Search Results for: PB-ROE

On PB-ROE

On PB-ROE

Here is an e-mail from a reader:

I’m curious about the intercept of the PB-ROE line. In your examples (http://alephblog.com/2012/02/25/thinking-about-the-insurance-industry/), only life had a negative intercept; the others were all positive. Here’s the implication:

?PB = a + b ROE (where a and b are the intercept and slope).

If I divide both sides by ROE I get:

PE = a / ROE + b

Taking the differential:

dPE = – (a / ROE^2) dROE

So if the intercept is positive, an increase in ROE results in a lower PE and vice versa.

So here are two questions:

1) Why would the relationship be negative? Is it because the higher ROE is achieved via leverage, is therefore riskier, and requires a lower PE??

2) Why is the intercept negative for life insurers but positive for the others?

First, you have to understand PB-ROE.? The idea is that there is a limiting factor to earnings with financial companies.? The earnings of financial companies is limited by its book capital.? I think this is correct to a first approximation.? But different financial companies experience different financial results; they have different ROEs.? How sustainable are those different ROEs?? ROEs tend to revert to mean; competition drives that.? How fast ROEs revert to mean derives from the length of the businsess written.? Long tail exposures found in life companies mean that a higher ROE usually gives more kick to the P/B multiple.

As an aside, with industrials and utilities =, I often think that sales are the limiting factor, and so my equation becomes:

P/S = a + b * E /S + e? (E/S = profit margin)

Now to your math.? You have the first equation wrong, it should be:

PB = a + b * ROE + e , where e is a normally distributed error term, so if you did the division by ROE, it would be:

PE = a / ROE + b + e / ROE, which means my error term could no longer be normally distributed.? So, you can’t divide through by ROE.? Not legitimate.

Let’s try a different approach.? What if we modeled P/E as a function of B/E?

First, to me that doesn’t make sense, because the idea of capital as a limiting resource goes out the window.

Second, if you did that the a and b would be different, because regression minimizes the squared differences of the dependent variable (actual versus expected).

So, with respect to what I said above, I would not do the math your way. Dividing and differentiating by ROE neglects the meaning of the original equation.? All models are just that, models.? But we can’t go neglecting what they internally assume, and expect to get good results.

So, I can answer your second question, but not your first question.? When we estimate PB-ROE, often the equations with the highest slopes have the lowest intercepts.? What that describes are situations where the ROEs, if they are high, are expected to remain high, and thus produce much higher P/Bs.? Such would be true with long duration coverages like in the life industry.

The reason the life industry is different is that the companies with high ROEs are expected to maintain those high ROEs for a longer period of time, because coverages are long, and pricing adjusts slowly.? With other insurance coverages, pricing adjusts annually or nearly so.

For a short-tail P&C company with an ROE of zero, I would expect a P/B multiple that is positive, because pricing adjustments and mean-reversion are coming soon.? For a life company with a low ROE, the adjustment will happen slowly, or it may never happen.? Perverse dynamics kick in when a company with long-tail coverages finds itself earning very little to nothing.? There is the tendency to mis-estimate reserves, “because we can’t be making so little.”? The length of accruals allows a greater degree of subjectivity to be injected into the estimates.? Short accruals get validated every year.? Long accruals don’t get that validation, at least not in a way that a public investor can see.

If you were an actuary inside the long-tailed life insurer, you would get some data telling you that your assumptions were optimistic, right, or pessimistic.? But it takes a while to figure out whether the last few years are a deviation or a trend.? Good actuaries dig in, and look at the causes for claims, trying to see if the reasons for policyholders making claims matches up with the original estimate of what the subject population would be likely to die (or have disability or LTC claims) from.? Too many abnormal claims may imply that the business has been underwritten wrong, and needs to be adjusted.

That analysis takes some doing, because long-tail life coverages are low-frequency and high-severity.? That’s why the qualitative data may help, by giving clues long ahead of the flood of claims that you did not expect.

To summarize: Life is different because the coverages are long duration in nature, and ROEs don’t change so rapidly.

 

Quantitative Analysis is not Trivial — The Case of PB-ROE

Quantitative Analysis is not Trivial — The Case of PB-ROE

I debated on whether to post on this topic or not. I try to be a gentleman, so I don’t want to be too rough on those I criticize. Let me start out by saying that those I criticize have honorable intentions. They want to make investing simple for investors. Noble and laudable; the trouble comes when one over-simplifies, and errors get introduced as a result.

I am both a quantitative and a qualitative analyst, which makes me a little unusual. It also means that I am not as good as the best qualitative or quantitative analysts. To be the best, it takes dedication that would squeeze out spending too much time on the other skill. I have always tried to stay balanced, which helps me as a businessman, actuary and investor. Good problem solving requires looking at a problem from many angles, and then choosing the right analogy/tool to do the job.

One of my readers, Steve Milos, forwarded to me a piece from Merrill Lynch’s life insurance analyst suggesting that Price-to-Book — Return on Equity [PB-ROE] analyses were simply low P/E investing in disguise. I tossed back a comment “The Merrill analyst doesn’t understand what he is talking about. PB-ROE analyses are richer than low PE, though in a few environments, like the present, they are similar.”, prompting Steve to say, “LOL, I love that ? now tell me what you really think!”

I decided to let the matter drop until Zach Maxfield, one of the analysts from Bankstocks.com, posted a laudatory article on Ed Spehar’s piece. I didn’t learn what I am about to write in a day, so let me take you on a journey explaining how I came to learn that PB-ROE analyses are valuable.

Back in 1982, I was a graduate teaching assistant at UC-Davis. The professor that I worked for used regression analysis in financial analysis to try to separate out effects that might be more complex than current modeling would admit. I did not get a chance to use the idea though, until 1992, when I began value investing, after my Mom gave me a copy of Ben Graham’s “The Intelligent Investor.” As I began investing, I noted that some stocks seemed better valued using book, others by earnings, and some by other metrics. Initially I began doing rule-of-thumb tradeoffs like Price to (book plus 5 times earnings). Eventually I wondered whether I had the right tradeoff or not, and how I might work in other metrics like dividends, sales, cash from operations [CFO], and free cash flow [FCF].

I’m not sure when it hit me, but I decided to run a regression of price versus earnings, book, sales, FCF, and CFO. Reasoning that sectors have different economic models, I did separate runs by sector. Truly, I should have done it by industry, or subindustry, as I do it today, but my initial attempts still found promising inexpensive stocks.

