Tom A's Stock Picks

Arch Coal - time to buy on the dip?

Rating: 3.00 not yet rated(1 votes)    Vote:

You are logged in as | Logout

Arch Coal (ACI) has been a wonderful growth story, making its way from 27.76 to as high as 77.40 over the past year. It recently sold off to the tune of 15%, closng Friday at 63.70, which raises the question whether this is a good time to try to catch the falling dagger - a question I would answer in the negative.

To complete my review, I browsed a number of analyst reports as well as the most recent 10-K and 10-Q, concentrating on management's discussion of operations. In addition, I visited the company's website and looked at their most recent investor presentations (impressive), and checked out coal on the Energy Information Administration website.

Coal, like oil, has had a tremendous price run as the energy and materials boom has developed. ACI management has done a good job positioning themselves for this boom and exploiting their new-found pricing power, particularly in metallurgical grade coal, where they have locked in prices at what appears to be the peak of the materials boom. The coal business operates on long-term contracts, and Arch sold most of their planned metallurgical production for the next year of so at very good prices.

The largest volume of Arch's prduction comes from the Powder Ridge Basin, out West, and is very low sulfer but also low in heat value. It sells for much lower prices than the metallurgical grade coal they mine in the Central Appalachia. However, management expects prices to increase, driven by international demand for coal for power generation, specifically in China and India. To make this thesis work, it is necessary to assume that Australia's current infrastructure and port congestion problems will continue unabated. Australia has ample supplies of coal and is nearer to the China and India markets. Arch is holding out for better long term pricing contracts on its Powder Ridge Basin production. EIA information shows Powder Ridge Basin prices declining for the past several months.

When projecting future earnings, I start with current year revenue, increase it by a growth percentage, and then get to earnings by using a net income percentage. My spreadsheet does this using historical averages, which I can over-rule if think I have good information about future revenue and margins. In the case of ACI, earnings estimates prepared this way are substantially less than analyst consensus figures. Using 5 year average revenue growth and the best historical year's margins, I get EPS of 2.67, while some analysts are getting around 5.50. It's about future margins.

It's about future margins and the sustainability of future margins. Steel is cyclical, and demand for metalurgical grade coal will be driven by this cycle. Whatever Australia's port congestion and infrastructure problems are, they will be solved when financial incentives become strong enough. So, if Arch earns 5 per share next year, P/E might be disappointing, based on concerns for sustainablity.

Arch is a wonderful company. Coal is the United State's most aboundant fossil fuel, a proven technology. ACI's Laurel Mountain facility in Central Appalachia is state of the art, a coal mine that is more like a factory. Injury rates have been low. Management was adroit in positioning themselves such that this facility came on line at a time of increasing demand. Future plans include a presence in the Illinois Basin, where they have a large contiguous area under control. They are working on Coal to Liquids (CTL), which is a viable technology, albeit one with a heavy environmental cost in terms of CO2 release. Mangement presents their story well.

Taking all of this together, I plan to add ACI to my watchlist and buy it if the prcie falls to an area I find attractive. As of this moment, that would be 40 per share.

Comments: 0

Fannie and Freddie - capital-lite financial strategies

Rating: 3.00 not yet rated(1 votes)    Vote:

You are logged in as | Logout

If I had to make one generalization as to why we have so much unease about our financial system, I would attribute it to the popularity of capital-lite strategies. Both banking and insurance are more profitable, but more risky, when done with reduced capital. The temptation is to push the envelope too far, rationalizing that risk has somehow been minimized and everything will be OK. Recent developments have highlighted the issue for Fannie Mae and Freddie Mac.

FNM and FRE are financial guarantors - they buy mortgages, hold some on the books, but bundle and sell most of them, guaranteeing the mortgages involved. If a mortgage that has been sold goes bad, they take it back. The situation is, they have been selling mortgages but retaining the risk of default. They recognize losses only when the mortgages are put back to them, which allows them to operate very efficiently - the capital-lite strategy. This is OK unless the merry-go-round stops, in which case they have losses to pay but no future income from which to pay them.

