I have been working these two on "adjusted book value," an industry specific nonGAAP metric which adjusts book value by adding the present value of unearned premiums and future installments. MBI now defines adjusted book value to include adding back mark to market losses on the insured portfolio of CDOs, to the extent they exceed impairments. ABK provides a comparable figure. MBI's adjusted book value is 39.63: a comparable figure for ABK is 28.68. Working with these two cases over the past year, I have become convinced that GAAP accounting seriously distorts the actual values, by overstating liabilities and understating assets. In a best case scenario, both would trade at around 1 X adjusted book value, so they possibly could quadruple from their current prices.
For that to happen, the main requirement is clarity around the size of housing/credit crunch losses. The ultimate trajectory of the housing crisis drives losses, and then there is the secondary issue of how accurate the companies are in estimating losses for years into the future.
My clearest window into this situation is Servicer Reports on direct RMBS. For ABK, I have identified 5 problematic loss cases which I track monthly: Bear Stearns Second Lien Trust 2007-1, First Franklin Mortgage Loan Trust 2007-FFC, Saco I Trust 2006-2, Saco I Trust 2006-10, and Saco I Trust 2005-10. The reports come out on the 25th, and include a wealth of information, including graphs of monthly default rates. What I saw, in 4 out of 5 cases, was default rates that are stabilizing or declining. This is consistent with ABK's conference call: "Outside of normal volatility, a reasonable takeaway is the delinquencies appear to be flattening out, whilst default rates, with a lag as one would expect, may have begun to decline."
The two worst cases, Bear Stearns and First Franklin, are looking better but are still reserved for cumulative losses of 70% and 65%. To me, these numbers are credible.
ABK also went into some detail on remediation. When mortgages are sold, warranties and representations are made as to the quality of the collateral. A good size survey, part random, part selective, revealed a shocking number of misrepresentations and breaches of warranty. ABK has booked 263 million of credits for remediation based on this information, and expects to do more. In some cases, the potential recoveries were well in excess of the losses that would be payable after considering subordination.
The situation is more complicated with respect to ABK's insured CDO portfolio, which garnered another 1 billion of impairments for the quarter. The CDO squared cases are easy: they commuted one, paying 850 million, and the remaining two large cases are reserved as total losses. Basically, rating downgrades of the RMBS collateral supporting the inner CDOs triggers adverse cash flow consequences for the outer CDO. The whole thing is ratings driven, and if downgrades are severe, total losses ensue.
ABK's CDO of ABS transactions contain mainly RMBS but also include varying proportions of inner CDOs, which behave the same as the inner CDOs of a CDO squared. Basically, if the total CDO collateral exposure exceeds the subordination, the loss potential increases radically. ABK has revised their disclosures on their website, providing a one page summary of each of the affected exposures. I reviewed the new disclosures, which clearly show the proportion of inner CDO collateral and the write-down taken, and I am satisfied that ABK has a handle on their losses and that there is a limited amount of additional pain coming in the future.
For MBI, last month I was able to review of sampling of their direct RMBS - I looked at reports on the Countrywide transactions and felt that performance was stabilizing at a relatively high default level, consistent with MBI's loss scenario which calls for current default rates to continue into the 2nd half of next year.
For MBI's CDO exposures, I looked at the disclosure on their website, Multi-Sector CDOs as of 6-30-2008. MBI did not take any meaningful additional impairments on this book, in marked contrast to AIG and ABK, both of whom made a trip to the confessional. My concern centered around the question as to what the difference might be, that no additional impairments are needed.
MBI discloses the percentage of CDO of ABS collateral included in their Multi-Sector CDOs, and it is significantly less than ABK's. As such, MBI has minimized the structural issue of losses triggered by downgrades. With that in mind, I am prepared to accept that MBI is being accurate and forthright in not taking additional impairments.
Finally, in the past week I have seen representatives of both Moody's and S&P on TV, giving out opinions that the housing crisis is stabilizing. To me, that says rating downgrades will be stabilizing, so that ABK's vulnerability on that issue may not yield further difficulties. Also, I saw Karl Case on TV, he is the other half of Case Shiller, the housing index, and he sees the situation as stabilizing.
So, with losses relatively well-defined, the path is clearing for shares of ABK and MBI to start gravitating upward toward the adjusted book value target.