It was not until 1998 that I ran into PB-ROE analysis for the first time. Morgan Stanley was marketing a derivative instrument that would reduce book, turn it into earnings, and reduce taxes at the same time. I became the external expert on that derivative instrument, while hating its sliminess. (The whole story is a hoot, but it would take too long, and isn’t relevant here. Suffice it to say that the EITF and the IRS killed it six months after the first transaction got done.)

For those who believed PB-ROE analysis, the derivative was a godsend — less book, more earnings. With my more general model, I said, “So what, give up book, get “earnings,” which come back to book value anyway. These are just accounting shenanigans.” I didn’t see the value of PB-ROE then.

By 2001, I was a corporate bond manager. The Society of Actuaries Investment Section recommended the book, “Investing by the Numbers” by Jarrod Wilcox. An excellent book, I learned a lot from it, and he explained the PB-ROE model to me for the first time. To the best of my knowledge, it is the only place where I have seen it explained.

Where does the PB-ROE model come from? It is a simplification of the dividend discount model. In 2004, I gave a talk to the Southeastern Actuaries Conference. The relevant pages are 5-11, where I go through an example of a PB-ROE analysis, and give the limitations of the analysis. There are several limitations, here they are:

 

  1. Encourages maximization of ROE in the short run, rather than the long run
  2. Revenue growth is often equated with earnings growth in practice
  3. ?Run rate earnings? is adjusted (operating) GAAP earnings, versus distributable earnings (free cash flow)
  4. Implicit assumption of constant earnings growth, required return, and dividend policy in the Price to Book versus ROE metric
  5. The model assumes that capital is the scarce resource needed to produce more earnings.
  6. ROA is more critical than ROE; it?s harder to achieve. In bull markets, anyone can add leverage.

 

Items 4 & 5 are the only problems intrinsic to the PB-ROE model; the rest are problems with how the model gets abused by practitioners. I don’t think that any industry fits those conditions perfectly, but I usually think that the are good enough for a first pass, and after that I make adjustments for different expected growth rates, excess capital, earnings quality and more.

 

PB-ROE is equivalent to low P/E investing when the regression line comes close to going through the origin (0,0). From my experience, that rarely happens. For my nine insurance subgroups (bigger than Mr. Spehar’s analysis — I cover them all), almost all of the intercept terms are different than zero with statistical significance. Or, as a colleague of mine said to me recently, “Thanks for teaching me how to do PB-ROE analysis,it really helped with my analyses on Japanese banks and US investment banks.”

 

Now, there is a seventh problem with PB-ROE, but it is more complex. So you run he regression and get the tradeoff of P/B versus ROE that the market is currently pricing. Is that the right tradeoff in the intermediate term, or are investors overvaluing or undervaluing ROE? Hard to tell, but when the regression line is flat or downward sloping (it happens every now and then), one has to question whether the market’s judgment is right or not.

 

In some environments, PB-ROE and low P/E investing will be similar, but that will not always be true. Do not accept a false simplification, even though it may be true at present. The PB-ROE model is richer, and works in more environments, after adjusting for the limitations listed above. PB-ROE is a very useful tool, and not “gobbledygook.”

Miscellaneous Notes

Miscellaneous Notes

When I was writing at RealMoney.com, I would often do little posts in the Columnists Conversation, and title them “Notes and Comments,” or something like that. ?I don’t normally do that here, but I would like to tie up some loose ends.

1) I received the following e-mail six weeks ago, and I feel it is worthy to be shared with readers:

Hi David,

I follow?the Aleph blog from time to time. I run value and special situations oriented hedge fund whose goal is to purchase businesses that sell for at least 50 cents on the dollar. It seems that we are like minded in investment terms. I have an extensive investment checklist which that I believe can add value to investors. It took me a few years and I derived it by reading stacks of annual reports from Buffett, Klarman, etc?

If it adds value to your readers, more than happy to share the 90+item investment checklist.

http://www.brarifunds.com/wp-content/uploads/BIF-Checklist.pdf

Regards,

Pope

Pope Brar, Managing Partner/Founder

Brar Investment Funds

I’ve read through the checklist and it is a good one. ?It has all of the elements of my processes (though I am not as rigorous) and much more. ?His checklist is worth a read. ?Have a look at it.

2) From last night’s post, a reader asked:

Lots of insurers here.? Given your expertise in that area, I’d be curious to know if you think this screen is turning up names that are on the riskier end of the spectrum.

I wrote a seven part series on this, and here are the summary ideas, and the links:

  1. Shrinking the share count
  2. Growing Fully Convertible Book Value per Share
  3. Price Momentum and Mean-Reversion
  4. On Conservative Management & Reserving
  5. Some Things Can’t Be Underwritten
  6. Analyzing Insurance Sub-Industries and the PB-ROE model
  7. Insurance Accounting and Miscellaneous Insurance Insights?

I’ve been decreasing my insurance shareholdings lately because:

  • Pricing is weak for most P&C coverages, and
  • I don’t trust the reserving for secondary guarantees in life and annuity policies.

Here’s the insurance companies from last might’s article in decreasing order of earnings yield:

Company Ticker Industry Country B/P E/P ROE
Imperial Holdings, Inc. IFT 0709 – Insurance (Life) United States ?1.38 ?37.03 ?26.83
Greenlight Capital Re, Ltd. GLRE 0715 – Insurance (P&C) Cayman Islands ?0.90 ?19.45 ?21.61
Assured Guaranty Ltd. AGO 0715 – Insurance (P&C) Bermuda ?1.18 ?18.59 ?15.75
American Equity Investment Lif AEL 0709 – Insurance (Life) United States ?0.86 ?16.77 ?19.50
Everest Re Group Ltd RE 0715 – Insurance (P&C) Bermuda ?0.88 ?15.35 ?17.44
Validus Holdings, Ltd. VR 0715 – Insurance (P&C) Bermuda ?1.00 ?13.30 ?13.30
Axis Capital Holdings Limited AXS 0715 – Insurance (P&C) Bermuda ?1.01 ?13.20 ?13.07
Endurance Specialty Holdings L ENH 0715 – Insurance (P&C) Bermuda ?1.31 ?12.55 ?9.58
CNO Financial Group Inc CNO 0709 – Insurance (Life) United States ?1.29 ?12.39 ?9.60
American International Group I AIG 0715 – Insurance (P&C) United States ?1.34 ?12.00 ?8.96
Montpelier Re Holdings Ltd. MRH 0715 – Insurance (P&C) Bermuda ?0.99 ?11.83 ?11.95
Allied World Assurance Co Hold AWH 0715 – Insurance (P&C) Switzerland ?1.00 ?11.73 ?11.73
XL Group plc XL 0715 – Insurance (P&C) Ireland ?1.12 ?11.72 ?10.46
Argo Group International Holdi AGII 0715 – Insurance (P&C) Bermuda ?1.27 ?11.55 ?9.09
Platinum Underwriters Holdings PTP 0715 – Insurance (P&C) Bermuda ?1.02 ?11.25 ?11.03
Allianz SE (ADR) AZSEY 0715 – Insurance (P&C) Germany ?0.92 ?11.08 ?12.04
ACE Limited ACE 0715 – Insurance (P&C) Switzerland ?0.84 ?10.92 ?13.00
ProAssurance Corporation PRA 0715 – Insurance (P&C) United States ?0.87 ?10.86 ?12.48
MBIA Inc. MBI 0715 – Insurance (P&C) United States ?1.45 ?10.86 ?7.49
National Western Life Insuranc NWLI 0709 – Insurance (Life) United States ?1.63 ?10.85 ?6.66
Partnerre Ltd PRE 0715 – Insurance (P&C) Bermuda ?1.23 ?10.75 ?8.74
Old Republic International Cor ORI 0715 – Insurance (P&C) United States ?0.88 ?10.53 ?11.97
Employers Holdings, Inc. EIG 0706 – Insurance (A&H) United States ?0.93 ?10.46 ?11.25
United Fire Group, Inc. UFCS 0715 – Insurance (P&C) United States ?1.05 ?10.30 ?9.81
Maiden Holdings, Ltd. MHLD 0715 – Insurance (P&C) Bermuda ?0.93 ?10.11 ?10.87
EMC Insurance Group Inc. EMCI 0715 – Insurance (P&C) United States ?1.02 ?9.88 ?9.69
Investors Title Company ITIC 0715 – Insurance (P&C) United States ?0.86 ?9.85 ?11.45
Protective Life Corp. PL 0709 – Insurance (Life) United States ?0.92 ?9.76 ?10.61
Lincoln National Corporation LNC 0709 – Insurance (Life) United States ?1.07 ?9.76 ?9.12
FBL Financial Group FFG 0709 – Insurance (Life) United States ?0.96 ?9.73 ?10.14
Assurant, Inc. AIZ 0709 – Insurance (Life) United States ?1.00 ?9.67 ?9.67
Kemper Corp KMPR 0715 – Insurance (P&C) United States ?0.95 ?9.64 ?10.15
Aspen Insurance Holdings Limit AHL 0715 – Insurance (P&C) Bermuda ?1.12 ?9.61 ?8.58
Horace Mann Educators Corporat HMN 0715 – Insurance (P&C) United States ?0.91 ?9.60 ?10.55
Unum Group UNM 0709 – Insurance (Life) United States ?0.98 ?9.55 ?9.74
WellPoint Inc WLP 0706 – Insurance (A&H) United States ?0.89 ?9.52 ?10.70
ING Groep NV (ADR) ING 0709 – Insurance (Life) Netherlands ?1.14 ?9.46 ?8.30
Axa SA (ADR) AXAHY 0709 – Insurance (Life) France ?1.19 ?9.46 ?7.95
Hanover Insurance Group, Inc., THG 0715 – Insurance (P&C) United States ?0.99 ?9.44 ?9.54
Baldwin & Lyons Inc BWINB 0715 – Insurance (P&C) United States ?0.98 ?9.42 ?9.61
American Financial Group Inc AFG 0715 – Insurance (P&C) United States ?0.87 ?9.15 ?10.52
Alleghany Corporation Y 0715 – Insurance (P&C) United States ?1.01 ?9.15 ?9.06
American National Insurance Co ANAT 0715 – Insurance (P&C) United States ?1.40 ?8.99 ?6.42
HCC Insurance Holdings, Inc. HCC 0715 – Insurance (P&C) United States ?0.82 ?8.92 ?10.88
Allstate Corporation, The ALL 0715 – Insurance (P&C) United States ?0.82 ?8.75 ?10.67
Symetra Financial Corporation SYA 0709 – Insurance (Life) United States ?1.23 ?8.64 ?7.02
Selective Insurance Group SIGI 0715 – Insurance (P&C) United States ?0.90 ?8.51 ?9.46
White Mountains Insurance Grou WTM 0715 – Insurance (P&C) Bermuda ?1.07 ?8.49 ?7.93
Fortegra Financial Corp FRF 0712 – Insurance (Misc) United States ?1.28 ?8.18 ?6.39
Cna Financial Corp CNA 0715 – Insurance (P&C) United States ?1.10 ?8.15 ?7.41
Stewart Information Services C STC 0715 – Insurance (P&C) United States ?0.83 ?7.96 ?9.59
Navigators Group, Inc, The NAVG 0715 – Insurance (P&C) United States ?1.09 ?7.68 ?7.05
Reinsurance Group of America I RGA 0706 – Insurance (A&H) United States ?1.08 ?7.49 ?6.94
Safety Insurance Group, Inc. SAFT 0715 – Insurance (P&C) United States ?0.84 ?7.39 ?8.80
State Auto Financial Corp STFC 0715 – Insurance (P&C) United States ?0.83 ?6.92 ?8.34
Genworth Financial Inc GNW 0709 – Insurance (Life) United States ?1.72 ?6.87 ?3.99
First American Financial Corp FAF 0715 – Insurance (P&C) United States ?0.87 ?6.75 ?7.76

Now, let me list for you the companies I would avoid on this list: IFT, GLRE, AGO, AEL, CNO, AIG, XL, MBI, LNC, FBL, AHL, ING, AXAHY, AFG, GNW. ?That does not mean that I endorse the others. ?In general, those that I say to avoid have poor underwriting skills or a bad business model.

3) Another letter from a reader, on a very different topic, the FOMC:

thanks again – I always look forward to this update.

My thoughts are, they are increasing their flexibility in one direction (towards??accommodation?).? While they did move the point about??after the purchase program ends? to a spot perhaps better suited to a discussion of that point, I also took it to mean that there may be less commitment to end QE.? (Although, so long as the deficit keeps declining, they really have no choice but to dial back purchases to keep the supply and the non-Fed demand in line.? This is the overlooked reason, I believe that long rates appear to be moving independently of Fed action.? Their demand is not the only variable).

