Annual Review — Insurance, tech, and all the rest

by Travis Johnson, Stock Gumshoe | February 10, 2012 4:55 pm

Finishing up our "buy, sell or hold" survey of past "Idea of the month" stocks.

Today I’m filling in the updated thoughts on all the other stocks that are still in our semi-active universe of “Idea of the Month” picks from past years (ie, we haven’t dropped them for reaching a price target, or being dumb mistakes that have been crushed). These are, as with the rest of the updates we’ve shared as the annual review process continues, in our order of “likingness.” Early next week I’ll merge all of these comments into one article for you, in the same order, just so we have a record of this year’s opinion updates, but if you want to catch up a bit you can see the income picks here[1] and here[2] (that was a two-parter), the commodity picks here[3], and the emerging markets picks here[4].

And these are, of course, just my opinions at this time — that doesn’t mean that these stocks are right or wrong for your portfolio, or for mine (I have bought some picks recently that I’d label overall as a hold, and have sold some “buy” ideas because of my own personal portfolio needs and priorities). Some of these stocks end up getting a lot of attention from newsletters or I end up buying and selling them and writing about them throughout the year, others are stocks that have interesting fundamental stories but don’t necessarily get our attention between annual reviews (unless a lot of folks ask about them, or I notice something that changes my mind).


Flowserve (FLS) — Buy

Flowserve has been running hot for quite a while, with a nice run after we featured it following the Value Investing Congress back in October. My opinion of the company hasn’t changed, though it’s a slightly stretched valuation now that the shares have run up by 30% — but the strong recurring revenue and the excellent long-term prospects for this seller of pumps and valves still put the stock at a buy … with a caveat: they report earnings on February 22, and I’m always nervous to make investments before a big earnings announcement, so in cases like this I’d usually plan to stagger my purchases, buying half a position before earnings and half after unless I have reason to be particularly confident about how the stock will perform after the release (I have no idea in this case, and I don’t own this particular stock). Flowserve may not be an easy call as a value stock anymore, but it is still value priced for the growth that’s expected (roughly 12-14% in 2012, picking up after that, for a price/earnings/growth ratio of about 0.75, which is cheap in my book).

Markel (MKL)[5] — Buy

I continue to really like Markel as my favorite insurance stock (not that I know all of them inside and out — I don’t ), but it is not a super-compelling buy at this price given their weak year last year. I own the shares and have no intention of selling anytime soon, but they’re coming off of a year of underwriting losses (102 combined ratio, which means that they’re losing on the insurance business and have to make it up with investment income if they want to be profitable — their goal is to have underwriting profits, which means a combined ratio under 100, and they generally have achieved that, but not in 2011). I like Markel’s continued investments in their venture investing arm, which has quietly grown quite a bit over the last couple years and is producing good income (the general point of “ventures” is buying operating businesses, not just investing in the stock and bond markets). Their investment performance has been so-so over the past year, in part because of low interest rates (insurance companies need a pretty big bulwark of stable bonds to ensure viability, and rates have been low), but Tom Gayner’s long-term investment performance has been strong and I expect he will manage their portofolio well going forward. The company remains very focused on growing book value over the long term, and they are, wisely, I think, not putting the portfolio at large interest rate risk by reaching for yield — they’re keeping the fixed-income portion in relatively short term bonds, which also hurt performance but reduces the risk of a clobbering when the rates finally go up. My argument has been, and history generally supports this, that Markel is a good buy when it gets down to a price/book valuation of 1.2 or below, and it’s barely there right now (price/book is 1.15), but over the past couple years the shares have generally traded at a lower overall price/book than they had for the previous decade. I think their weak earnings performance might spur some selling and give a better buy price later this year, but I think it’s unlikely to drop much below $350 or so absent a market crash that wrecks their book value. If you can be patient and let them compound book value for years it’s still a buy, it’s inexpensive compared to book value but risks losing ground if they don’t get back to profitable underwriting this year and justify a return to a premium valuation.


Zimmer Holdings (ZMH) — Buy

When I first wrote about Zimmer almost exactly three years ago, it was irrationally cheap — at less than ten times trailing earnings because of a short-term earnings blip due to some changes in their selling and marketing procedures and some legal issues, as well as some concern that semi-elective procedures like knee replacements would tail off in a weak economy (as they did and do, to some degree). Right now, you can buy Zimmer for about 15X trailing earnings and a forward PE of just about 12, which is a reasonable but not voracious buy — it was cheap before earnings late last year, but now all the analysts have raised estimates and it’s now just a decent buy of a dominant company in an industry with strong tailwinds (we’re all getting older and falling apart). Still worth buying that kind of company, even if it’s not quite a bargain. And though I don’t always love relying too much on analyst estimates, it’s worth noting that the analyst estimates have been right on over the past four quarters — so there’s some confidence to be had in the forward estimate of a 12 PE, and perhaps in the underlying earnings growth of 9-10% that those analysts project going forward.