Last year, with MBI at 31 and ABK at 25, I was of the opinion that they could triple or quadruple from that level. Sadly, I was wrong. Now, with MBI at 10.92 and ABK at 5.22, I am of the opinion that they could quadruple or quintuple from the current level. Am I sadly wrong? There is a difference - for starters, the stocks are far lower today than they were when I originally got on the bandwagon. But the main difference is in the information involved: when I got started on this trade, the companies didn't know what the future held in store, didn't understand their own exposures, and consequently couldn't provide clear disclosures. That has changed, the cards are out on the table, the losses are far worse than expected, but now the worst is known.
Looking at my portfolio performance, I am even with the S&P 500, reckoning from the beginning of SLO-1. I am outperforming the S&P 500 for 1,3 and 6 months. Aside from my losses on ABK and MBI, which total about 15% of my original NAV, I have made money on all other positions combined. When I last added to my position in MBI, I bought enough shares to bring it up to 15% of my portfolio: for ABK, I brought it up to 10%. Now, as MBI goes over 25% of a larger portfolio, I have been reducing the position to stay in compliance. When ABK starts to hit the 25% level, I will reduce it along the same lines.
If this situation develops along the lines I envision, I will be taking profits from MBI and ABK for the next six months, reinvesting the proceeds into other value ideas. My original error on MBI and ABK was that I started with too big positions. On these contrarian type catch a falling dagger ploys you need to start small as it could be necessary to average in repetitiously. Once I got into the situation, I felt my best odds of recovery lay in holding, monitoring carefully, and adding to my positions if the outlook improved. While it has been a difficult 6 months, results are validating my recovery strategy.
Another thought - these were experiments in a "high conviction" strategy. The idea was, to do a lot of homework, then make larger bets on the cases were I was extremely confident of my analysis. Unfortunately, getting to the high conviction point on a complex case such as these can require far more time and research than I anticipated when I embarked on the journey. It may involve learning things that only experience and the passage of time can reveal.
"A little knowledge is a dangerous thing:
Drink deep, or taste not the Pierian Spring."
In reviewing the 2Q 08 Conference calls for the above (transcripts are available at Seeking Alpha), much of the focus of the Q&A was on cash flow/positions and opportunities to build land pipelines at an advantage, by acquiring the assets of small to medium builders, either directly or from banks that may wind of owning them as construction loans go bad.
When things are booming, you could own a homebuilder and look at a steady flow of earnings, but then you look at the cash flow and say "Where's the beef?" The problem is that profits are plowed back into acquiring land. But when the housing market slows, well-run builders continue to sell houses, but do not replenish land inventory, generating cash. Some will sell land, to raise cash and perhaps use the cash later to buy better positioned land at a discount. TOL, KBH, and RYL all have cash and lines of credit which they believe position them well to load their pipelines with land when the timing is right, which will be soon now - they are looking at deals.
There has been a lot of press about how Regional and Local Banks are overloaded with construction loans and will wind up owning the land involved, taking losses. The stronger national homebuilders will be there, to pick off the best assets at bargain prices.
I have been playing homebuilders on a tangible book value basis, looking to buy at a price to tangible book of 1 or less and planning to sell at 1.5 or better. Because writedowns are ongoing, the target has been moving: however, my impression reading the conference calls was that this trend is stabilizing. Also, marked down land will generate larger profits when recovery commences, and some deferred tax assets that have reserves against them may in point of fact be realized if and when the industry recovers. Because of that, I tend to think book values for homebuilders may understate assets in the event of a recovery.
Homebuilders have rallied on and off this year. I have owned TOL and RYL in my Marketocracy and personal accounts since last year, taking some profits when they would rally and then buying the shares back on the dips. As of this moment, I plan to add to the positions on the dips and be a little less willing to sell until they reach my target prices.
]]>I had been operating on a pure value strategy, with poor results. The change was to add consideration of momentum to my thinking. I started to add and remove stocks based on value criteria, which I supplied, and momentum criteria, which I got from the rating scheme used by my brokerage, Schwab. A stock had to satisfy both criteria. MBI and ABK, which had huge unrealized losses, where left out of this strategy as I expected them to recover. Broadly speaking, the combined value/momentum approach worked well, and the expected recovery in the dynamic duo has started to materialize.
