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Historical Results and Commentary

Portfolio Analysis

 

Feb 11, 2007

 

Holdings

 

 

Feb-07

1

FNF

2

COP

3

CAT

4

NKE

5

SAFT

6

VRSN

7

SNP

8

AHL

9

INTC

10

C

11

TOA

12

F

13

MS

14

TKC

15

HMC

16

CRYP

17

X

18

DOW

19

NBG

20

ACH

 

 

Performance of Individual Stocks For last 3 months

 

Feb-07

 

FNF

12.79%

COP

6.17%

CAT

9.26%

NKE

10.56%

BA

5.53%

VRSN

16.90%

SNP

12.68%

PCLN

12.26%

INTC

2.75%

C

6.51%

TOA

21.49%

F

1.75%

MS

7.00%

TKC

4.99%

HMC

10.60%

CRYP

44.10%

X

26.37%

DOW

3.91%

NBG

9.15%

ACH

35.64%

 

 

Total Increase (Decrease) since last quarter: 13.02

Additions:  SAFT, AHL

Subtractions: PCLN, BA

Commentary:  I have parted ways with PCLN and BA.  Both have done well for the portfolio.  PCLN has set a new record for the shortest amount of time an equity has been held in the portfolio (1.25 years, or 5 quarters).  Such a short holding time for PCLN does not portend a fundamental change in strategy for me.  In this specific case, I felt Priceline with a PE of 37 did not represent a substantial margin of safety anymore.  BA has also reached what I view to be a high level in regards to its fundamentals, with a PE approaching 30. 

 

Both these stocks may very well continue to go up, but I have already admitted many times that I have no functional strategy for timing the high points of stocks, so missing peaks is something I have come to accept.  However, with both these stocks, I feel my timing has been somewhat premature.  Both stocks have reasonable momentum behind them, and their forward 12 month PEs are both about half of their current PEs.  However, I feel that neither stock presents a reasonable margin of safety anymore.  Boeing will probably stagnate, and Priceline will….well, I have no idea as I do not understand the movements of tech stocks once they decouple from their fundamentals.  So, I wish it luck in its irrational course from now on, but it is time to part ways.

 

The two additions this quarter were both insurance firms.  SAFT is an auto insurance company in New England and AHL is a Bermuda-based reinsurer.  The logic behind both acquisitions was similar.

 

  1. Both stocks present excellent value.  Both are priced reasonably close to the book value of their equity, and both are trading at PEs of around 6. 
  2. Both stocks have also seen solid growth in the book value of their equity, and their operating income and revenues have also grown at a respectable clip.  The one exception was AHL in 2005.  In this year, hurricanes in the Gulf of Mexico created a statistically unlikely scenario which negatively impacted the performance of AHL.  This made AHL’s stock more attractive, as the market unnecessarily compensated for a perceived increase in risk.
  3. Both stocks have dividend yields of about 2 percent per anum.
  4. As insurance firms, both stocks have conservatively financed investment portfolios.  This allows me to piggyback on their investment gains.

 

The portfolio now has 15 percent of its holdings in insurance based companies (including FNF).  This reflects my growing conservatism as an investor as I feel the strong run we have had since 2002 will move us into a new and unstable period of precariously high valuations in the next 1-2 years if we are not already in such a phase.

 

A Closer Look At Aspen Insurance1

For the last 7 years, most of my commentaries and large-scale investing decisions have been based on large scale social and economic events rather than the close scrutiny of financial statements.  However, over the past 2-3 years I have started to pay more and more attention to financial statements, and I have enjoyed learning some of the principles of securities analysis.  The acquisition of AHL (and also SAFT) were heavily influenced by looking at its fundamentals.  The following is a breakdown of my logic analyzing AHL.