?Final thought -?to what extent do you think that the Fed?s great misunderstanding is their inherent bias towards lowest rates possible under any economic conditions: i.e. for any given level of inflation, that Fed policy is best that reflects the lowest level of non-inflationary?interest rates [because this presumably encourages credit expansion and therefore economic growth]?

?To my way of thinking, the difficulty with this is that it assumes that credit always has to expand FASTER than the economy overall.? I don?t mean that credit expansion is not important, it is a big component of growth, just that credit can?t grow faster than income forever and at some point, we have to find a model that enables income to grow fast enough to increase living standards without overleverage.

?To me, this is the central policy challenge of the 21st century, because a) globally, credit has surged relative to national income and has reached a limit, b) populations are aging and must therefore favor lower levels of credit – and consumption – overall and c) the bills associated with 1 and 2 are now coming due.

?The Fed, however, seems stuck on the idea that their job should be to inflate rapid credit expansion regardless of the creditworthiness of the borrowers.? This strikes me as dumb, or perhaps more like wishful thinking that if credit expands, growth will drive incomes higher and somehow these will catch up (with some acceptable lag).

?Notice that no one at the Fed talks about things like the household savings rate any more?? I would be ok with QE if the Fed could explain that they were facilitating an orderly deleveraging: in which case Household Debt/Equity (which indicates potential for end-consumer final demand) would be a better metric than unemployment.

?As it is, I believe that what they are really targeting (large) bank balance sheets, and that QE is really a massive backdoor subsidy to money center banks to guarantee enough operating income to allow them to write off bad loans while increasing capital reserves to comply with Basel III.? (Full disclosure, I have a significant portion of my assets in a large US bank that was trading well?below the strike price of the warrants issued against its shares to Berkshire Hathaway at the time I purchased the shares, which bank shall remain nameless).

?Politically, I suppose, saying,??well, we need to ensure banks are profitable so as to ensure the solvency of the payments system? looks disturbingly like a bailout for the 1% and is out of touch with a more populist America.

?Anyway, sorry for the diatribe, but curious to get your thoughts.? I think I am less reflexively sceptical about the efficacy of the Fed?s policy (but I fully agree with your view that they are not supporting employment with it).

?Thanks again for all the work you do.

The central idea I would like to comment on is that incremental easing has had less and less effect on the economy, at least in the short-run. ?Aside from energy companies, willingness to invest in the business has been light, while willingness to buy back stock has been high. ?That doesn’t produce growth in the economy.

The Fed doesn’t realize that it can’t stimulate the economy at the zero bound. ?QE is ineffective, and may become fuel for high inflation if the banks start to lend aggressively. ?Inflation is not the goal, and I think many policymakers are confused — the goal is real growth.

We can protect the payments systems by protecting the regulated subsidiaries of banks, and letting the holding companies bear the losses, which is what we failed to do in 2008-2009.

All that said, we have a punk economy, but what will happen if we get a large increase in bank lending, leading to inflation. ?What will the Fed do then?

On Insurance Investing, Part 6

On Insurance Investing, Part 6

This piece is the sixth out of seven in a series that I have been writing at Aleph Blog.? Here are links to the first five pieces:

Recently I decided to spend some time analyzing the insurance industry.? It?s a different place today than when I became a buy-side analyst ten years ago.? Why?

First, for practical purposes, all of the insurers of credit are gone.? Yes, we have Assured Guaranty, and MBIA is limping along. Old Republic still exists. Radian and MGIC exist in reduced states.? The rest have disappeared.? In one sense, this should not have been a surprise, because the mortgage and credit guaranty businesses never had a scientific model for reserving.? I?m not even sure it is possible to have that.

Second, the title insurers are diminished.? Some, like LandAmerica are gone. Fidelity National seems to be diversifying itself out of insurance, buying up a restaurant chain last year.

Third, health insurers face an uncertain future.? Obamacare may disappear, or Obamacare could slowly eliminate insurers.? It?s a mess.? Insurers debate to what degree they should compete in insurance exchanges.

But beyond all of that, valuations are fair-to-cheap across the insurance industry.? Part of that may stem from ETFs.? Insurers as a whole are smaller than the banks, but not as much smaller as they used to be.? Now, if you are a hedge fund, and you want to short banks, you probably have the best liquidity shorting a basket of financials, which shorts insurers as well.

That may be part of the issue.? There are other aspects, which I will try to address as I go through subindustries.

Offshore

By ?Offshore? I mean P&C reinsurers and secondarily insurers that do business significantly in the US, and who list primarily on US exchanges, but are not based in the US.? Most of them are located in Bermuda.

In 2011-2012, many of them were challenged by the high levels of catastrophes globally.? But the prices of the reinsurers did not fall because pricing power returned, and investors expect higher future earnings as a result.

Before I go on, I need to explain that what I will use to give a rough analysis of value is a Price-to-Book vs Return on Equity analysis [PB-ROE].? For more details, you can read my article here.? The short explanation is that companies in the insurance business (and other financials) are constrained by the amount of equity (net worth) that they have.? The ability to earn a return as a percentage of the equity [ROE] drives the market valuation as a fraction of the equity [P/B].

Here is a scatterplot for PB-ROE for the Offshore group:

Offshore

 

Companies above the line may be overvalued, and companies below the line may be undervalued.? ROE is what is expected by analysts for the next fiscal year, not what has been obtained in the past.

The fit is fairly tight, and indicates mostly logical valuations for this group.? The companies that are possibly overvalued are: Arch Capital [ACGL] and Renaissance Re [RNR]. Possibly undervalued: Tower Group [TWGP] and Endurance Specialty [ENH].

Now, this simple model can fail if you have an intelligent management team that has a better model.? Arch Capital and Renaissance Re may be that.? But with an expected ROE of less than 20%, it is hard to justify their valuation, when the average stock in this group needs an expected 11% ROE to be valued at book.

Why such a high ROE to get book?? Earnings quality.? Reinsurers have noisy earnings due to catastrophes.? You don?t give high valuations to companies that run hot or cold.? But the trick here is to see who is accumulating book value the fastest ? they tend to be the stars over time.? Endurance and Arch have been good at that.

Life

The life insurance business would be simple, if it indeed were only life insurance.? Much of the industry is handed over to annuities, and all manner of asset gathering.? Even life insurance can be made more complex through variable and variable universal life, where assets are invested in stocks, and do not receive a rate from the company.

Part of the trouble is that variable products are not simple, but the insurers offer guarantees for a fee.? When I see those products, my reaction is usually, ?How do they hedge that?!?