Looking at my portfolio from a sector point of view, here is where it stands:
Financials - 52.00%
Informatin Technology - 26.50%
Industrials - 9.77%
Consumer Discretionary - 7.52%
Health Care - 3.86%
There has been much debate as to whether we have seen the bottom on Financials. I think we have, based on my view that the Case/Shiller housing index overstates house price depreciation or appreciation, as well as reviews of servicing agency reports on troubled CES, HELOCS, and subprime portfolios, which suggest stabilization in delinqency trends. The recovery in financials has a long way to go. However, now would be a good time to start reducing my exposure to this sector: I will be gradually whittling it down, and putting the proceeds to work elsewhere. I recently sold a few shares of ABK and MBI as they rallied off their extreme lowpoints, although I continue to believe they both have ample room to increase.
The Information Technology sector has been good to me. My largest profits are from JBL, and I have started to pare that position.
I have no Energy positions. A feature of current markets which I dislike is the prevalence of what I call negative momentum strategies. Once anything starts down, short-sellers pile on and pummel it mercilessly. Fundamentals are brushed aside, creating extreme value entry points. You don't want to get in front of this process while it is steam rollering everything in its path, but following along in the wake of the destruction there is money to be made. I will start easing my way into Energy, because I see the upward movement of oil prices as a long term phenomenon driven by supply and demand. I missed the boat the last time around and I will start accumulating a position during this pullback.
I will look at COP, APA, DVN, XOM, OIS, SU, BJS, RIG, DO, FTO, VLO & TSO. Most of them are stocks I have owned successfully in the past, a few are recommendations from other investors whose opinions I value. I expect to develop my positions slowly, as funds are liberated from Financials, hopefully by not making any sudden moves I will achieve a smooth transition and avoid any large timing type losses.
Other ideas are in auto parts & supplies, JCI and MGA. These are quality companies that have made money for me in past automotive downturns.
The short financials/long energy and commodiities trade has broken down and reversed itself. Thre were so many hedge funds and other momentum players doing the same thing, it is not surprising that the shift has been sudden. From where I stood in February, I think I played it right, to sit and wait for the turnaround. But I wound up fighting the tape for a long time, very painful. My goal is to get ahead of the rotation, rather than fighting it: hence the cautious and incremental approach to the transition.
Aside from that, I have a lot more positions than I usually carry. I will cull, using the combination value and momentum approach, and add using the same criteria.
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The process will involve surgery, in the form of selling non-core operations and reducing the risk profile of assets and liabilities. Over the past ten years AIG has grown rapidly and profitably, but under today's economic conditions is revealed as bloated by excessive risk and complexity of operations. I think mark to market losses are overstating the company's difficulties: and, accordingly, the test of the surgeon's skill and patience will be the extent to which assets and liabilities are taken off the balance sheet without holding a fire sale. Other financials, such as Merrill Lynch, seem to be willing to buy their way out of trouble, to the detriment of shareholders.
The resulting slimmed down company would do P&C Insurance, Life and Annuities, and Aircraft Leasing as core operations. Businesses such as AIG Financial Products Corp, with its super senior credit defult swap portfolio, which has generated a stunning run of mark to market losses, would not be part of the core and would require to be dealt with.
Earnings going forward might be 3.00 per share, book value could be maintained at 30 per share, and a realistic target price would be around 42 per share. From where the stock is trading today, you could make money. However, I see less value than I did a week ago.
My estimated outcome is not very ambitious - the reason being, 2 month CEO Willumstad sounds resigned about mark to market losses, already in capitulation mode. My view is that the credit crisis has got the value of all mortgage related assets and liabilities way out of sync with the performance of the underlying collateral. With a balance sheet that has large amounts of both assets and liabilities that are mortgage related, it would be all too easy to erase a lot of value needlessly, in the interest of placating shareholders who have lost their appetite for risk.
In addition, Willumstad was unwilling to rule out a capital raise. AIG has already raised 20 billion: shareholders do not need further dilution. A capital raise would drive the stock down further, resulting in a self-fulfilling loss of value. AIG uses an Economic Capital Model that is driven by market values. They complain of the difficulty of getting a stable indication of required capital. I interpret that to mean that if market values of their assets decrease further, or if they have to take more mark to market losses on their bond insurance, they will raise capital to meet the rating agency double A requirements.