As GSEs, Freddie and Fannie enjoy the implied support of the Federal Government. With the mortgage securitization system in disarray, Fannie and Freddie have been annointed as the saviors and have increased their volume and market share, at profitable rates. OFHEO, their regulator, has relaxed already lenient capital requirements in order to permit them to perform their mission. Fannie and Freddie have enjoyed free access to capital markets, because of the implied Federal guarnantee, so the best case scenario is that they raise capital (debt, not equity) to cover their losses, continue to do new business at a profit, and everything works out fine. Shareholders are rewarded with ample profits form increasing volume and market share.

From a risk point of view, insurance companies and banks get most of their risk from three areas: operations, investments and liquidity. As a rule of thumb, an insurance company that does risky underwriting will do conservative investing, so as to mitigate overall risk. In the case of Freddie and Fannie, what they insure (conventional mortgages) is not very risky, and what they invest in (more of the same) is not very risky. As such, their overall risk profile is low, the exception being the use of inadequate capital creates a possible liquidity hazard. In my opinion, the Federal Government would intervene well befor liquidity would become an active issue.

Lehman Brotheres recently pointed out that technically the implementation of a new accounting standard, FAS 140, would require Fannie and Freddie to have much more capital than is now required. The shares tanked 20% on the news, but have rallied a bit since. CDS spreads (the premium to insure their debt against default) have widened substantially. Many observers have noted that the implied Federal support does not extend to shareholders, who would wind up with nothing if Freddie or Fannie had to raise dilutive capital due to excessive losses.

I watched an interview on Bloomberg TV with James Lockhart, head of OFHEO, on the subject. His position was, that as their regulator he saw no need for the additional capital and they were doing very well on the pay as you go scheme. All we need to do is just keep on rolling down the road: the only danger is if we stop. My reaction, based on politics as usual, is that the most likely outcome here is that Fannie and Freddie will be able to continue as they have been, potentially a lucrative investment - remember, both banking and insurance are profitable when done with a minimum of capital.

I looked at Freddie a few weeks ago, noting that their entire shareholders equity consisted of deferred tax assets. If management is unable to project sufficient future profits to use the deferred tax assets, they would need to be written off, reducing book value to zero. I shorted the stock briefly in my personal account, then covered as I couldn't get a handle on the political aspects of pretending everything is OK.

After my experience with financial guarantors ABK and MBI, I think that the popularity of negative bets on them is due to its effectiveness as a hedge against "the big one." In the event of a Depression, they are toast. That is why the short sellers are so fearless and the CDS spreads so wide. Now that line of thinking is starting to spread to Fannie and Freddie. If this is the big one, the stocks go to zero, and a short position is a wonderful hedge against an extreme outcome to our current economic difficulties. The thinking on the CDS has got to be the same - if this is the big one and some of the agency paper is no good, those who hold CDS protection on Freddie and Fannie will rule the world. An attractive prospect.

A likely outcome is that Freddie and Fannie will be shorted mercilessly, and coddled carefully by regulators, creating an extreme buy point for those who care to bet on the idea that this is not "the big one."

Comments: 1

Reflections on Value Investing

Rating: 3.00 not yet rated(2 votes)    Vote:

You are logged in as | Logout

After a difficult 6 months in SLO2 and in my personal portfolio, I take some comfort in reading the occasional article about various well-regarded and previously successful professional value investors who have experienced similar underperformance. The question comes up, why not switch over to something that works, like long energy and commodities and short financials and consumer discretionary?

With energy and commodities looking more and more like bubbles, and with financials wearily scraping out what looks like a deep saucer bottom, it doesn't make any sense to realize substantial losses on stocks I consider undervalued in order to bet the meager proceeds on companies that are cruising around in the vicinity of 52 week highs. Now would not be a good time to try the chameleon act.

