Private Equity: Short Term versus Long Term Rationality

Posted on 14 June 200720 June 2017 by David Merkel

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:

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:

Interest rates on the long end going to at least 6%-7%. At that point, I believe it will get too risky.
The equity market being closed to the IPOs of the companies that need to be flipped. It’s wide open right now.
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?
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.
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

Posted on 14 June 200714 June 2007 by David Merkel

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:

Protectionism could erupt, and diminish the amount of oil shipped across our oceans.
Too many new boats could be built, eroding the value of existing boats.
I could have done the math wrong.
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

Posted on 7 June 200720 June 2017 by David Merkel

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:

the credit default swap market.
the synthetic CDO market (related to #1, I know)
nonprime commercial paper
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.

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.

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.

The Great Garbage Post

Posted on 25 April 200727 April 2007 by David Merkel

Perhaps for blogging, I should not do this. My editors at RealMoney told me that they liked my “Notes and Comments” posts in the Columnist Conversation, but they wished that I could give it a greater title. Titles are meant to give a common theme. Often with my “Miscellaneous Notes” posts, there is no common theme. Unlike other writers at RealMoney, I cover a lot more ground. I like to think of myself as a generalist in investing. I know at least a little about most topics.

Now, I have to be careful not to overestimate what I know, but the advantage that I have in being a generalist is that I can sometimes see interlinkages among the markets that generalists miss. Anyway, onto my unrelated comments…

1) So many arguments over at RealMoney over what market capitalization is better, small or large? Personally, I like midcaps, but market capitalization is largely a fallout of my processes. If one group of capitalizations looks cheap, I’ll will predominantly be buying them, subject to my rule #4, “Purchase companies appropriately sized to serve their market niches.” Analyze the competitive position. Sometimes scale matters, and sometimes it doesn’t.

2) My oscillator says to me that the market is now overbought. We can rise further from here, but the market needs to digest its gains. We should not see a rapid rise from here over the next two weeks, and we might see a pullback.

3) My, but the dollar has been weak. Good thing I have enough international bonds to support my balanced mandates. I am long the Yen, Swissie, and Loony.

4) Sold a little Tsakos today, just to rebalance after the nice run. Cleared out of Fresh Del Monte. Cash flow looks weak. Suggestions for a replacement candidate are solicited.
5) Roger Nusbaum is an underrated columnist at RealMoney in my opinion. Today, he had a great article dealing with understanding strategy. He asked the following two questions:

If you had to pick one overriding philosophy for your investment management, what would it be?
If you had to pick four of your strategies or tactics to accomplish this philosophy, what would they be?

Good questions that will focus anyone’s investment efforts.

6) In the “Good News is Bad News” department, there is an article from the WSJ describing how the SEC may eliminate the FASB by allowing US companies to ditch GAAP, and optionally use international accounting standards [IFRS]. If it happens, this is just the first move. Eventually all companies will follow an international standard, that is, if Congress in its infinite wisdom can restrain itself from meddling in the management of accounting. The private sector does well enough, thank you. Please limit your scope to tax accounting (or not).

7) Also from the WSJ, an article on how employers are grabbing back control of 401(k) plans. Good idea, since most people don’t know how to save or invest. But why not go all the way, and set up a defined benefit plan or a trustee-directed defined contribution plan? The latter idea is cheap to do; we have one at my current employer. Expenses are close to nil, because I mange the money in-house. Even with an external manager, it would be cheap.Would there be people who complain, saying they want more freedom? Of course, but they are the exception, not the rule, and of those who complain, maybe one in five can do better than an index fund over the long haul. I am for paternalism here; most ordinary people can’t save and invest wisely. Someone must do it for them.

8) Finally, the “hooey alert.” The concept of using custom indexes to analyze outperformance smacks of the inanity of “returns-based style analysis.” I wrote extensively on this topic in the mid-90s. Anytime one uses constrained optimization to calculate a benchmark using a bunch of equity indexes, the result is often spurious, because the indexes are highly correlated. Most differentiation between them is typically the overinterpretation of a random difference between the indexes. Typically, these calculations predict well in the past, but predict the future badly.

That’s all for now.

Full Disclosure: long TNP FXY FXF FXC