The company's discussion of the super senior CDS portfolio mark to market was strange: last quarter, they saw 1.2 to 2.4 billion of maximum stress losses: now they see 5 to 10 billion of maximum stress losses. Their representative declined to provide a figure for expected losses, saying only that it was less than 5 billion. They talked about new processes to stress test the business: I would guess it's like ABK's AA Bespoke transaction - AIG's underwriters missed the point when they wrote the business and now they see their error as losses are on the horizon.
The mark to market on the investment portfolio was mostly moving losses from Accumulated Other Comprehensive Income to the Income Statement. Book value is not affected, but earnings are reduced. Most of the portfolio is investment grade and performing adequately. Losses have been realized for accounting purposes, but there has been no fire sale as of yet.
To summarize, I see a lot of value but question management's ability and willingness to solve the problems in the best way for shareholders. I can't figure out whether it's a deer in the headlights sort of thing, or management being deliberate in exploring their options. I plan to hold my small position through September, when Willumstad should be articulating his plans to get the company back to its core businesses. If I hear a good plan and the resolve to execute it properly, I will stay with the position: if not, I will exit. I expect a downward trajectory of the stock, and increasing clarity as to the values that can be salvaged and the prospects of future earnings. Somewhere in this process there might be a very interesting buy point.
]]>As an example, oil recently spiked upward toward 150 per barrel, then just as suddenly tanked to 119. While the upward march was in progress, numerous sage talking heads debated whether the cause was speculation or the beneficent rules of supply and demand. Everyone saw fundamental supply/demand equations as supporting 150 oil, if not 200 oil. Now, an equal number of energy gurus see demand supporting oil under 100, maybe even 70 per barrel.
The attitude of the press and other commentators on mark to market accounting is similar. As financial companies report huge mark to market losses on hard to value assets, they are praised to the extent they capitualte and sell the offending assets for a fraction of what they are worth. There is honesty there, healing, cleansing - going to the confessional, lancing the boil, so on and so forth. John Thain (CEO of MER) is a poster child for this phenomenon.
However, when the whole farcical folderol is taken to its ultimate peak of fatuity, there seem to be dim glimmerings of dissent. Of course I am talking about bond insurance, my dynamic duo, ABK and MBI.
ABK recently reported a surprising profit. After taking mark to market losses on its portfolio of insurance provided in CDS form, the company wound up with a profit because it had to mark down the value of these liabilities to reflect the public perception of their creditworthiness. The situation developed as follows: when ABK and MBI were downgraded by Moody's & S&P, the already astronomical cost of CDS protection on their creditworthiness spiked to insane levels. According to GAAP, the companies are required to use this information when evaluating their liabilities.
Several commentators have published articles accusing ABK of parlaying an accounting technicality into bogus profits. As Ambac made abundantly clear on their conference call, they are simply playing by the rules.
There seems to be this underlying belief that King Market is wiser than Solomon, totally clairvoyant, able to peer into the future with uncanny insight. I am sorry to inform you that this is not the case: by far to the contrary, King Market is a riff-raff, an unruly mob of speculators and manipulators, a vigilante posse armed with the pretext of capital adequacy.
Fortunately, King Market's subjects seem to quietly subvert his idiotic rulings, going on with their lives in a more or less orderly manner while maintaining the pretense that his directives have some basis in fact. An example: ABK has gone from a low of 1.04 to 5.85 at yesterday's close, an increase of of 462%. Nobody seemed to notice too much, but I was watching in wonder as the fruits of what my friendly critic Fernando called a "double down rampage" accumulated in my portfolio.
AIG reported last night - more mark to market - I will listen to the conference call and try to sort it out. MBI is scheduled to report on Friday. No doubt there will be more mark to market idiocy in their financials. I don't know how King Market will respond. But I will look at the adjusted book value, weigh the mark to market against management's estimates of actual losses, and govern myself by reason.
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First, the size of SCA's settlement with Merrill needs to be placed in context. Eric Dinallo, Superintendent of the NYSID, was involved in that deal because SCA was on the brink of insolvency. Because Dinallo's political allegiance is to the municipal bond insurance policyholders, and his agenda is to conserve capital to support their protection, Merrill had no alternative but to take what they could get before the window of opportunity closed. Dinallo, in a TV interview, was careful to differentiate between Ambac and MBIA, which are well capitalized, and the likes of SCA, which was on the verge of insolvency.