Swiss Helvetia Fund (SWZ) — Buy

The Swiss Helvetia Fund is a closed-end fund of stocks headquartered in Switzerland, with a historically very heavy emphasis on the big three: Novartis, Roche, and Nestle. I can’t argue with holding any of those excellent dividend-generating consumer necessity stocks these days, so I still like the portfolio — even though there’s been some ups and downs with the perils of Swiss banks (they’re creeping back into the top ten holdings again after being pared back a couple years ago), and with the stress over the skyrocketing Swiss Franc that was hurting their exporters (like all three of those companies) before the bank stepped in to peg the Franc to the Euro (much to the consternation of forex speculators).

SWZ has a strong distribution history, most of the distribution comes from capital gains in the portfolio but consistent income from dividend raisers like Nestle also means that SWZ has a fairly predictable regular dividend in the 3% range. The extra payments over the past year have boosted that so that the total overall payment to shareholders was almost exactly $2 per share, for an effective yield of close to 20% (these kinds of capital gains you can think of as reducing your cost basis, so if you look at SWZ on our tracking page and see that it’s only gone from $9 to $10, note that you’ve also gotten $2 in capital gains distributions this year). I don’t expect that level of capital gains every year, or anywhere near it, but would be surprised if they don’t continue to provide a yield that’s above average, probably in the near-5% range from this point absent huge market swings in their major holdings. The fund also typically trades at a discount to net asset value, as do most closed-end funds — right now the discount is pretty average, right around 11%. I wouldn’t expect the discount to disappear, but there’s not a huge fear that the discount would widen much, especially with the strength of their core holdings.


Akamai (AKAM) — Hold

I should know better than to count out Akamai — it was when the market panicked over competition and the shares got cheap, and everyone thought that their content delivery network model would become commoditized or irrelevant, that I suggested looking at the stock, and they bounced back with earnings growth and better margins very quickly after that. It went up to $60 or so then fell back down as competition concerns and margin pressure hit the shares again, I shared some updated thoughts last Summer when AKAM was in the mid-$20s and said that though it was almost tempting enough to buy I’d wait for a price closer to or below $20 or some heavy insider buying to get back in. It did briefly dip below $20 last Fall, so if you happen to have caught those low prices I’d again do something to protect profits here — the shares jumped 10% on great earnings yesterday, but you’re still paying a huge premium for a stock that is not growing earnings all that quickly. At this price you’re paying about 20X 2013’s estimated earnings for a stock that’s not likely to grow earnings at more than 10-12% per year, and with a history of vacillating performance as competitive pressur ebbs and flows. Great company, excellent exposure to growing e-commerce and cloud computing demands, but I think it’s recently gotten too expensive again.

Westport Innovations (WPRT)[6] — Hold

Westport is one of the most successful stocks we’ve ever covered, and it continues to amaze me with its huge gains … but I would be very nervous about getting in at these prices unless you’re a nimble trader (I’m not). Drawing a picture where WPRT’s current price is justified by foreseeable earnings takes a real leap of faith, even though I do think they’re in an excellent position to benefit from what ought to be dramatic uptake of natural gas engines in the trucking industry in the coming decade. I thought the company was possibly getting a bit extended a year ago, when it was trading at around $18, so take my concern with a grain of salt — it’s now over $40 on continued enthusiasm for the potential natural gas transportation push from Congress, which means the company has a market cap of about $2 billion and has never made a profit … and trades at 10X sales. Their revenues are climbing rapidly, and it’s true that the natural gas glut helps their prospects tremendously, since cheap natural gas versus expensive diesel is arguably a more compelling long-term argument for truck owners than are vacillating federal policies on subsidies or tax credits.

I’d hold if I owned it (I don’t), and would probably put a stop loss in to protect profits if I’d held it for these remarkable gains of the past year, but cannot come up with a justifiable reason to buy it at this price other than “it’s going up.” If I were to bet on a big resurgence of natural gas trucks right now I think I’d be more comfortable with Cummins (CMI) at this point (Cummins Westport, their joint venture for nat gas engines, is by far the most lucrative part of Westport’s current operations) — Cummins is a growth darling as well, but it’s also priced reasonably on fundamentals right now, it won’t have the leverage that WPRT does to ongoing natural gas truck enthusiasm, but it has some exposure to that as well as exposure to a renewed trucking fleet and global growth in heavy equipment, and I can justify the price far more easily for Cummins than I can for Westport. Westport is a great, great, great story, which can make a stock incredibly expensive — it could easily double from here even though I think it’s pricey — but story stocks that don’t have some kind of foundation in earnings or revenues to keep up with that lofty valuation get frightening when the story turns or the storyteller hiccups.