 

The simple explanation is that AHL offers two things that are extremely attractive.  First, AHL has long term investments of nearly $5 billion, even though its market capitalization is only about $2.4 billion.  With a pool of long term investments that is almost double the market capitalization of the stock, any return on long term investments will be levered by a factor of two on a per share basis.  The company also pays a dividend of about 2.2 percent per share.  So, assuming a conservative return on long term investments of 4.5 percent, one is almost guaranteed a return of 11.2 percent per year, excluding any positive results from the core business of reinsurance underwriting!  Second, the stock is trading at a slight discount to book value.  Sometime in the near future this will reverse itself and AHL will trade at a premium to book value.  Therefore, an investor now should anticipate to benefit from this eventual change, probably sometime in the next 10 years.

The following is a more complicated ways of saying what I have just said in the previous paragraph:

 

The following table shows some of the fundamental characteristics of AHL.  These have been approximated for the end of 2006:

Price (Dec 31, 2006)

26.30

Market Cap

2.31 billion

P/E Ratio (TTM)

6.12

P/E Ratio (average earnings last 3 years)

17.5

P/BV

0.92

Dividend Yield

2.30%

AHL has several strengths from a value perspective.  It has a reasonable dividend yield, it is trading at a discount to book value, and the company has a very low P/E ratio based on earnings in 2006.  However, when earnings over the past 3 years are averaged, AHL has an unspectacular P/E.  This is primarily because the company’s property reinsurance business took a major hit during the unusually active hurricane season in 2005, and to some extent in 2004 as well.  These years of losses also caused growth in insurance premiums to stagnate in 2006 as the company rethought its diversification strategy and did not renew or pursue certain types of policies to underwrite. 

 

It is my belief that the unusual years of 2005 were anomalous and do not represent a fundamental shift in the climate system nor a failure of the general insurance community to properly evaluate risk probabilities.  If anything, the added uncertainty and attention being given to natural disasters can be exploited by insurers to increase the margins on their premiums, boosting profitability.  Betting on a reinsurance company is a lot like betting on a casino.  Iteration to iteration, the bet can lose, but over time, such a bet will necessarily win since reinsurers and casinos both stack their respective games in their own favor. 

 

So, how is AHL’s price going to evolve?  Here is how I am modeling the probable evolution of the stock price.  It is my belief that sometime over the next 10 years, AHL’s price will trade at a higher premium to its book value of at least 1.3 times.  So, how does this make the stock a good buy now?  The following outlines my thought processes:

 

First, I modeled AHL’s earnings as coming from two basic sources: reinsurance underwriting and returns from investments.  Earnings are essentially the return on investment income added to earnings from reinsurance underwriting.  The return on investment is given by the annual growth in long term investments, which I have assumed to be a conservative 4.50%.  The return on premiums is the size of net premiums earned times the profit margin on those premiums (the loss+expense ratio).  Over the last 5 years, the average loss+expense ratio has been 90 percent, so I have used this figure in the model.  This is probably too high of a figure, as the unusual 2005 results have been averaged into this figure, but, hey, this is a conservative model.  I have also assumed the following things:

  • Dividends will be paid out as one quarter of after-tax earnings. 
  • Remaining earnings will be converted into long term investments (I suppose some of it would have to go to cash to provision for growth in insurance premiums, but since short term cash accounts could probably yield close to the 4.50 per year that I am assuming as the return on long-term investments, things should work out more or less the same accounting for things this way)
  • There are no share buybacks or additional paid-in capital moves.
  • I have ignored long term debt, as it is small and so I am taking a short cut here
  • Tax rates are estimated to reach 30 percent by 2008.  I assume AHL will milk their loss in 2005 to lower the effective tax rate for 2007 (an probably 2008 and possibly onwards as well).  This is just a guess.  I have no idea what the estimated tax rate should be, but choosing the industry average of 30 percent is a conservative assumption I am making. 