Merrill mentioned in their press release that they were negotiating with MBIA on a settlement. I would anticipate that MBIA's position will be that they pay their obligations when due and in full, and that their obligations are to pay principal and interest when due on the insured transaction. Any acceleration would be at their choice. Further, MBIA would plan to assert any rights or remedies available to them to remediate the loss. Any settlement with MBIA will be arms length and will provide a far better indication of what bond insurance settlements will be worth than the SCA deal with Merrill.
My concern to is find evidence which can bridge the gap between mark to market losses and the impairments or loss reserves established by MBIA and Ambac. The companies have been asserting that a large part of the mark to market losses will never result in actual losses. Moody's has stated that this is "broadly consistent" with their view, based on expected losses.
Ambac's settlement of the AA Bespoke transaction is the first clue on mark to market vs. actual losses. Ambac had a mark to market loss of 1 billion, and recognized an impairment of 789 million as of 3/31/08. The settlement, which I believe was a genuine agreement between two parties who were under no pressure to compromise, was for 850 million. Doing the math, the difference between Ambac's impairment and the mark to market was 211 million, of which 150 million, or 71%, was reversed. In this case, the mark to market overstated the actual loss.
Food for thought: Ambac's cumulative Mark to Market losses as of 3/31 are 5.6 billion over what they have recognized by reserves or impairments. If 71% of that is going to reverse, then Ambac's GAAP book value is going to increase by 13.85 per share as the magnitude of the the losses is clarified by the passage of time. Not too shabby for a company that has recently traded as low as 1.05 per share.
As a bonus, the Ambac settlement was less than the rating agencies' stress case estimates, so it increases their capital cushion.
It would not be useful to extrapolate too much from one piece of information. The "AA Bespoke" transaction was a CDO squared stuffed with mezzanine sub-prime RMBS and not typical of Ambac's portfolio or of anything MBIA insured. But I am encouraged by this development and will continue to hold my long positions in ABK and MBI.
]]>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.
]]>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.
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.
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
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."
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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.
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An article in the Financial Times quoted "sources" to the effect that Ambac and MBIA have been pursuing the possibility of commutation of many of their policies. The scenario is that an investor, perhaps an investment bank, owns a mortgage backed security backed by sub-prime collateral that is insured by one of the monolines. Because the monoline's credit is deeply discounted by the market, the investment bank has to mark the bond to market, creating an unrealized loss. To hedge this loss, the investment bank buys CDS protection on the monoline, which offsets the unrealized mark to market loss on the bond. Or, alternatively, they buy credit protection on the ABX, an index of sub-prime bonds. I believe that this index overstates the severity of future losses, and the protection is accordingly over-priced, in sync with the bond, which is under-priced.
The monoline, meanwhile, has been doing surveillance, recognized that they will be making payments, and booked a loss. The rating agencies have been doing stress case analyses and requiring that the monolines have capital equal to 1.3 X the stress case losses in order to qualify for triple A status. Suppose the bond is 1 billion, and a realsitic loss estimate is 500 million. A stress case estimate could be 700 million, so the monoline would need 910 million (700 X 1.3) capital to carry the policy and loss on its books and maintain a triple A capital level. Paying the loss of 500 million would free up 410 million of capital. The investment bank, if they are agile, cashes the claim check and unwinds the CDS position at a profit. The mark to market losses, which are grossly in excess of reality, go away. The monoline is suddenly over-capitalized, even by rating agnecy standards. Everybody is very happy.
Paying the claims in advance sounds a lot like compromising liabilities, but given the shared knowledge of the participants and the distorted economic realities around these transactions, it makes a lot of sense.
In some cases there might be some warranties and representations liability to discuss. When mortgages are bundled and sold, warranties and representations as to the quality of the mortgages are made. Both MBIA and Ambac have been going through their insured books to look for any misreprentations or breaches of warranty that may have been made in connection with the transactions. Merril Lynch and Coutrywide Financial both have material liabilities on their balance sheets against warranties and representations claims. Sometimes lies work best on a willing listener and the two parties are really in it together. There might be some situations where items of this type could be swapped back and forth, netted out, and swept under the carpet, avoiding much embarassment and hard feelings.
This whole thing is like a hall of mirrors: reality is distorted in a multitude of twisted images. But the investment bank and the monoline insurer, both of which have been diligently studying the servicer reports on the underlying collateral, and putting their projections into industry standard software, can probably develop a realistic value of the claim, reach an agreement, and settle. There is a question as to how many holders there are on some of these instruments - the more holders, the harder to unwind the whole deal. I tracked a few of them via SEC filings, it looks like most issues wound up spread among an average of 15 holders. That seems a little unwieldy to me but everybody has got to be well-motivated and they should be able to work something out.