Loews (L)[7] — Hold

Loews has been pretty steady over the past couple years, despite the fact that I got cold feet about the stock shortly after featuring it as an “Idea of the Month” pick. My personal reluctance to hold the shares was largely due to my unease about the prospects at CNA Financial (CNA), the insurer that makes up about half the value of this conglomerate. CNA Financial continues to be a very weak insurance company, but it has now gotten so overwhelmingly cheap, trading at 0.6X book value, that it’s hard to argue that Loews investors are banking on returns from CNA. Loews’ other major divisions are their shareholding and general partnership in Boardwalk Pipeline (BWP), and their controlling ownership of Diamond Offshore (DO), and the company certainly trades at a discount to net asset value. Their 90% holding in CNA is valued at about $7 billion, the 50% of DO is $4.3 billion, and the 66% of BWP is $3.5 billion at current market prices, so you can see that the market is still discounting the parent pretty substantially (as it usually does, to be fair), since L carries a market cap of $15 billion. They do also carry some debt and have net cash on the holding company balance sheet, but since the subsidiaries are majority owned it’s hard to distinguish their cash from the holding company cash — basically, the way it looks now is that you buy the three big subsidiaries and you get a bit of investment cash, their Highmount natural gas exploration and production business (which is suffering from low prices), and Loews hotels (which is tiny, comparatively speaking) for free. It’s a discount, but not a super-compelling one — it’s still really all about performance at CNA Financial and whether Diamond Offshore can continue spitting out cash without having to invest too much in rigs, DO has been a cash cow for them but their fleet is getting a bit old. I might buy these shares to gamble on a turnaround at CNA financial, since that insurer has been improving operationally — CNA currently trades at 0.6X book value, which is ridiculously cheap and means Loews, as a discount on CNA, would give some additional leverage to a CNA turnaround. Do be mindful, however, that they’ve been trying to turn CNA around and make it consistently profitable on an underwriting basis for years and haven’t gotten there yet. The good Property and Casualty insurers with better long-term underwriting performance are generally trading at a 10-20% premium to book these days, though most of them also took a big hit from the Thai floods, New Zealand earthquake, Japanese Tsunami and/or Hurricane Irene, it’s not been a good year for catastrophe insurance.

FTI Consulting (FCN)

This is one of the few stocks that’s down sharply since the March, 2009 lows — I picked it largely because of their industry-leading position in bankruptcy and restructuring consulting, at a time when I thought we’d see a pretty big wave of bankruptcies among midsize companies. That didn’t happen, so even though FCN gets more of their business from cyclical segments that are growing pretty well right now, their margins are taking a hit because restructuring is where they get a big profit boost. They have active and successful consulting businesses in technology and litigation support, for sure, and they also benefit from good IPO markets with their strategic consulting for emerging companies, but it doesn’t seem like they’re going to return to the excellent performance that led them to become (with the help of lots of bolt-on acquisitions) one of the best performing stocks of the early 2000s. I think FCN is likely to track the S&P pretty closely from here, and that’s not why I was interested in the shares — I sold my holding quite a while ago, I don’t have a particularly good argument for buying or holding the shares here so I’ll call it a sell.

Activision Blizzard (ATVI) — Sell

I sold my shares of Activision Blizzard last Spring after the stock remained persistently tepid regardless of the improving performance of the company — this is the largest of the video game publishers, with a growing online/smartphone/casual gaming business but still heavy, heavy reliance on console games like their ongoing blockbuster Call of Duty franchise and on World of Warcraft and similar subscription-based multiplayer role playing games. When I first recommended this one (and bought it myself) about three years ago I expected them to continue to dominate the business with their hits, which they’re arguably doing, but I became concerned about the lack of traction in the Guitar Hero franchise as they essentially dropped it last year and what that meant for their more “casual” gamer business (the folks who don’t commit their lives to mastering World of Warcraft or Call of Duty, but who play quick games on their iPhone in the dentist’s office). The stock has grown into its profits, but the profits haven’t grown like I originally thought they would given the high margins of their blockbuster console games, I think the real question for ATVI is whether console gaming is going to experience another renaissance, with a new wave of new Xbox’s and Playstations and a new wave of demand for $60 game disks (those products are incredibly old, six or seven years, though they have been tweaked and Xbox has gotten the Kinect to keep them growing). I think ATVI, with declining revenue from World of Warcraft and what seems to me to be a trend away from blockbuster high-intensity games and toward casual (and inexpensive) games on iPhones and in facebook, is going to have a hard time getting real earnings growth in the years ahead. I would sell the shares, despite the seemingly pretty reasonable valuation — I could be wrong, but I think the industry is evolving so fast that this massive company is going to have a harder time with the turn than their smaller competitors, and I remain concerned with how absolutely dependent they now are on Call of Duty’s blockbuster new releases. This might, to be fair, be an overreaction — they are not going to collapse overnight or go out of business, they pay a growing (if small) dividend and have a big buyback planned of about 8% of their shares. I just don’t see a high likelihood that they’ll be able to sustain Call of Duty forever and they haven’t yet developed another franchise that even comes close to succeeding that blockbuster.

Endnotes:
  1. income picks here: http://stockgumshoe.com/2012/01/annual-revisit-income-ideas-part-one/
  2. here: http://stockgumshoe.com/2012/02/annual-revisit-income-ideas-part-two/
  3. commodity picks here: http://stockgumshoe.com/2012/02/annual-review-commodities-stocks-and-related-picks/
  4. emerging markets picks here: http://stockgumshoe.com/2012/02/annual-review-emerging-markets-ideas/
  5. Markel (MKL): http://www.stockgumshoe.com/tag/markel
  6. Westport Innovations (WPRT): http://www.stockgumshoe.com/tag/westport-innovations
  7. Loews (L): http://www.stockgumshoe.com/tag/Loews

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