On a more personal level, it's about taking the advice: "Be yourself." I attempt to beat the market by picking stocks, and I put considerable thought and effort into the process. My natural tendancy is to focus on value, and this occasionally leads me into contrarian positions. I admire John Neff, not for deep analysis of stocks or markets, but for the tenacity with which he held to to his convictions on value - an attribute which was key to his long term success.

My two best performers were Olin (OLN), in the basic chemicals industry, and BJ Services (BJS), in oil field services. Both of them increased about 50% after economic conditions in their industry became more favorable. BJS is very dependent on North American natural gas, and when that rallied BJS was carried along. I have sold off my entire position. OLN is in the chlor alkali business, which would normally be dependent on strength in housing and automotive. However, as the situation developed, caustic soda demand got tight, and OLN has a cost advantage over its competition because it is less dependent on electricity generated by natural gas. I have liquidated all but 300 shares.

My two losers were financial guarantors Ambac (ABK) and MBIA (MBI). Comparing myself to other value investors, they got burned on the likes of Washington Mutual (WM), National City (NCC), CItigroup (C), Fannie Mae (FNM) and Freddy Mac (FRE). I was tempted by some of the above, but with amazing perspicacity and fine-turned judgement I saw the declines coming and avoided them all. Leaving aside the sarcasm, I have been asking myself why if I could see the problems with banks, I didn't see them for the financial guarantors, and still believe ABK and MBI are good investments.

The answer is I was drawn to MBI and ABK because I spent much of my working life in insurance, understand the busniess, and have made money investing in insurance companies. After initially underestimating the complexity of the issues involved, I have developed a good understanding of the situation, and I enjoy keeping up with developments and blogging on the issue from time to time. I have a strong opinion, and regard the risk/reward as very favorable here.

As a practical matter, value investing will frequently leave the investor waiting for improvements in conditions in the economy, a specific industry, or company specific problems. The value may be there, but a catalyst is required - either a dramatic surprise or a long term change in perceptions or conditions. In my opinion, the current financial crises is largely a hysterical over-reaction - things simply are not as bad as the press and those who profit from the difficulties of others would have us believe. I can't predict how much unnecessary loss the current panic will create: so, I position myself to benefit if and when it abates, and I wait.

My thanks to all who commented on my blogs or corresponded with me, especially Russ, Don, Dave, Becky and Fernando. It's about companionship on a journey. I have been watching in wonder as FRE and FNM tank 50% - they have the dread disease - they "need capital." Do I dare to call a bottom?

Tom

Comments: 3

Property and Casualty Insurance - overlooked value in financials

Rating: 3.00 not yet rated(1 votes)    Vote:

You are logged in as | Logout

With the financials rallying 31% over the past week, all of a sudden there are a lot of commentators who advise buying banks, either selectively or by using ETFs. Lost in the shuffle are Property and Casualty and Multi-line Insurance, where many well-known companies are trading in the area of book value, normally a buy point. Over the past 10 years, you could make money consistently by buying insurance companies at around 1 X book value and selling at around 1.5 X book value. P/Es are under 10 in some cases, always appealing to the value investor.

Property and casualty insurance is not an easy business - many of the products are commodities, competition is intense, and the the business is cyclical. What happens is that when insurance companies make money they reduce rates, trying to buy market share. All the companies do the same thing, and rates go down until nobody is making any money. Right now, the insurance business is coming off a protracted run of profitability, where combined ratios have at times been under 90. The combined ratio is the sum of the loss and expense ratios, expressed as a percent, and anything under 100 indicates an underwriting profit. So, they can't stand prosperity, and rates have been declining.

In addition, insurance companies earn investment income. A large part of their statutory surplus is required to be in bonds. As a result, many of them are exposed to MBS, to include sub-prime.

Finally, insurance is prone to catastrophes, most recently Katrina did a number on Allstate (ALL), among others. From time to time something like asbestos liability surfaces, or a line of business like products or professional liability becomes wildly unprofitable.

Taking all of this together, some analysts have expressed concern that these companies may be value traps, with poor industry fundamentals outweighing what otherwise would be attractive valuations. On the other hand, these companies are unique among current financials in that most of them are over-capitalized. Specifically, an industry norm is to write 2 dollars of premium for each dollar of surplus - a two to one surplus ratio. Many companies, and the industry as a whole, are at a premium to surplus ratio of more like one to one.