As these grossly exagerated and multiply hedged positions are unwound, values will revert to reality very rapidly. The agile will reap large rewards: the slow and clumsy will incurr crushing losses.
Meanwhile, Tom Brown (at bankstocks.com) has likened Moody's to a referee that throws out the rule book. He uses basketball, I like soccer: the referee (Moody's), comes up behind the player (MBIA), trips him up, then shows him a yellow card. MBIA, noting that the rules no longer apply, will no longer play by them. Maybe it was a red card and MBIA is no longer in the game - if so, they will take their ball (capital) and go home. They will act in their shareholder's best interests and spend the capital in excess of double A requirements to buy back their shares at a fraction of their intrinsic value. This will not be hard to do as the short-sellers are shovelling them out as fast as they can borrow them. Moody's calls this "capital extraction," at least when MBIA does it. I call it justice for shareholders.
Ambac and MBIA, if you think about it, have been hedging their stress case hypothetical losses with a combinaton of cash and investment grade securities, at a 1.3 X level. There is no need for them to be particularly agile as the cash and investment grade securities are stable in value. The magnitude of the actual losses wil become clearer each month, and they can unwind at any time the other players want to and it will be to their advantage. The other hedgers have problems: the mis-priced bonds, the mis-priced CDS, the mis-priced shares of Ambac and MBIA, the ABX index, the overstated mark to market losses - the whole mess will unwind in chaos, and somebody will be slow, clumsy, or just unlucky, trampled as the herd panics and runs for the exits.
I am long the shares of Ambac and MBIA, and neither position is hedged. .
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Jabil was not exactly a high conviction pick when I bought it. After noting that I have had mixed success with looking for value based on a low price to sales ratio, I took a shot at JBL, citing the P/S ratio at .18 and a large insider buy by Tim Main. The thinking was, if they could get margins back up to their 5 year average, it would boost the stock to somewhere between 17 and 27. Now, with a quick profit of 45% in a matter of months, I am tempted to start selling.
Like most value investors, I like to complain that I always sell too early. Ken Fisher, whom I regard as a minor guru, wrote a book early in his career where he advocated buying industrials at a P/S of .40 and selling them at .80. Jabil is an electronics manufacturing service, but there is a lot of mechanical content in what they build, so I see an industrial. From 1998 through 2006, Jabil traded at a P/S of over .80 every year. A .80 P/S ratio, based on my estimate of 2008 sales, would yield a share price of 48, which seems ridiculous to me, based on realistic EPS projections. But 27, the high side of my original target range, seems within reach.
So, there is no need to sell the stock, just because it's going up.
]]>Moody's acknowledges that MBIA has capital consistent with an Aa rating, but nevertheless downgrades them to A2, a total of 5 notches, citing concerns about "aggressive capital management." After they raised capital, MBIA declared their intention to downstream 900 muillion of the proceeds from the holding company to the insurance company, to support the triple A rating. Following S&P's downgrade, which occurred in spite of the fact that their capital met the triple A target, MBI elected to retain the money at the holding company level, and rightfully so.
From a tactical point of view it makes a lot of sense, to hold the funds in reserve and deploy them responsively as situations arise. Ackman made a big deal about where the funds were, and now Moody's is dancing to his tune. I saw Moody's initial announcement that they might downgrade MBIA further than double A as a thinly veiled threat, aimed at compelling MBIA to strand the funds at the insurance company level. MBIA did not comply, and Moody's delivered.
Among Moody's other concerns were the possibility that MBIA might engage in "capital extraction," meaning buybacks or a special dividend. I think the choice of words betrays a desire to denigrate MBIA's motives and justify an excessive rating action. Moody's cites MBIA's lack of financial flexibility, occasioned by a share price that has been pounded so low that raising equity capital makes no economic sense. Because the intrinsic value of MBIA shares is 42.15, buying them back at 5.59 makes an awful lot of sense. A careful review of share ownership shows that much of MBIA's float is owned by Warburg Pincus or other strong value investors: so much so that the repurchase of any meaningful amount of shares would place short-sellers in a very awkward position, having borrowed and sold more shares than they will be able to buy back and return. A nice short squeeze would resolve the share price issue. I find it difficult to believe that Moody's would not understand how helpful it would be to MBIA's situation to do the buyback.