Thus I am concerned for insurers that are ?equity-sensitive? as I reckon them.? Here is the PB-ROE scatterplot:

Life

 

A tight fit.? The insurers that are seemingly undervalued are equity-sensitive ones: Phoenix Companies [PNX], Aegon [AEG], and ING [ING].? Those that are overvalued are Citizens [CIA], Eastern Insurance Holdings [EIHI], and Atlantic American [AAME].? For the undervalued companies, I am unlikely to buy because I am skeptical of the accounting.? I would look further down the list and consider buying some companies that are more reliable, like Assurant [AIZ], National Western [NWLI], and Fortegra Financial Corp [FRF].

One more note: to get book value in Life Insurance, you need a 9.8% ROE on average.? That?s high, but I expect that is so because investors are skeptical about the accounting.

Property & Casualty

This graph gives PB-ROE for the entire onshore P&C insurance industry:

Onshore

 

It?s a good fit.? Again, the casualties of the last year weigh on the property-centric insurers, but for the most part, this is logical.

Potential underperformers include First Acceptance [FAC], Employers Holdings [EIG], and Erie Indemnity [ERIE].? Below the line: Hartford Financial Services [HIG], Hilltop Holdings [HTH] Hartford Financial [HIG], and United Insurance Holdings [USIH].

Again, these are only screening tools.? Before buying or selling, understanding management and reserving quality, and riskiness of the lines of business makes a considerable difference.? Erie Indemnity has an ?asset light? model where it manages insurers, but does not bear underwriting risk.? Hartford has a significant life insurance and annuity exposure.? Models are models, and we have to understand their limitations.

Health

With Obamacare, I don?t know which end is up.? It could end up being a giant sop to the health insurers, or it could destroy the health insurers in order to create a government single-payer model, rather than the optimal model for cost reduction, where first parties pay directly, or pay insurers.? You want reductions in medical costs, get the government out of healthcare, and that includes the corporate deduction for employee health insurance.

My rationale is this: it could mess up the private market enough that the solution reached for is a single payer solution. I?ve talked with a decent number of health actuaries on this. The ability to price risk is distinctly limited. Young people pay too much, older folks too little. That?s a formula for antiselection. I think Obamacare was badly designed. I will not achieve its ends, and when the expenses start coming in, they will be far higher than anticipated. That has been the experience of the government in health care in the US. Utilization is underestimated, the further removed people from feeling its costs.

There are many models for profitability here, which makes things complex, but here is the present PB-ROE graph:

Health

It?s an okay fit, with the idea that the following companies might be undervalued: Wellpoint [WLP] and Humana [HUM].? And the following overvalued: ?Molina Healthcare [MOH].

I don?t regard myself as an expert on the health insurance sub-industry, so treat this with skepticism.? I include it for completeness, because I think the PB-ROE concept has value in insurance.? One more note, the PB-ROE model thinks of this as a safe investment subindustry, because to have a book value valuation, you have to have an ROE of 1.8%.

Financial Insurers

This group comprises the surviving mortgage, title and financial insurers, and two companies in the ghoulish business of buying life insurance policies from sick people.? Here?s the PB-ROE graph:

Financial

This graph is weird, because it slopes down, and does not have a good fit.? That?s because we?ve been through a rough period financially, and in many cases GAAP accounting does not do a good job with these companies that take a lot of credit risk.

We can still look for companies that have high price-to-book, and low ROEs ? note Life Partners [LPHI] and Radian [RDN] as possible sell candidates. We can also look for companies that have low price-to-book, and high ROEs ? note Assured Guaranty [AGO] and MBIA [MBI] as possible buy candidates.

This subsector is more difficult than most, because credit is not an underwritable risk.? It is feast and famine.? We are in a period of feast now, so in some ways what is bad is good.? The more risk, the more return.? But winter may come soon ? who knows what the Fed may do?? In general, I avoid this subsector for longs.

Insurance-Related Companies

This is a group that is a non-group.? It?comprises brokers and insurance service providers.? Here?s the PB-ROE graph:

Insurance Related

It doesn?t look like much of a group.

As it is the potential outperformers include?Brown & Brown [BRO], and Aon [AON], two leading insurance brokers.? A potential underperformer Willis Group [WSH], another leading insurance broker.

Summary

Insurance is complex, and the accounting is doubly complex, which is a major reason why many stay away from it.? But insurers as a group have had reliable and outsized returns over the rememberable past, which should encourage us to do a little kicking of the tires when a decent amount of the industry trades below its net worth and is still earning money with little debt.

In my opinion, this is a recipe for earnings in the future, and why I own a lot of insurers for myself, and for clients.

In the final part of this series, I will go over some nuances of insurance accounting ? I leave it to the end because it is kind of dull, but can make a lot of difference, because some companies look cheap and aren?t really cheap.

Full disclosure: long AIZ, ENH, NWLI for clients and myself

 

Thinking about the Insurance Industry

Thinking about the Insurance Industry

Recently I decided to spend some time analyzing the insurance industry.? It?s a different place today than when I became a buy-side analyst nine years ago.? Why?

First, for practical purposes, all of the insurers of credit are gone.? Yes, we have Assured Guaranty, and MBIA is limping along. Old Republic still exists. Radian and MGIC exist in reduced states.? The rest have disappeared.? In one sense, this should not have been a surprise, because the mortgage and credit guaranty businesses never had a scientific model for reserving.? I?m not even sure it is possible to have that.

Second, the title insurers are diminished.? Some, like LandAmerica are gone. Fidelity National seems to be diversifying itself out of insurance, recently buying up a restaurant chain.

Third, health insurers face an uncertain future.? Obamacare may disappear, or Obamacare could slowly eliminate insurers.? It?s a mess.

But beyond all of that, valuations are depressed across the insurance industry.? Part of that may stem from ETFs.? Insurers as a whole are smaller than the banks, but not as much smaller as they used to be.? Now, if you are a hedge fund, and you want to short banks, you probably have the best liquidity shorting a basket of financials, which shorts insurers as well.

That may be part of the issue.? There are other aspects, which I will try to address as I go through subindustries.

Offshore

By ?Offshore? I mean P&C reinsurers and secondarily insurers that do business significantly in the US, and who list primarily on US exchanges, but are not based in the US.? Most of them are located in Bermuda.

In 2011, many of them were challenged by the high levels of catastrophes globally.? But the prices of the reinsurers did not fall because pricing power returned, and investors expect higher future earnings as a result.