That raises the question, what to do with the extra capital. The standard answer, use it to write business at a loss and make it up on increased market share, may be less attractive than formerly. Reading the papers and watching TV, industry executives may have become aware that having adequate or more than adequate capital is a huge business advantage, and they may attempt to deploy the capital in more useful ways. Buybacks come to mind, as do increased dividends. Where is Carl Icahn when you need him? He could take a stake, make a stink, and presto! Out comes a special dividend. Years ago it was a popular ploy, buy an insurance company with excess capital, strip it out, and take it from there.

Seriously, well run companies in difficult industries make good investments. I have had profitable results using a buy low sell high strategy on these companies, and now may well be a time to start the cycle again. Meanwhile, most of them pay a dividend. Here are some ideas:

Chubb (CB) - At 47.00 on 7/21, P/E of 6.6, P/B 1.1. Specializes in D&O Liability and in high end Personal Lines. Over the past ten years it has always traded at a P/B of 1.5 or better at some time during the year. Dividend 1.82, 2.81% yield. My target 62.

Cincinnati Financial (CINF) - 26.93 as of 7/22. P/E of 7.4, P/B 0.8. Very strong relationship with the Agencies who represent them. Premium to Surplus ratio is low. Large equity investments, largest holding is Fifth Third Bank (FITB). The appeal to me is, its assets are all liquid and FITB will presumably recover. Dividend is 1.56, yielding 5.79%. Meanwhile, buying liquid assets at 80 cents on the dollar seems like a good idea, at least in moderation. My target, 36.

Hartford Financial Group (HIG) - 62.55 as of 7/22. P/E of 8.9, P/B of 1.1. Large and diversified. Over the past ten years it has always traded at a P/B of 1.6 or better at some time during the year. Dividend 2.12 yielding 3.39%. My target 85.

Allstate (ALL) - 44.33 as of 7/21. P/E of 7.4, P/B 1.2. Well-known, Personal Auto and Homeowners, large market share in hurricane exposed states. Over the past 5 years, share buybacks have averaged 3.4%. Dividend is 1.64 yielding 3.7%. Over the past ten years, has always traded at a P/B of 1.6 or better at some point during the year. My target 57.

American International Group (AIG) - 28.14 as of 7/22. P/E N/M, P/B 0.9. Large and diversified, misadventures in bond insurance are well-publicized. Recently added capital and changed management. Accounting has been less than pristine. Over the past ten years it has always traded at a P/B of 1.9 or better at some point during the year, so it is potentially a doubler from where it lies. Dividend .88 yielding 3.13%. This requires some risk tolerance, my target 56.

I would not jump in with both feet here, because the Property and Casualty price cycle seems to be heading down right now. However, I do plan to accumulate meaningful positions in all of the above, and will monitor and hopefully enlarge the positions over a period of time. For any of you who use options, distant expiration in the money calls seems like an attractive strategy to to me - the leverage would increase returns. Patience will be rewarded.

I am planning a series of posts over the next several weeks, covering each of the above in detail.

Comments: 1

Allstate - still a good buy

Rating: 0 not yet rated(0 votes)    Vote:

You are logged in as | Logout

Allstate (ALL) recently reported 2Q 2008 Earnings, .05 per share, a 98% decline year over year. The decline was caused by a combination of higher than usual catastrophe losses and change in intent write-downs on the investment portfolio. While the numbers are unsettling at first glance, they do not affect my view that Allstate is undervalued based on its strong industry position and long-term earnings potential. Before going into the conference call and current issues, here is a brief overview of historical performance:

Allstate has increased its tangible book value per share by a little over 5% per year for the past five and ten year periods. That includes some major hits from asbestos liability in 2001-2002 and Katrina in 2005. The dividend is 1.64, yielding 3.64% at a recent share price of 45.00. Share counts are in steady decline due to buybacks which have averaged 3.4% per year for the past 5 years. Over the long haul, this adds up to about 9% annual return. Buying the shares when they are trading low in their range, higher returns can be achieved.