 

The following three tables show projections of growth through 2016.  The first assumes a 0 percent compounded annual return (CAGR) or premiums, the second a 5 percent CAGR, and the third a 10 percent CAGR.  All figures are in millions of USD, except for per-share data or percentages, and values from 2007 onwards are estimated:

 

Model Assuming 0% CAGR of Premiums

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Long Term Investments

922.4

1616.3

2735.9

3689.1

4681.1

5019.760076

5242.4478

5455.5506

5673.688

5896.9788

6125.545

6359.511

6599.0044

6844.1559

7095.0991

Net Investment Income

8.5

29.6

68.3

121.3

204.4

225.8892034

235.91015

245.49978

255.31596

265.36405

275.64952

286.17799

296.9552

307.98702

319.27946

Return on Investments

0.92%

1.83%

2.50%

3.29%

4.37%

4.50%

4.50%

4.50%

4.50%

4.50%

4.50%

4.50%

4.50%

4.50%

4.50%

Net Premiums Earned

120.3

812.3

1232.8

1508.4

1676.2

1700

1700

1700

1700

1700

1700

1700

1700

1700

1700

Loss+Expense Ratio on Net premiums earned

0.89

0.78

0.84

1.17

0.82

0.9

0.9

0.9

0.9

0.9

0.9

0.9

0.9

0.9

0.9

Approximate Income from Insurance premiums

13.233

178.706

197.248

-256.428

301.716

170

170

170

170

170

170

170

170

170

170

Pretax Income Estimate

21.733

208.306

265.548

-135.128

506.116

395.8892034

405.91015

415.49978

425.31596

435.36405

445.64952

456.17799

466.9552

477.98702

489.27946

Estimated Tax Rate

 

 

 

 

18.90%

25.00%

30.00%

30.00%

30.00%

30.00%

30.00%

30.00%

30.00%

30.00%

30.00%

Estimated Earnings

 

 

 

 

410.4601

296.9169026

284.1371

290.84984

297.72117

304.75483

311.95467

319.3246

326.86864

334.59091

342.49562

Dividends Paid

0

0

8.3

45.5

71.8

74.22922564

71.034276

72.712461

74.430293

76.188708

77.988667

79.831149

81.71716

83.647728

85.623905

Reinvested Capital (to Long Term Investments)

 

 

 

 

338.6601

222.6876769

213.10283

218.13738

223.29088

228.56613

233.966

239.49345

245.15148

250.94318

256.87172

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

EPS

 

 

 

 

4.56

3.30

3.16

3.23

3.31

3.39

3.47

3.55

3.63

3.72

3.81

Dividends Per Share

 

 

 

 

0.80

0.82

0.79

0.81

0.83

0.85

0.87

0.89

0.91

0.93

0.95

Cumulative Dividends Per Share (2007 onwards)

 

 

 

 

 

0.82

1.61

2.42

3.25

4.10

4.96

5.85

6.76

7.69

8.64

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Estimated Book Value of Equity

878.1

1298.7

1481.5

2039.8

2389.3

2727.960076

2950.6478

3163.7506

3381.888

3605.1788

3833.745

4067.711

4307.2044

4552.3559

4803.2991

 

Model Assuming 5% CAGR of Premiums

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Long Term Investments

922.4

1616.3

2735.9

3689.1

4681.1

5019.760076

5245.8233

5466.7764

5697.8006

5939.3763

6192.0075

6456.2228

6732.5766

7021.6505

7324.0547

Net Investment Income

8.5

29.6

68.3

121.3

204.4

225.8892034

236.06205

246.00494

256.40103

267.27193

278.64034

290.53002

302.96595

315.97427

329.58246

Return on Investments

0.92%

1.83%

2.50%

3.29%

4.37%

4.50%

4.50%

4.50%

4.50%

4.50%

4.50%

4.50%

4.50%

4.50%

4.50%

Net Premiums Earned

120.3

812.3

1232.8

1508.4

1676.2

1760.01

1848.0105

1940.411

2037.4316

2139.3032

2246.2683

2358.5817

2476.5108

2600.3364

2730.3532

Loss+Expense Ratio on Net premiums earned

0.89

0.78

0.84

1.17

0.82

0.9

0.9

0.9

0.9

0.9

0.9

0.9

0.9

0.9

0.9

Approximate Income from Insurance premiums

13.233

178.706

197.248

-256.428

301.716

176.001

184.80105

194.0411

203.74316

213.93032

224.62683

235.85817

247.65108

260.03364

273.03532

Pretax Income Estimate

21.733

208.306

265.548

-135.128

506.116

401.8902034

420.8631

440.04604

460.14419

481.20225

503.26717

526.3882

550.61703

576.00791

602.61778

Estimated Tax Rate

 