Finally, Moody's "takes comfort" in the fact that the 900 million will be available at the holding company level to facilitate the Asset Management company's activities as it posts collateral and funds termination payments necessitated by the gratuitous severity of the downgrade. Berkshire Hathawy, 19.09% owner of Moody's, and a recent entrant into the municipal bond business, will no doubt also "take comfort." I see an effort to make MBIA's situation as difficult as possible.
At Moody's website, they are now boasting about the accuracy of their ratings, on a one year basis. They seem to have forgotten the criminal negligence which labelled so much garbage as triple A and created this whole mess to begin with. Now they want to prove that they are the tough cop on the beat.
Among the what-ifs is the possiblity that the repurcussions in the bond market from the downgrade will precipitate another game of Insurance as Political Football, with NY Supreritendent of Insurance Eric Dinallo as referee. Dinallo to date has made every effort to be a constructive force in this situation, and I hope he continues. My understanding is that his authority as presently constiututed relates to solvency rather than ratings, and MBIA's solvency is not an issue.
As an investor, I need to keep my eye on the ball - in this case, my value metric. The intrinsic value per share of MBIA still stands at 42.15, the "analytic adjusted book value", as MBIA calls it. This is a nonGAAP metric which adds the present value of future installments and disregards mark to market losses to the extent they are expected to reverse over time. The chances of realizing this value in the best way - by MBIA regaining its triple A rating and writing profitable bond busniness - now seem remote. However, the figure is still a fairly good approximation of the value in run-off.
Somwhere in a back room at Pershing Square Bill Ackman has a wax doll, he sticks it full of pins and mutters various imprecations and incantations against MBIA, Voodoo short-selling, more than half the public believes him, MBIA is doomed, the walking dead. The vociferous drumbeat of negative publicity reinforces the overall effect. I notice recently that a lot of the mentions of his name and techniques are coming with cautions and qualifications, so there is some hope his influence is waning. But I am getting nervous, as he has seriously weakened what was an entirely viable business, almost by brute force of malevolence.
MBIA went over their liquidity situation again after the downgrade, and they issued a press release asserting that they will encounter no problems meeting collateral requirments or termimation payments. I question whether you can move that much money, it's in the billions, without some losses, but I do not expect any liquidity issues.
Krishna Gullapalli, a round one competitor, recently posted a comment on my blog, asking me when I expected to show a profit on my monoline positions. Possibly it was a rhetorical question, but it is one that requires an answer.
TIME, as some philosophers note, is a four letter word. The central issue here is the adequacy of management's loss estimates. Based on house prices declining another 10 to 15% and the defaults continuing at the current rate for 18 months, Jay Brown, CEO of MBIA, has said that they will not have to revise their 3/31/08 loss estimates if the crisis develops as projected. Tom Brown, at bankstocks.com, makes some interesting arguments to the effect that the housing crisis will be far less severe than most projections. Check it out. I have done some work, getting a look at the servicer reports for various books of mortgages insured by monolines, and I am encouraged by what I have seen through 5/25, my last report. If MBIA management is correct about losses, my trades will show a profit by the end of the year.
I am intrigued by the possiblity of buybacks, given how low share prices are compared to intrinsic values. There are also possiblities arising from the establishment of new triple A entities, capitalized with the funds that are no longer required to support triple A ratings at the old insurance companies. Ambac is optimistic about the possiblities of remediation on their portfolio, which I take to mean enforcing warranty and representations liability on the mortgage originators. The size of warranty and representations liablities on Countrywide's and Merill Lynch's balance sheets suggests these hopes may be realistic. Bear Stearns last financial statement was silent on the issue. MBIA is also planning to avail themselves of all rights and remedies in the event of any breaches of warranty or misrepresentations. Any of these possiblities could come to fruition before the end of the year.
My remaining problem with this position is Ackman's voodoo vendetta: I have not been able to come up with a suitable tactic to deal with it. Various rants on my blog, letters to authorities, and letters to the editor have availed me nothing. The internet is wonderful - after a careful search, I have located a Voodoo practitoner (in Haiti), who, for a small fee, will be employing his black arts against Ackman. It cost me 39.95, which I charged against my VISA card. Already I notice his hair is turning whiter...Target (TGT) is heading down...
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