Current issues include 1) the effect of the credit crisis on the investment portfolio, 2) the soft market in P&C insurance and 3) issues related to Homeowners/catastrophe exposure, to include regulatory backlash in affected states. What I heard in the conference call was reassuring with respect to all three concerns.

Net realized capital losses were 1.2 billion, consisting mostly of change in intent. Insurance companies, if they intend to hold an asset to maturity, can make their mark to market adjustments in Other Comprehensive Income, which is a balance sheet item and doesn't affect income. If they decide they do not intend to hold the assets until they recover, then the loss is moved from OCI and recognized in earnings. Allstate is implementing a risk mitigation program in their investment portfolio, and combining that with their opinion that the economy and financial markets will continue under pressure, they elected to recognize a large amount of mark to market losses into income. Many of the assets are performing.

I think it is healthy to recognize losses, provided it does not lead to a fire sale of temporarily impaired assets. What I heard on the conference call was that Allstate would like to reduce risk on MBS and CMBS but has no intention of conducting a fire sale. With the advantage of 20/20 hindsight, it would have been nice if risk mitigation had been put into effect a year ago, but it is good to accept the current situation and move on.

With respect to the soft market, what I heard is that the market is back to a trend where companies are taking small, incremental rate increases as needed. This usually leads to decent profits. The frequency of automobile losses has been trending down, due to improvements in vehicle safety, road design, and DWI enforcement. Reduced mileage due to the cost of gas may also reduce losses. This is offset by an increase in claim costs. Allstate notes that State Farm and others have higher combined ratios that they do, so the soft market should hurt others more than them. Allstate has been exerting price discipline.

Allstate writes a lot of Homeowners in catastrophe prone states. The solution is simple, a combination of reinsurance and rate increases. Unfortunately, insurance becomes a political football and rates have been reduced, or rate increases denied, in states such as Florida and California. I can remember in 1969-1970 when I first got into insurance as an underwriter, how dismayed and upset I was over a massive confrontation between the Governor of Massachusetts and the Insurance Industry over rates for state mandated automobile insurance. It seemed as if nobody would be insured, traffic in Massachusetts would halt, and we would all have to update our resumes. Of course, the situation was worked out, and life went on.
Over the long haul, state regulators cannot compel insurance companies to operate at a loss. The games of insurance as political football can be intense, spirited, wonderful press and a real shot in the arm for local politicians, but ultimately insurance companies just seem to find a way to make a buck.

For what is primarily an automobile insurance company, I think demographics provides a strong argument for long term profits. When I worked for Kemper Insurance in the 70's, they maintained loss experience for senior drivers and found that from 55 on up to 75 or more more drivers get safer as they age. So, the baby boomers as they age will be an ongoing source of profit for auto insurers, Allstate included. That is my opinion of the long term trend, and I would not let a slow year or two discourage me too much on Allstate.

In common with others affected by mark to market losses, Allstate now offers two versions of book value, with and without the mark to market losses. Because of their change in intent, my analysis uses the GAAP figure, which includes the mark to market losses. On that basis, and noting that Allstate has traded at a P/B of over 1.5 at some point during the year for ten years straight, my target would be 58. Projecting 2009 EPS at 6.50, and applying a P/E of 12, I get a target of 78. Between the two figures, 65 seems well within the realm of the possible.

I am holding Allstate in my SLO portfolio, with an unrealized loss of about 10%. I will continue to hold and look for a chance to enlarge the position as cash becomes available.

Comments: 1

Hartford Financial - more value in Multiline Insurance

Rating: 0 not yet rated(0 votes)    Vote:

You are logged in as | Logout

Hartford Insurance Group (HIG) recently reported 2Q EPS of 1.73, down 12% year over year. After reviewing their financials and reading the conference call, I think HIG is attractive as a value stock, based on a P/B of 1.1 and TTM P/E of 9.4. The dividend, 2.12, yields 3.3% at a recent price of 63.65. Book value per share grew 7.87% per year from 1998 to 2007, so there is a long term trend of creating shareholder value. Add the dividend yield and returns approximate 10% per year: and, starting at the current P/B of 1.1, there is ample room for price appreciation.