 

 

 

18.90%

25.00%

30.00%

30.00%

30.00%

30.00%

30.00%

30.00%

30.00%

30.00%

30.00%

Estimated Earnings

 

 

 

 

410.4601

301.4176526

294.60417

308.03223

322.10093

336.84157

352.28702

368.47174

385.43192

403.20554

421.83244

Dividends Paid

0

0

8.3

45.5

71.8

75.35441314

73.651042

77.008057

80.525232

84.210394

88.071754

92.117934

96.35798

100.80138

105.45811

Reinvested Capital (to Long Term Investments)

 

 

 

 

338.6601

226.0632394

220.95313

231.02417

241.5757

252.63118

264.21526

276.3538

289.07394

302.40415

316.37433

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

EPS

 

 

 

 

4.56

3.35

3.27

3.42

3.58

3.74

3.91

4.09

4.28

4.48

4.69

Dividends Per Share

 

 

 

 

0.80

0.84

0.82

0.86

0.89

0.94

0.98

1.02

1.07

1.12

1.17

Cumulative Dividends Per Share (2007 onwards)

 

 

 

 

 

0.84

1.66

2.51

3.41

4.34

5.32

6.34

7.41

8.53

9.71

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Estimated Book Value of Equity

878.1

1298.7

1481.5

2039.8

2389.3

2727.960076

2954.0233

3174.9764

3406.0006

3647.5763

3900.2075

4164.4228

4440.7766

4729.8505

5032.2547

 

Model Assuming 10% CAGR of Premiums

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Long Term Investments

922.4

1616.3

2735.9

3689.1

4681.1

5019.760076

5250.5376

5481.0622

5727.6809

5991.8389

6275.1218

6579.2698

6906.1932

7257.9889

7636.9594

Net Investment Income

8.5

29.6

68.3

121.3

204.4

225.8892034

236.27419

246.6478

257.74564

269.63275

282.38048

296.06714

310.77869

326.6095

343.66317

Return on Investments

0.92%

1.83%

2.50%

3.29%

4.37%

4.50%

4.50%

4.50%

4.50%

4.50%

4.50%

4.50%

4.50%

4.50%

4.50%

Net Premiums Earned

120.3

812.3

1232.8

1508.4

1676.2

1843.82

2028.202

2231.0222

2454.1244

2699.5369

2969.4905

3266.4396

3593.0836

3952.3919

4347.6311

Loss+Expense Ratio on Net premiums earned

0.89

0.78

0.84

1.17

0.82

0.9

0.9

0.9

0.9

0.9

0.9

0.9

0.9

0.9

0.9

Approximate Income from Insurance premiums

13.233

178.706

197.248

-256.428

301.716

184.382

202.8202

223.10222

245.41244

269.95369

296.94905

326.64396

359.30836

395.23919

434.76311

Pretax Income Estimate

21.733

208.306

265.548

-135.128

506.116

410.2712034

439.09439

469.75002

503.15808

539.58644

579.32954

622.7111

670.08705

721.84869

778.42628

Estimated Tax Rate

 

 

 

 

18.90%

25.00%

30.00%

30.00%

30.00%

30.00%

30.00%

30.00%

30.00%

30.00%

30.00%

Estimated Earnings

 

 

 

 

410.4601

307.7034026

307.36608

328.82501

352.21066

377.71051

405.53068

435.89777

469.06093

505.29408

544.8984

Dividends Paid

0

0

8.3

45.5

71.8

76.92585064

76.841519

82.206253

88.052665

94.427627

101.38267

108.97444

117.26523

126.32352

136.2246

Reinvested Capital (to Long Term Investments)

 

 

 

 

338.6601

230.7775519

230.52456

246.61876

264.15799

283.28288

304.14801

326.92333

351.7957

378.97056

408.6738

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

EPS

 

