Variant Perceptions

Category: insurance

Thinking about investing in US banks? a short answer to David Merkel

In the comments section to the post Three Years After Lehman I got this deceptively simple question from David Merkel, the author of the classic The Aleph Blog,

I recommend that you try to talk with M3 Partners, Chris Whalen or Hovde – if they will talk to you. They know banks far better than I do, and I am pretty certain they are bearish.

I’m no expert on banks. I only have a few question marks:

  • Exposure to Europe
  • Exposure to repo lending/borrowing
  • Lack of clarity because of illiquid assets, and lack of mark-market accounting.
  • Home equity lending
  • Over-reliance of clipping pennies from the Fed, at a time when the front end of the yield curve has collapsed.

Basically, I don’t trust the accounting. Why should I buy bank stocks when I can buy safer insurers at similar or better discounts, where I know the accounting is mostly fair, and the liability structures are stronger?



My first thought was that it was nearly impossible to answer all David’s “few” question marks in the comment section but surely I could answer his insurance versus banking question. How wrong I was. When the short answer became two pages long it was fairly obvious that it was the stuff for a post. It probably needs editing but the short answer was already taking too much time:



I am sure others do not feel as comfortable as you with insurance accounting and underwriting standards. I certainly do not and you have been my man when I want corroboration on those issues (smile)

I imagine that when you mean investing in insurance companies, you are referring to insurance companies where you personally feel comfortable with their underwriting and their history. Besides basic rules of thumb to check reserves, the accounting will not help much predicting future losses.  Also I suppose that there are some sectors that you would not trust like life insurers with large guaranteed annuities portfolios or some mortgage insurers.

That reaches a central point of investing in financial firms: some leap of trust is almost always needed. For insurers you cannot know every single policy, for banks you cannot know every single loan. There are a couple of mREITs that I know all their loans but those are an exception.

There are several investment approaches to this “leap of trust” thing:

  1. Do not trust any financial firm ever: that has been the path taken by several good investors. They prefer to keep it outside their circle of competence and I will not try to convince them to change. You have to pick your spots. At the same time, there is a leap of trust in any type of investment (BP/security, NWSA/ethics, HPQ/acquisitions) even if you trust the accounting, that as we know it is not always the case. I personally have lost money investing in some simple businesses, in simple industries with lots of net cash, and instead made substantial returns in some complex distressed situations.
  2. Buy great companies with great teams: Because of some accident an investor may get to know in depth some financial sector (you insurance, me banking) and get comfortable with some teams. Good teams can avoid disasters for decades and the top of them can regularly achieve 12%+ average ROE and grow. That is a recipe for fantastic returns. I consider this approach risky. Historically many have had style drift like AIG and also be exposed to nationwide cataclysms. For example, Bank of Ireland was the best of Irish banks but that did not help much. Besides, it can nurture complacency and abdication on the part of the investor.
  3. Wait for the earthquake and look for survivors: that combined with signs of a new management team doing what is necessary (exiting marginal business, manage for capital and cash flow, reducing legacy assets significantly) can be a powerful combination. You are NOT trusting management, you are seeing it in action and following its progress.

As you have probably noticed this blog is mostly devoted to turnaround investing and that means point #3. It is a way of trying to avoid the pitfalls of #2 by waiting to see the order of magnitude of the cataclysm and watch management in action not just in words or reputation.

One key historical advantage of approach #3 for banks is that damaging credit bubbles are usually tied with real estate booms, deregulation, overvalued or even fixed exchange rates (for countries not indebted in own currency), and sustained current account deficits. Some recent examples are Latin America 82, Scandinavia 90, Mexico 94, Asia 96, Argentina 00, Subprime 08, Eastern Europe and PIGS 11. Bubbles driven by excess internal depository savings badly invested are much more rare and different in their consequences (Japan 1990s, maybe China today).  That provides several advantages to an informed investor:

  • Avoidable: Real Estate is a big proportion of banks’ balance sheet and usually with deregulation capital is lobbied to be thinned. Most crisis in other categories are usually sideshows: they are not big enough or risky enough. So by only following a couple of categories it is possible to avoid 90% of banking crisis.
  • Measurable: when the punctuation hits Real Estate, the other categories follow linear processes that can be measured and followed for a sign of a turn (with the exception of C&D, always one big if):
    1. Pricing and collateral of new loans are improved
    2. Regulators are tougher
    3. Bubble loans become a lower percentage of portfolio over time
    4. Cash and liquidity increases
  • Scope limited: wherever real estate goes (residential or commercial depending on the type of bubble) that is where the banks will go. If the government does not intervene, watch out (1932). If the government delays or avoid the devaluation of a fixed currency (Greece, Ireland, Spain today) watch out. Loans that are non-performing are difficult to hide. They will show in regulator reports, the cash flow statements or real estate industry reports.
  • Time limited: CRE and MBS from bubble times become a lower percentage of the total portfolio over time, while the new loans should be perfectly OK with the improved underwriting and pricing.
  • Hated or unloved: headlines do not help and many people were financially burned, so you can wait for confirmation before investing. People get trapped in the morality tale just when it is already in the past. Also it is not like buying the dip is a must, there may be several opportunities. The important part is to improve the probability of a hit because the upside is enormous anyway.
  • Replicable: learn one running play and play it ad infinitum. There is always a country suffering undeserved short term capital inflows, misusing them, and becoming the next candidate for a banking blow out  … with the following renaissance. Just look at Greece or Australia. There are twists here and there, like for example countries indebted in their own currency like the US, but isn’t it nice to have a perpetual compounding machine?

The funny thing is that at the moment there is not a single bank stock in my portfolio. It is circumstantial because I have had small and medium banks on and off over the last year and I think the banking sector today is fertile ground indeed.

In this blog I have tried to bounce and structure ideas on approach #3, the turnaround approach. It needs more work, pragmatism and flexibility than what is normally understood as value investing. Its success is tied to avoid investing in every single opportunity but only the high probabilities, and there must be several high probabilities in the banking sector today:

  • Good industry: there is a bank in every Western film. There is a bank branch or an ATM in every commercial location. That is how critical and entrenched are banks in a modern economy and even its history. It is oligopolistic at the local level, without technology obsolesce, and has high regulatory barriers to entry (just ask Walmart). Chris Whalen may not like the oligopolistic setup but I am not seeing many advocates of a utility model. And the alternative of too much dumb private competition was one primary reason of the mess we are in. A highly regulated and oligopolistic model has historically worked.
  • Pool of good businesses: retail banking is a local business where you want strong local market share (or a collection of strong local market shares like Bank of America and Wells Fargo). There are plenty of cheap banks with local dominance funded by long-term low-cost deposits with margin to absorb negative shocks. It is not like Bank of America is the only option, actually I think there are better risk-adjusted alternatives with similar upside.
  • Hidden downside protection: I am finding multiple cash flow positive banks that are most probably overcapitalized and over-reserved. There is some regulatory risk (pushed to dilute) but at the current prices the upside is big even with some dilution.
  • Emphasis in the core business: loose times, loose capital. Tight times, tight capital. The best example of all is Bank of America selling stakes in Canada, Europe and China (that also reduces Private Equity and Credit Card exposure) while redoubling their efforts in the good old USA. Heavy emphasis on the core business, even if it shrinks a company, is a sign of a management that gets it. It improves profitability in the long term and reduces risk.
  • The investor has time to close the loop: I usually prefer small and mediums firms because they are less followed and their turnarounds are easier. But hate can also provide time to confirm that all skeletons are out of the closet … and banking is the most hated sector today. There are still not many in the media realizing that most banks are improving. Even the smart Chris Whalen, that has been positive of medium banks, is probably missing the improvement in the Big 4 normal operations and capital ratios most probably because of too much attention to the off balance sheet putback liabilities (issue that would require a whole new post to give it justice).
  • First cash flow statement, then balance sheet, finally income statement: And the banks cash flow is at several years highs.You can distrust the balance sheet but it is much more difficult to lie with the cash flows statement. If these loans and operations are so bad, why they are so profitable? It is not like there has not been enough time for bad loans to explode.
  • Look for stable or improving earnings potential: In non-financial firms l prefer stable or growing revenues targeting a turnaround based on cost reductions. For banks I look for stable or growing assets and deposits with provisions reducing over time. Most banks’ franchises are still intact and legacy issues are getting reduced. For example, the much maligned Bank of America has been increasing total deposits and core deposits.

And as I argued in Three Years After Lehman, the sector turnaround seems to be going full speed ahead. At this speed that means most of the US banking sector legacy issues should be behind in a year or so.

Therefore, any criticism of the banks should be focused on things off-balance sheet like putbacks or new shocks like Europe. Measuring their order of magnitude should be a piece of cake but I am not seeing many doing that calculation and much less balancing it against the capital, reserves and profitability of each bank. That is the game.

I will not try to convince you David out of insurance companies especially when they are cheap and right in the middle of your circle of competence. Actually, I think it is an interesting sector to follow these days:

But if the American commercial banks are safe, they are a lot cheaper than the American insurance companies. For example, if Bank of America survives – and I am not saying it will – it generates close to $40B in pre-tax pre-provision earnings and is priced around $80B. I do not know of any such disparities in the insurance sector (maybe you do?)