Hartford is a major player in both P&C and Life Insurance. They have done a good job on retirement products, variable annuities, and expanded rapidly in Japan. Demographics should favor them as more baby boomers start looking for secure retirement investments. Also, higher gas prices should improve personal automobile insurance results due to fewer miles driven.

Why so cheap? Reading the conference call, many analysts were concerned about the size of mark to market losses. HIG expects to hold most of their asset backed securities to maturity and as such has taken the mark to market losses in Accumulated Other Comprehensive Income (AOCI), a balance sheet item, which affects GAAP Shareholders Equity but does not impact reported earnings. The GAAP book value per share is 55.51, the book value excluding AOCI is 64.68.

This difference, 9.17 per share, is partly the result of changing interest rates but to a large extent reflects the market's perception of the risk involved in assets that have been marked to market. HIG's process is to review the assets monthly as reports come in and project future losses under various stress case scenarios. After John Thain's performance on the issue of holding vs. taking fire sale losses, can we give Hartford CEO Ramani Ayer complete credibility? He was on CNBC yesterday, presents himself well, and is confident that HIG will not have to realize any unnecessary losses by any kind of a fire sale. On a personal level, he was a speaker at a luncheon I attended in 1995 or thereabouts, made a good impression then, and now in 2008 I am looking at an impressive ten year record for HIG in terms of increasing book value per share. So, I am willing to go along with 64.68 as management's best estimate of book value and use it as a metric for determining value.

HIG also has a 1.5 Billion capital cushion compared to the most restrictive rating agency standard for an AA rating. That fact supports their contention that they can hold to maturity.

Another key question is the P&C price cycle, which is in a soft market phase, and HIG's ability and willingness to exert price discipline. In personal lines, HIG sees the same trend Allstate reported, that most companies are taking small incremental increases as needed, which will sustain profitability. In commercial lines, prices are down 7% but Hartford has accepted some reduction in new business. For P&C, the combined ratio, excluding catastrophes and prior year, is 90.7, which is favorable. They are improving their estimates for combined ratio and reducing their estimates for written premium, indicative of pricing discipline - they are unwilling to write business at a loss in order to maintain or gain market share.

My guess is that the current investment climate will make the industry more careful to maintain underwriting profits, since investment returns are questionable because of the credit crisis. Under this scenario, the soft market would be less pronounced.

Asbestos liability: Hartford has large reserves for asbestos liability, from time to time they increase them. The last real news I saw on asbestos was that courts were making it progressively more difficult for lawyers to get away with drumming up claims based on trivial exposures, so I think the danger of large additional reserves is remote.

Another issue is that Hartford will be taking a DAC charge in the third quarter. Deferred Acquisition Costs is an asset item, which is amortized into expenses over the life of the business involved. Hartford reviews their assumptions during the third quarter every year, and expects to take a charge of between 330 and 640 million. That would reduce EPS by 1 or 2 dollars for the quarter, but future expenses due to amortization would be reduced. To me, this is a timing issue and if it makes a bump in the third quarter numbers I would not be unduly concerned - it might present a buying opportunity.

Over the past ten years, HIG's market price has varied form a P/B of as low as .9 in 2003 to 2.7 in 1999. It has traded above 1.5 every year over that period. Using GAAP book value, I get a target on that basis of 82 per share. Because I lean toward management's view on the mark to market, that very little of it will eventually be realized, I think the 82 target is on the low side: if mark to market losses revert over time, that would give me a target of 97. Using EPS, I think Hartford can do 8 a year reliably and at a P/E of 12 that would be 96.

I recently started a position on HIG and plan to add to it over the rest of the year, believing that I may get better prices if the current bear market in financials persists.

Comments: 0