 

 

 

4.56

3.42

3.42

3.65

3.91

4.20

4.51

4.84

5.21

5.61

6.05

Dividends Per Share

 

 

 

 

0.80

0.85

0.85

0.91

0.98

1.05

1.13

1.21

1.30

1.40

1.51

Cumulative Dividends Per Share (2007 onwards)

 

 

 

 

 

0.85

1.71

2.62

3.60

4.65

5.78

6.99

8.29

9.69

11.21

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Estimated Book Value of Equity

878.1

1298.7

1481.5

2039.8

2389.3

2727.960076

2958.7376

3189.2622

3435.8809

3700.0389

3983.3218

4287.4698

4614.3932

4966.1889

5345.1594

 

There are lots of other things I could do.  I could play around with changes in the profit margin on underwriting premiums, the return on investments, etc.  But, for my purposes, I have chosen conservative numbers and, well, if things happen to do better than my conservative estimates, that is great!

 

The following chart sums up my logic for purchasing AHL right now.  I believe that sometime in the next 10 years, when the whims of the market choose to favor AHL or the reinsurance sector in general, we will see AHL trade at a higher premium to book value, at least 1.3x and potentially higher.  This could be brought about by a number of things such as increasing growth estimates for reinsurers, higher estimates for profit margins for reinusers, or a lack of other value opportunities in the market that will cause people to favor reinsurance.  Who knows why for sure, but I think this is going to happen. 

 

The following chart models the potential returns on this outcome given two variables: changes in the annual growth in premiums and also time.  To read this chart one can pick two variables.  For example, if the appreciation to book value happens in 2012 and the annual growth in premiums to that point has been 6 percent, then the return on the investment would be 15.72% per year from the end of 2006 through the end of 2012.  Assuming that all of the following 100 possibilities have an equal probability of occurring, then the expected return from such an experiment would be a 21.63 CAGR.  Pretty cool.

 

Time to 1.3x BV Pricing and Stock Returns Given a Range of Growth In Reinsurance Premiums for AHL

Annual growth in premiums

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

0%

56.069%

30.977%

23.105%

19.207%

16.831%

15.203%

14.001%

13.068%

12.314%

11.689%

1%

56.08%

31.00%

23.15%

19.26%

16.90%

15.29%

14.10%

13.17%

12.43%

11.81%

2%

56.09%

31.03%

23.19%

19.32%

16.97%

15.37%

14.19%

13.28%

12.54%

11.93%

3%

56.10%

31.06%

23.23%

19.38%

17.04%

15.45%

14.28%

13.38%

12.65%

12.05%

4%

56.11%

31.08%

23.27%

19.44%

17.11%

15.53%

14.38%

13.48%

12.77%

12.18%

5%

56.116%

31.109%

23.317%

19.493%

17.184%

15.617%

14.471%

13.587%

12.881%

12.298%

6%

56.13%

31.14%

23.37%

19.56%

17.27%

15.72%

14.59%

13.72%

13.03%

12.46%

7%

56.14%

31.18%

23.42%

19.63%

17.36%

15.82%

14.70%

13.85%

13.17%

12.62%

8%

56.16%

31.22%

23.48%

19.70%

17.44%

15.92%

14.82%

13.98%

13.32%

12.77%

9%

56.17%

31.25%

23.53%

19.77%

17.53%

16.02%

14.94%

14.11%

13.46%

12.93%

10%

56.18%

31.29%

23.58%

19.85%

17.62%

16.13%

15.05%

14.24%

13.61%

13.09%

Under all of the above scenarios, I anticipate AHL will outperform the S&P 500.

Of course, there are lots of things that could go wrong.  Another major natural disaster could occur.  However, by choosing an underwriting margin of 10 percent I believe I have provisioned for this potential in my model, since in good years underwriting margins should be higher, perhaps 17 or 18 percent.  The competitive environment could intensify as well, or growth could turn negative in a big way.

 

1This commentary was added on April 25th 2007 

 

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Introduction

Historical Results and Commentary

Portfolio Analysis