Before I go on, I need to explain that what I will use to give a rough analysis of value is a Price-to-Book vs Return on Equity analysis [PB-ROE].? For more details, you can read my article here.? The short explanation is that companies in the insurance business (and other financials) are constrained by the amount of equity (net worth) that they have.? The ability to earn a return as a percentage of the equity [ROE] drives the market valuation as a fraction of the equity [P/B].

Here is a scatterplot for PB-ROE for the Offshore group:

 

Companies above the line may be overvalued, and companies below the line may be undervalued.? ROE is what is expected by analysts for the next fiscal year, not what has been obtained in the past.

The fit is fairly tight, and indicates mostly logical valuations for this group.? The companies that are possibly overvalued are: Arch Capital [ACGL] and Global Indemnity [GBLI]. Possibly undervalued: Everest Re [RE] and Endurance Specialty [ENH].

Now, this simple model can fail if you have an intelligent management team that has a better model.? Arch Capital may be that.? But with an expected ROE of less than 10%, it is hard to justify their valuation, when the average stock in this group needs an expected 13% ROE to be valued at book.

Why such a high ROE to get book?? Earnings quality.? Reinsurers have noisy earnings due to catastrophes.? You don?t give high valuations to companies that run hot or cold.? But the trick here is to see who is accumulating book value the fastest ? they tend to be the stars over time.

Life

The life insurance business would be simple, if it indeed were only life insurance.? Much of the industry is handed over to annuities, and all manner of asset gathering.? Even life insurance can be made more complex through variable and variable universal life, where assets are invested in stocks, and do not receive a rate from the company.

Part of the trouble is that variable products are not simple, but the insurers offer guarantees for a fee.? When I see those products, my reaction is usually, ?How do they hedge that?!?

Thus I am concerned for insurers that are ?equity-sensitive? as I reckon them.? Here is the PB-ROE scatterplot:

 

A very tight fit.? The insurers that are undervalued are equity-sensitive ones: Phoenix Companies [PNX], American Equity Investment {AEL] , Lincoln National [LNC], and ING [ING].? Those that are overvalued are FBL Financial [FFG], and CNO Financial [CNO].? CNO has issues from long-term care, a coverage I dislike a great deal.? FBL is worth exploring.

One more note: to get book value in Life Insurance, you need an 11.7% ROE on average.? That?s high, but I expect that is so because investors are skeptical about the accounting.

Property & Casualty

This graph gives PB-ROE for the entire onshore P&C insurance industry:

 

It?s a good fit.? Again, the casualties of the last year weigh on the property-centric insurers, but for the most part, this is logical.

Potential underperformers include Hallmark Financial Services [HALL], Hilltop Holdings [HTH], Eastern Insurance Holdings [EIHI], Old Republic International [ORI], and Erie Indemnity [ERIE].? Below the line: Hartford Financial Services [HIG], Allstate [ALL], Tower Group [TWGP], and Horace Mann [HMN].

Because of the lower risk in P&C insurers, a firm only needs to earn an ROE of 6.6% to have a book value valuation.

Health

With Obamacare, I don?t know which end is up.? It could end up being a giant sop to the health insurers, or it could destroy the health insurers in order to create a government single-payer model, rather than the optimal model for cost reduction, where first parties pay directly, or pay insurers.? You want reductions in medical costs, get the government out of healthcare, and that includes the corporate deduction for employee health insurance.

My rationale is this: it could mess up the private market enough that the solution reached for is a single payer solution. I?ve talked with a decent number of health actuaries on this. The ability to price risk is distinctly limited. Young people pay too much, older folks too little. That?s a formula for antiselection. I think Obamacare was badly designed. I will not achieve its ends, and when the expenses start coming in, they will be far higher than anticipated. That has been the experience of the government in health care in the US. Utilization is underestimated, the further removed people from feeling its costs.

There are many models for profitability here, which makes things complex, but here is the present PB-ROE graph:

It?s a pretty good fit, with the idea that the following companies might be undervalued: Wellpoint [WLP] and CIGNA [CI].? And the following overvalued: ?Molina Healthcare [MOH] and Wellcare Health Plans [WCG].

I don?t regard myself as an expert on the health insurance sub-industry, so treat this with skepticism.? I include it for completeness, because I think the PB-ROE concept has value in insurance.? One more note, the PB-ROE model thinks of this as a safe investment subindustry, because to have a book value valuation, you have to have an ROE of 7.8%.

Other Insurers and Insurance-Related Companies

This is a group that is a non-group.? It? comprises brokers, service providers, title and financial insurers.? Here?s the PB-ROE graph:

Pretty tight for a non-group.? Perhaps it is because it derives off of a much larger group, some of which has died off, leaving behind profitable entities.

As it is the potential outperformers include? Assured Guaranty [AGO], the largest remaining financial guaranty insurer, Fortegra Financial Corporation [FRF] a third party administrator of sorts, and what remains of the title insurance industry, Fidelity National [FNF], First American [FAF], and Stewart Title [STC].? That is one beaten-down group, and, one that would benefit a lot if housing bounced back.? There is a lot of potential earnings power there, and it trades for little above book value.

Potential underperformers include AJ Gallagher [AJG] and E-Health [EHTH].? I?ve dealt with AJ Gallagher professionally, and have respect for their management team, but maybe the valuation is stretched there.? E-Health is a health insurance broker, and over its existence hasn?t done anything deserving of a premium valuation.

And, for this non-group, it is riskless enough that you only need a 4% ROE to have a book value valuation.? This is one beaten-down sector of the market, and one that I do not own any of, but that I will eventually return to, because I have owned I in the past.? Should residential real estate finally normalize, many of these companies will fly.

I write this as one that was bearish on housing-related stocks since 2005.? There is potential here.

Summary

Insurance is complex, and the accounting is doubly complex, which is a major reason why many stay away from it.? But insurers as a group have had reliable and outsized returns over the rememberable past, which should encourage us to do a little kicking of the tires when so much of the industry trades below its net worth and is still earning money with little debt.

In my opinion, this is a recipe for earnings in the future, and why I own a lot of insurers for myself, and for clients.

Full disclosure: long ENH, but I may take other positions for clients in the next month

The Best of the Aleph Blog, Part 2

The Best of the Aleph Blog, Part 2

This second period goes from May to July 2007.? Here we go!

A Modest Proposal to Raise Taxes on Mr. Buffett (and me)

Points out how the problems with the tax code are really more about defining income rather than tax rates.? It is easy for the rich to defer/shelter income — far better to tax increases in net wealth, and tax all people like traders, who are marked-to-market at the end of each fiscal year.