Also the situation is a little different, closer to investing in insurance companies after asbestos … the shenanigans are out in the open! You are faced with the more simple task of evaluating the trustworthiness of the companies projections without short term time pressure.

That is one huge advantage. Some time has passed and you are seeing how some of those projections have performed. Actually some competitors have gone down the drain that is also good for the survivors enjoying improving interest spreads.

With insurance companies, I personally do not know the shenanigans in this soft pricing market. Some have said that AIG was an example of a company too aggressive on pricing backed by the government but from my novice point of view they are not doing so bad in this catastrophic year. Conclusion, I do not know where are the insurance sector hidden bombs and to go by reputation and a track record is not usually my style, a style that shuns complacency.

Hope this answers your question David. Maybe next time I will post the answer to the few question marks …it is already running three pages long.


P&C insurance historic profitability

One industry that has been mentioned in passing in this blog, and which I am following for signs of better pricing and a cyclical bottom, is property and casualty insurance. We mentioned in a previous post how several players are priced well below book value consequence of a soft market with ROEs below cost of capital. This situation should be unsustainable and the big question is when is going to reverse.

This nice chart from a recent W.R. Berkley Corporation presentation illustrates not only the under performance of the industry in terms of ROE but also its dependency on investment profits to achieve those returns. With interest rates at the end of a secular 30 year decline – they can not go below zero, can they – the question is when and how much pricing and underwriting profits should recover.

These are some estimates of which lines will be most impacted and the price elasticity to compensate for the investment income shock. Oh, and thanks Mr. Berkley for that nice  checklist too.

Munger on financials

The beauty of a financial institution is that there are a lot of ways to go to hell in a bucket. You can push credit too far, do a dumb acquisition, leverage yourself excessively – it’s not just derivatives

Wesco Meeting 2002

Munger on expecting the unexpected

What’s interesting in Japan is that every life insurance company is essentially insolvent because they promised to pay 3%. Who’d have thought that this could lead to insolvency, but interest rates went to zero and stayed there for years. They tried to invest in equities, but got negative returns. Can you imagine 13 years with negative equity returns and interest rates below 1%?

Is it inconceivable that it could ever happen here? I don’t think so. Strange things happen.

Wesco 2002 Annual Meeting

Thinking about investing in insurance companies?

I made a mistake in the last post. How could I possible hide some interesting data in an inconspicuous link at the end of a boring side comment? David Merkel deserves better than this.

These are the historic reserve deficits of some large insurance and reinsurance companies with long tail risk. His main target was teflon Hank Greenberg that has been denying any responsibility in the AIG debacle. Some chutzpah given all the evidence indicating compromised underwriting standards, under-reserving, increased leverage and declining ROA under his reign. AIG Financial Products and its CDSs were the last consequence of Greenberg’s risk taking leadership and his nonnegotiable 15% ROE target: the ultimate yield hog

But that is old history, soon to be forgotten to become the foundations of the next bubble. Much more interesting for our own purposes is David’s heavy lifting in evaluating reserve practices of such interesting companies like Berkshire, Markel, and White Mountains.

I know that David has liked PartnerRe for a long time and now it is at a probably conservative 0.76x book value. Cincinatti Financial is one that I have not analyzed either but it is priced at 0.88x book value. If you are interested, I suggest to check their investment record and current portfolio; if we are taking long tail risk please tell me that at least we are doing something interesting with that float. They do not have the investment reputation of a Berkshire or a Markel but that just might be appearances.

Probably the most surprising chronic under reserving is White Mountains. For those that do not know, White Mountains has been a staple of value investing portfolios and they themselves were early investors and promoters of Michael Burry’s Scion Capital. And as David mentions, conservative accounting is something they talk about. Does anyone have absolutory or confirming evidence?

As a passive investor, I tend to avoid long tail risk insurance companies like the plague. David’s work is rear view, an evaluation of past decisions, but you can not be sure about their current ones in a soft pricing environment. Even risky banking construction and development loans have durations of just a couple of years, so many of the big bad C&D loans are probably behind us. That is not the same with long tail insurance and when things go sour, turning around an insurance ship with long tail inertia is a Titanic work.

I am also a skeptical man, how can I be at ease with an investment based on management’s pedigree when so much is at stake? It is not that I distrust them personally; it is about having seen from the inside that controlling the commercial areas is an almost impossible organizational act. If you want to know more about the gap of what is needed and what we have, you should read about how National Indemnity operates in Buffett’s letters.

Some well respected companies like Fairfax Financial had their share of problems in the early 2000s and an old standing company like Lloyd’s was brought down to its knees by the weight of asbestos claims. Bad underwriting and reserving can bring down even short tail risk companies like Lincoln General: former part of Kingsway Financial situation currently under litigation.

