Accounting – Page 15 – The Aleph Blog

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.

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.

Bridging the Accounting GAAP

Posted on 2 May 2007 by David Merkel

When I started this blog, I did not plan on writing so much? about accounting, but I follow the news flow.? It seems like the EU and the US have come to a meeting of the minds in unifying accounting standards.? It looks like the EU gave up the least in the compromise.

Though there are some ways that IFRS are better than GAAP, (more consistent in the way they treat financial assets and liabilities), I think that the change will make accounting slightly more opaque, and lower comparability, until all US firms are forced to use one standard or the other.

I do not look forward to having to study IFRS.

Twelve Unusual Items Affecting the Markets Now

Posted on 30 April 20071 May 2007 by David Merkel

1) The TED [Treasury-Eurodollar] spread, which is a measure of market confidence, is up dramatically over the past two months, from 18 basis points to 52 at present. That indicates decreased confidence in the banking system, though swap spreads have not widened to confirm that judgment.

2) The Indian Rupee has rallied almost 10% against the dollar over the past two months, because of the need to recycle the US current account deficit, and restrain inflation at home, tighter monetary policy is needed in India, and many other developing nations. That means upward pressure on their local currencies, which will hurt their exporters. India is letting that process happen at present, other developing countries are allowing dollar liquidity to further inflate their economies.

My view is that the next major blow-up will happen as a result of a neophyte developing large country central bank overshooting on their tightening of monetary policy. China is my lead candidate, but India could do it as well.

3) Ordinarily I like what Jack Ciesielski has to say. He is far beyond me in terms of understanding the nuances of accounting standards, and I recommend his work to all professionals. I think his recent Barron’s article misses a nuance of SFAS 159, though. If SFAS 159 were mandatory, Fannie and Freddie might have some difficulties. But SFAS 159 can be ignored by any company that wants to ignore it, and used to the degree that any company wants to use it, so long as they disclose where they are using it and where they aren’t using it. So, I’m not sure the SFAS 159 has much relevance to Fannie and Freddie over the short run. Over the long run, it might be different if SFAS 159 becomes mandatory, or if the US adopts International Financial Reporting Standards.

4) I have posted at RealMoney on numerous occasions regarding overvaluation of many risky asset classes versus safe asset classes. I appreciated the piece at TheStreet.com regarding Jeremy Grantham, and the piece over at The Big Picture discussing it. I think he is right, but early. We haven’t run out of liquidity yet, and perhaps we get an exponential rise in risky assets that signifies the end. On the other hand, tightening global central banks in aggregate could be the end. For the cycle to change, we need a fall in profit margins, and a rise in discount rates. I think both are on the way, but they don’t come like clockwork.

As an aside, if managed timber is still cheap to Mr. Grantham, that could be a good place to hide. Decent return, and some inflation protection.

5) Dig this article from Businessweek. Know what it reminds me of? Manufactured housing back in 2000-2003. Lenders bent over backwards to keep loans current, at a price of future credit quality, and only gave up when their companies were facing death. Most died; a couple survived and much of the remaining corpus is part of Berky now.

The banks will keep marginal lending alive until it becomes a serious threat to their well-being; after that they will act to protect the banks. The severity of loan defaults thereafter will be very high.

6) How much international goodwill has the US lost through unilateralism? Part of that cost is measured by the fall in the dollar. The current account deficit presumes on the good graces of the rest of the world, but at the edges, if our policies aren’t well-liked, the deficit will get cleared at lower exchange rates for the dollar. Just another reason that I am long foreign currencies.

7) Central bank tightenings? Look at Japan and China. I have a little more belief that China will continue to tighten; they have been doing so for the last year. The acid test is how much they are willing to let their currency appreciate, and I think China will let that happen.

I am more skeptical about Japan. Their central bank is not very independent, and regardless of the article I cited, there isn’t a lot of reason for the Bank of Japan to act rapidly. Central Banks are political creatures that avoid pain; they are not entrepreneurs, particularly not in Japan.

8) What’s better in accounting, rules or principles? The current mood in accounting leads toward principles. The idea is that principles allow for a more accurate description of the corporate economics than the application of rules that though consistent, may not fit all companies well.

I split the difference on this issue. We need rules and principles. Rules for consistency and comparability, and principles for accuracy to individual situations. That is why I would have two income statements and two balance sheets. One off of amortized cost that would be consistent and comparable across all firms, and one off of fair market value, that would give management’s view of the economics of their firm.

9) I had been critical of the FOMC over at RealMoney because they had not been injecting enough reserves into the banking system in order to keep the Fed funds rate at 5.25%. Over the last week they have amended their ways. They have bought bonds and sold cash, and now Fed funds resides more comfortably near 5.25%. (I would post a link, but as I write the Fed website is not responding.

10) A harbinger of things to come: Fitch downgrades some 2006 subprime deals.

11) The Wall Street Journal was “dead on” this morning about talking about the degree of leverage being applied to the markets. I’ve been writing about this at RealMoney for some time, and I would advise everyone to look closely at their asset portfolios, and ask what assets would be at the most risk if financing were interrupted. For equity investors, I would encourage you to be long stocks with high ROAs, not high ROEs.

Do derivatives make a mockery of margin requirements? You bet they do, and we can start with furures and options, before moving on to private agreements.

12) Leave it to Caroline Baum to catch the mood of the government, and apologists for the current economy. Ex-housing, we are doing fine. Another way to say it is housing is doing lousy, and export-oriented sectors have not made up the difference.

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That’s what I am seeing now. Are you seeing thing I am missing, or do you disagree with what I have said? Post here, and let’s discuss it.

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