Talking to Management

One of my “labor of love” pieces written for RealMoney — five parts, dealing with how to interrogate management teams.? A lot of the game is asking the wrong questions, and seeing how management answers them.

Back From Bermuda

Uh, this post made me persona non grata in Bermuda for 2-3 years.? I think I could return now.? Part of the difficulty was that I was not told that sessions were supposed to be “off the record.” That said, my blog was the most popular blog in Bermuda for a day.? Apologies, HF, and thanks for inviting me; sorry to embarrass you.

Thinking About What Might Blow Up

Fascinating to see all of the markets that were going to blow up within 15 months trotted out for display.? Also, the basics of my theory on how one detects bubbles.

What Brings Maturity to a Market

Failure brings maturity to a market; risk-based pricing follows the realization of risk.

PIMCO in Theory and Practice

Important piece, because people watch PIMCO on the tube, and think that they make money off of their economic predictions, which are often wrong.? PIMCO is really a bunch of intelligent fixed income quants, who make their money off of mispriced out-of-the-money volatility.

Private Equity: Short Term versus Long Term Rationality

Analyzing comments of Cramer and others as to when the Private Equity bull market would end.

Speculation Gone Wrong, Or, Tops are a Process

I was commenting on how it is hard it is to call a top, because they are processes rather than events.? Who can tell how long foolish liquidity can last?

Trailing E/P as a Function of Treasury Yields and Corporate Spreads

Part one on my “Fed Model.”? Analyzing secondary factors in stock and bond performance.

Subprime Credit, Illiquidity, Leverage, Contagion and Concentration

I suggested that a small number of players would get hit by losses in subprime.? True enough, but what I did not know was how much risk was still being held by investment banks.

Efficient Markets Versus Adaptive Markets

A post I cite frequently, mainly for the joke at the end, but a post that tries to make the point that markets are not fully efficient, but they are somewhat efficient.

Quantitative Analysis is not Trivial ? The Case of PB-ROE

In some environments, PB-ROE and low P/E investing will be similar, but that will not always be true. Do not accept a false simplification, even though it may be true at present. The PB-ROE model is richer, and works in more environments, after adjusting for the limitations listed above. PB-ROE is a very useful tool, and not ?gobbledygook.?

Defends the PB-ROE model while admitting its limitations.

The ?Fed Model?

Defends a version of the dividend discount model, and shows the simplifications that the “Fed Model” imposes are unrealistic, while showing that a more realistic model can add value over the long run.

A Fundamental Approach to Technical Analysis

Tries to explain how an intelligent fundamental investor would think about technicals, particularly in markets that are less liquid.

Twenty-Five Ways to Reduce Investment Risk

This article got me an invite to write an article for a Canadian business magazine.? But this article encapsulates the many ways I think about risk in investing.

Dissent on Dividends

Roger Nusbaum ably pointed out how demographics favors an increasing amount of dividends being paid to retiring Baby Boomers.? That is true.? We have ETNs being set up to do that (beware of Bear Stearns default risk), and hedge fund-of-funds crowding into strategies that synthetically create yield.? Beyond that, we have Wall Street creating funky yield vehicles that gyp facilitate the yield needs of buyers (while handing them capital losses).

My main point is this.? Approach yield the way a businessman would.? If you see an above average yield, say 4% or higher, ask what conditions could lead them to lower the yield. History is replete with situations where companies paid handsome dividends for longer than was advisable.

Back in 2002, I heard Peter Bernstein give an excellent talk on the value of dividends to the Baltimore Security Analysts Society.? At the end, privately, many scoffed, but I thought he was on the right track.? I still like dividends, but I like businesses that grow in value yet more.? Aim for good returns in cash generating businesses, and the dividends will follow.? Stretching for dividends is as bad as stretching for yield on bonds.? That extra bit of yield can be poisonous, leading to capital losses far greater than the incremental yield obtained.

Dividends are good, but they are a very imperfect way to approach the market.

Is the S&P 500 30% undervalued?

A somewhat whimsical piece that looked at implied equity volatility alone, and suggested that either the equity market was low, or equity volatility was high.? The truth was neither.? Equity volatility would blow out and go higher still, along with credit spreads.? Fortunately I was not dogmatic about my model’s conclusions.? I was more bearish in general in late July.

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So much for that era.? It was an interesting time as the bubble neared its apex.

A Summary of my Writings on Analyzing Insurance Stocks

A Summary of my Writings on Analyzing Insurance Stocks

Well, whaddaya know?? I received a nice mention at The Ideas Report For Serious Investors. Unexpected, and an honor. I really like their blog and have added it to my RSS reader.? So, I left them this comment, which is not published yet:

Hey, thanks for mentioning me. Here’s a bonus for those with access to RealMoney:

And away from RealMoney:

I hope you enjoy these. They are the bulk of my thoughts on insurance stocks, aside from issue-specific commentary.

David

Disclosure: long ALL NWLI SAFT RGA AIZ PRE CB

I went back through all of my blog posts in insurance to analyze what were the best things I had written on insurance investing.? I also added one more blog post idea to my list.? A long time ago, I wrote a 16-page paper summarizing the whole insurance industry for a former employer.? It was urgent, so I pulled an all-nighter at the ripe old age of 43.? He was deeply grateful for the piece, and then it never got published.? It was supposed to span three issues of his newsletter, but it never appeared in one.? I have no idea why it never ran, but it bugged me that it never did.? So, with a little updating, I hope to release it in serial form sometime in the next few months.? I have lost the original file, so I will have to scan it in and edit it.

But enough of that — the articles listed above are a reasonable summary of how I analyze insurance and other financial stocks.? For those that invest in stocks, I hope you enjoy these posts.

PostscriptApologies to PlanMaestro, Manual of Ideas republished his work, and I appreciate the two mentions from him at his blog, Variant Perceptions.? He expands his thoughts on my most recent piece on AIG’s under-reserving.? Keep it up PlanMaestro, and remember, PartnerRe does not discount its reserves.

How Stocks Work, Sort of

How Stocks Work, Sort of

I enjoyed the pieces by Felix Salmon and James Surowiecki, and Eddy Elfenbein on how stocks work.? I have reproduced their arguments here, together with my thoughts.

Felix Salmon: What’s the relationship, in theory, between a company’s return on equity, on the one hand, and its stock price, on the other? Does a high return on equity mean a rising stock price, or is it a rising return on equity which means a rising stock price? Or, to put it another way: if one company has an ROE which is (expected to be) flat at 4%, and another company has an ROE which is (expected to be) flat at 14%, would you expect the latter to rise more than the former, or indeed either of them to rise at all?