Not to detract from a beaten sector, but at current prices personally I am preferring other alternatives in the financial sector.

PD: If someone has done or seen similar analysis with Fairfax Financial, Montpellier RE, Greenlight RE, Aspen or others, could you be kind to share it with us mere mortals? Too busy analyzing other financials.

No position

Insurance Sector Price to Book

While reviewing the presentation of a new reinsurance company, I run across some interesting data on historic price to book multiples for insurance companies.

In the context of also low banking multiples, it seems like the financials is one interesting place to look for ideas. There are several P&C insurance companies with good track records below 1x book value. But before getting too excited let me remind you the warnings about investing in banking and in financials in general:

  1. Black Box: you will never be 100% sure of its balance sheet quality
  2. Leverage: no perfect margin of safety
  3. Thin margins: usually no competitive advantage and bad performance pays
  4. Macro matters: you just can not ignore it. Deflation, inflation and interest rates have an impact
  5. Leadership matters: more than in any other sector, good management is crucial to control risk and allocate capital. This is not Coca Cola that can survive a series of bad CEOs

Part of the reason for the low insurance valuations is the soft pricing environment discussed at length in several articles by the StreetCapitalist and RationalWalk. Insurance is a cyclical business, where commercial pressures drive uneconomic pricing, that destroys capital, leading no the next hard market. As Peter Lynch mentions in his books, one way to invest in the sector is to anticipate these waves. Not an easy thing to do if you are not a card carrying member.

Let me also remind you the critical questions when using book value multiples in financials:

  1. How conservative is that book value?
  2. Is it improving?
  3. How are capital ratios and the need for value destroying new capital or a reorganization?

An excellent blog to read for an inside view of the sector is the now classic David Merkel’s Aleph blog. He posted recently an excellent analysis of reserve practices of several insurance companies that is tightly related to question #1. Very recommended.

Deep value shopping Season part 1

The shopping season is overwhelming and I am not talking about Christmas gifts. The selling of already depressed small cap stocks for tax reasons can be the source of real bargains. Their analysis is taking a lot of reasearch so postings are going to be sparce over the next weeks. Besides I am also desperately in need for vacations (yes!).

To compensate, the next weeks will be about sharing interesting leads. These are in no way recomendations and I do not own most of them. On the same token, I will gladly like to hear from readers their potentials flaws. I will start with beaten down financials. These are companies very difficult to analyze however complexity is a positive in my deep value investing toolkit when there is downside protection and the price is right.

Citizens Republic Bancorp (CRBC): a bank with conservative underwriting, NPAs have been stabilizing and are still less than 6%, a substantial portion of it is reserved, management is also confident that they are more than half through the snake. They have a solid deposit base and leadership position in Michigan and it trades at less than 0.4 tangible book and 3x pre-tax pre-credit earnings. I know, I know, it is Michigan. However, for the same reason the competition was decimated and, believe it or not, their deposits are growing double digits.

The South Financial Group (TSFG): If you did not like the previous bank idea, do not even look at this one. The company was decimated with the recent downgrades of regional banks. They had their share of problems in Florida, but after a recent capital injection their NPA is only 4.4% with 70% of them reserved. There are still some mortgage and CRE problems in the Carolinas, but they look more than half way through and it is just too cheap to ignore: less than 0.3 tangible book and less than 2x pre-tax pre-provisions earnings.

Maguire Properties (MPG): Are you crazy Plan? Commercial real estate, more than 4 billion of debt, negative equity, and priced for bankruptcy? Yes, but. Check the structure of the debt, most of it is non recourse secured by individual properties so they can unload the problematic Orange County properties until they end up with a profitable core. Go to their site and check their buildings in downtown LA: US Bank Tower, The Gas Company Tower, Wells Fargo Center, KMPG Center. Most of them 95%+ leased to AAA tenants and you are buying their equity at less than $70 million. And they have several profitable parking lots. If I ever had a variant perception is this business. Not for the faint of heart

Kingsway Financial Services (KFS): Everything was going great with this insurance turnaround: change of leadership, cost reductions, asset disposals, improving underwriting, stock and debt buybacks and then … all hell broke loose. The Pennsylvania Department of Insurance is challenging in court their disposal of Lincoln Insurance through charity gifts. The issue with a potential reversal of this transaction is not so much Lincoln, which had been written off and its liabilities limited. It is more a potential cross default covenant affecting other subsidiaries. At less than 0.2x conservative tangible book value, a turnaround that is/was in full swing, and a legal process that will take time my bet is that the price already discounts most of the risk. So if I manage to find some margin of safety in the debt structure I might buy some.

I will repeat again: these are not recommendations. I have no position in any of these stocks but I might buy some of them over the next week. Do your due diligence.

No position