm. We survived as other insurance companies went under or exited the business, but as more companies failed, the credit quality bar kept getting raised higher, until we were marginal to the market. Confederation’s failure was the last nail in my coffin. I asked my bosses whether I could synthetically enhance my GICs by giving a priority interest to the GIC-holders in an insolvency, but they turned me down, and I closed down an otherwise profitable line of business.
Failure brings maturity to markets, and market mechanisms. When a concept is new, the riskiness of it is not apparent until a series of defaults occurs, showing a difference between more risky and less risk ways of doing business. Let me give some more examples:

Stock Market Leverage: How much margin debt is too much, that it helps create systemic risk? In the 20s leverage could be 10x, and the volatility that that policy induced helped magnify the boom in the 20s, and the bust 1929-1932. Today the ability to lever up 2x (with some exceptions) is deemed reasonable. If it is not reasonable, another failure will teach us.

Dynamic Hedging: In the mid-80s, shorting stock futures to dynamically hedge stock portfolios was the rage. After all, wasn’t it a free way to replicate a costly put option?

When it was first thought up, it probably was cheap, but as it became more common the trading costs became visible. For small price changes, it worked well. Who could predict the magnitude of price changes it would be forced to try and unsuccessfully hedge? After Black Monday, the cost of a put option as an insurance policy was better appreciated.

Lending to Hedge Funds: I’m not convinced that this lesson has been learned, but if it has been learned, the crisis from LTCM started that process. After LTCM failed, counterparties insisted more closely on understanding the creditworthiness of those that they expected future payments from.

Negative Convexity: Through late 1993, structurers of residential mortgage securities were very creative, making tranches in mortgage securitizations that bore a disproportionate amount of risk, particularly compared to the yield received. In 1994 to early 1995, that illusion was destroyed as the bond market was dragged to higher yields by the Fed plus mortgage bond managers who tried to limit their interest rate risks individually, leading to a more general crisis. That created the worst bond market since 1926.
There are other examples, and if I had more time, I would list them all. What I want to finish with are a few areas today that have not experienced failure yet:

  1. the credit default swap market.
  2. the synthetic CDO market (related to #1, I know)
  3. nonprime commercial paper
  4. covenant-lite commercial loans, particularly to LBOs.

There is nothing new under the sun. Human behavior, including fear and greed, do not change. In order to stay safe in one’s investments, one must understand where undue risk is being taken, and avoid those investments. You will make more money in the long run avoiding foolish risks, than through cleverness in taking obscure risks ordinarily. Risk control triumphs over cleverness in the long run.

Thinking About What Might Blow Up

Thinking About What Might Blow Up

The credit cycle is kind of like a Monty Python skit where the humor has reached a point of diminishing marginal returns. At that point, they might blow something up, and move onto the next skit. Credit cycles end with a bang, not a whimper. Take a spin down the last few cycles:

  • 2000 — Nasdaq, dot-coms
  • 1997-98 — Asia/Russia/LTCM
  • 1994 — Mortgages/Mexico
  • 1989 — Banks/Commercial Real Estate
  • 1987 — Stock Market
  • 1984 — Continental Illinois
  • Early ’80s — LDC debt crisis

In each case, we had assets that were weakly financed.? When liquidity began to become scarce, the entities that were weakly financed faced sharply rising borrowing costs, and many defaulted.? The purpose of this piece is to muse about what entities in our world today are reliant on the presence of favorable financing, and would suffer if that financing ceased to exist.? Here’s my initial list.? Can you give me some more ideas?

  1. Too obvious: CCC-rated bond issuers.? We’ve had a lot of them issue debt over over the past three years.? Those that have not shored up their balance sheets and paid down debt will suffer if they need additional financing.
  2. Yield-seeking hedge funds.? When the credit cycle turns, yield becomes poison.? Those holding the equity of Collateralized Debt Obligations, and other levered forms of credit will have a rough time, particularly if their investors ask for their money back.
  3. Dodgy mortgages.? We’ve already seen the beginning with subprime mortgages, but there are more loans that will hit resets over the next twelve months.? The troubles with Alt-A lending will be more spread out, but it really hurts to have your financing rate jacked up at a time that the asset financed is experiencing weakness in price.
  4. Private equity over-borrowing.? Much of private equity relies on the idea that they can have an easy liquidity event five years from now.? What if interest rate are three percent higher then?? P/E and EV/EBITDA multiples will be lower, not higher, and then what do you do with all of the debt used to finance the purchase?
  5. Overly indebted cyclicals, and mergers that increase leverage.? Companies that presumed too much about the future get killed when the cycle turns.? The mergers and recapitalizations that looked so promising are horrid when the willingness to take risk drops.
  6. Mis-hedged investment banks.? This is a little more speculative, but in a credit crisis, investment banks without adequate liquidity are in the soup.? Lehman Brothers barely survived 1998; in a more severe crisis, who would get harmed?
  7. Sovereign nations with large current account deficits.? This is the most controversial category.? I am not talking about the main emerging markets here; I am talking about developed countries that lack discipline, like Iceland, New Zealand, and the United States.? The large emerging markets are in better shape than the derelict nations that they fund.? If the debt is in their own currency, the nation has more options than merely defaulting.? They can inflate, or create a two-tier currency system to give foreigners the short end of the stick.? (Think of Argentina, or South Africa back in the 80s.)


These are the weak entities that I can think of. ?There are more, I am sure, particularly as the demographic crises emerge over the next decade, but for now, if liquidity becomes scarce, these are the entities?that will suffer.

How Do You Value an Insurance Business?

How Do You Value an Insurance Business?

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

How to Sell a Securitization

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:

  1. 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.
  2. 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.
  3. Sell all of the loans/bonds off to an entity with a stronger balance sheet, and realize a loss on the deal.
  4. 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.

Listen to Cody on Risk Control

Listen to Cody on Risk Control

Cody has an point that everyone should listen to in his post, Cody on Your World with Neil Cavuto.? I still regard myself as a moderate bull here, but it is altogether wise to take something off the table here.? My methods have me forever leaning against the wind.? As an example, near the close yesterday I trimmed some Anadarko Petroleum as a rebalancing trade.? I still like Anadarko, but at a higher valuation, it pays to take something off the table.? Why?? Because we don’t know the future, and something could happen out of the blue that transforms the risk profile of the market in an instant.


So, what does this mean for me?? I’m up to 12% cash in my broad market portfolio, which is higher than the 5-10% that I like it to be, but not up to the 20% (or down to zero) where I have to take action.? My balanced mandates are taking on cash to a lesser extent.? A 5.25% yield is pretty nice.


Now, here’s where I am different (not better, but different) than Cody.? Cody advocated taking 20% off the table (in his Fox interview), whereas I am forever taking little bits off the table as the market runs.? My robotic incrementalism takes the emotion out of the selling and buying processes.? That said, I may leave something on the table versus someone making bigger macro adjustments.


Whatever you do, it has to be comfortable for you in order to be effective.? The market may go up further from here; on average, I expect it will do so, but I can imagine scenarios where it will not do so.? That’s why I take a little off the table each time my stocks hit upper rebalance points; my baseline scenario may not happen, and rebalancing to target weights protects against what is unexpected.? It is a modest strategy that guards against overconfidence, and will always allow you to stay in the game, no matter how bad the market gets.


I don’t have to be a raving bull or raving bear.? I just have to control my risks, and over the long run, I will do pretty well.? Cody will do well too; he just does it differently.

Full Disclosure: long APC

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