Jim Surowiecki: Your first question, unfortunately, can’t really be answered in the abstract. It’s perfectly possible for a business with high returns on capital to still be overvalued – that is, for its stock price to overestimate the cash flows it will generate over time. In that case, the fact that a company is generating high returns on capital won’t translate into an increase in its stock price. Microsoft’s average return on invested capital, for instance, is consistently good – above 25% — but its stock is just about where it was a decade ago.

This speaks to your second question, which is really about expectations. If the market is accurately forecasting the returns on capital of the low-ROIC company and the high-ROIC company, you wouldn’t expect the latter’s stock price to dramatically outperform the former. But assuming both are fairly valued, the high-ROIC company will have a much higher valuation, meaning it will generate more income for shareholders going forward (in the form of dividends, buybacks, etc.)

That’s why, all things being equal, you want to own shares of companies that generate high returns on capital rather than those of companies that don’t. This is, in a way, self-evident. If you put money into a company, you want it to use that money to generate high returns, higher than you could get elsewhere. That’s what companies that have high returns on capital do: Microsoft earns an additional twenty-five cents for every dollar it invests. By contrast, companies with low returns on capital create less value, and companies that earn returns that are lower than their cost of capital (as was true of Japanese companies between 1990 and the early part of this century) actually destroy value for their shareholders.

Eddy Elfenbein: A company?s share price is the net present value of all future cash flows. A company?s return-on-equity is a measure of profits for the next year relative to present equity, so the two are connected. However, a high ROE does not translate to a rising share price, but a rising ROE should. Regarding your question, I would assume that the market has discounted both stocks? net present value which incorporates ROE. Therefore, I would only expect the stocks to rise at the pace of the risk-free rate plus the equity risk premium.

This may help: ROE can be broken down into three parts; profit margin, asset turnover and leverage. It goes like this:

Profit margin is earnings divided by sales. Asset turnover is sales divided by assets. Leverage is assets divided by equity.

Earnings……….Sales…………..Assets
—————X—————-X————–
Sales…………….Assets………..Equity

Note that the sales and assets cancel each other out to give you Earnings divided by Equity.

David Merkel: The question can be answered in the abstract, with some noise.? With a few assumptions/limitations as disclosed in this article, Quantitative Analysis is not Trivial ? The Case of PB-ROE.? In most mature industries where capital constrains growth, there is a linear relationship between price-to-book and and ROE.??? This is a result of the dividend discount model, given the assumptions of the article that I cited.

There is the inherent assumption that net worth is the limiting factor in doing new business.? If that is not the case, then the model does not work.? If sales is the limiting factors the equation becomes price-to-sales as a function of profit margins.

FS: What’s the relationship between stock price, ROE, and risk-free rate of return? Would one expect ROEs in a country with a zero risk-free rate to be lower than ROEs in a country with a higher risk-free rate? How does that feed in to stock prices, if at all?

JS: You would expect returns on invested capital to be lower in countries with lower risk-free rates (like Japan). Two reasons suggest themselves for this: first, the low risk-free rate may be indicative of lower growth prospects for the economy as a whole. But also, when the risk-free rate is low, the hurdle rate for corporate investments is also lower (because investors’ expectations of what counts as a reasonable return are also lower.) That may make companies more likely to invest in low-return projects. Both factors have something to do with why Japanese firms have underperformed over the last twenty years (and in particular in that 1990-2002 stretch). But I think the most important factors explaining the low ROIC of Japanese firms were their indifference to shareholder value and their willingness to invest in value-destroying projects.

EE: Again, a company?s share price is the net present value of all future cash flows. ROE is the best measure of the growth of future cash flows. How do we discount that? We discount it by the cost of capital which is risk-free rate plus an equity-risk premium. That?s why a lower risk-free rate tends to boost equity prices.

According to the Gordon Model, it should look something like this:

Price = Earnings/(Risk Free Rate + Equity Risk Premium – ROE)

DM: The risk free rate often has little to do with where corporations can source funds.? Eddy talks about the equity risk premium, but that varies over time.? At present that risk premium is high.? If the country in question is in a liquidity trap, like Japan, equity risk premiums are high.? In general, equity risk premiums are a free market, and disconnected from the “risk free rate” represented by short government bonds

FS: How can a company with a positive ROE destroy economic value for shareholders?

JS: The key to understanding how a company with a positive ROE can nonetheless destroy economic value is simply recognizing that equity is not free. It has a cost, just like debt does, a cost that reflects the return that investors demand as compensation for the risks and opportunity costs that owning equities entail. We can debate how to calculate that cost of equity (risk-free rate + market risk premium is a simple solution). But the basic principle is, as I said above, that a company is only creating economic value for its shareholders if it’s earning more than its cost of capital. Again, this is intuitive: if you were the part owner of a company that, on a risk-adjusted basis, was earning less than the yield you could get on a 30-year T-bill, you probably wouldn’t keep your money in that company, because you would effectively be losing money with every day that passed. Shareholders feel the same way, so the share prices of companies that earn less than their cost of capital are unlikely to rise over time. According to a study by the Japanese government, Japanese companies’ return on capital was below their cost of capital for roughly the entire decade of the 1990s through 2002. If you want to know why Japanese stock prices fell precipitously during that period, that’s the biggest reason why: the companies weren’t creating any value for shareholders. And what made it worse was that, as a result of the bubble, expectations were already inordinately high.

One thing I should say, though: Japanese companies have significantly improved their performance in the past five years, and there’s a strong case to be made that, as in the U.S., the recent sell-off of the Nikkei has been massively overdone. In fact, if you think that the transformation of Japanese firms in recent years will be long-lasting (I’m agnostic on the question), then the Nikkei looks very undervalued right now – or at least it did before it rose something like 15% in the last week and a half.

EE: All companies in all industries are in phantom competition with the cost of equity capital. Even though you can?t see it, you?re struggling against it every day. So even if a company manages to squeak out positive ROE, capital will not flow your way if you keep losing to everybody else.

DM: No disagreement here.? Companies must earn more than their cost of capital in order to add value.? This helps explain why low positive ROEs trade at a discount to book value.

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That’s all, and spite of all the discussion here, I own shares of? Honda Motors and the SPDR Russell/Nomura Small Cap Japan ETF,

Full disclosure: long JSC HMC

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