by Travis Johnson, Stock Gumshoe | November 9, 2012 8:21 pm
So many people are asking me about the election results that I feel like I should share some of my opinions — but the short answer is: I can’t help it, stock prices that fall make me want to buy more stock. Stocks fell a bit after the election. And I bought some more today.
It may be that the world is heading to Hell in a handbasket — but people have been predicting that for as long as there have been people, and investors have particularly been predicting that for the last two or three years as the bad news from Europe, the clearly unsustainable US Government budget, and big-picture issues like an aging population make those who invest money for a living very worried.
And since many big-money investment managers, individual investors, and many high-profile businesspeople really, really, really wanted Obama to lose — and wanted it so badly that they shouted about it on TV and predicted doom if Obama was reelected — I think that there’s a good chance that a good number of investors really “drank the kool-ade” on that, not only making a loud argument but actually believing in their hearts that if Romney became president the economy would be OK, and if Obama was reelected the world would collapse.
That’s just silly.
Not that I want to start up a political debate here — in truth, that’s the last thing I want — and it might be that the stock market and the economy would have done better with a Romney presidency than they will with another four years of President Obama, but we don’t know that and we never will, and the one thing that we consistently do as a people is overreact, often dramatically, to minute changes in the philosophical approaches of our leaders.
Neither Romney nor Obama was likely to or is inclined to institute a police state, throw old people off of Medicare, confiscate private property on a grand scale, start a new war, or try to crush either poor people or rich people. What we do know is that the economy is growing slowly, that a lot of people are out of work in this country and in Europe, and that there will have to be dramatic changes over the next decade in the way the US government collects and spends its revenue… and that it’s quite possible that the “fiscal cliff” fixes in the coming months will mean that the economic performance of the country might be either better or worse than is currently expected, depending on what kind of solution the politicians can agree on.
And does knowing that do us any good as investors? No, not really — it just causes fear and uncertainty and, to some degree, unnecessary paralysis. And it does so at a time when our most fearful and uncertain cohort of investors, the baby boomers, are most worried about money anyway, just as they’re retiring in large numbers. Which is probably part of the reason why some stocks are getting clobbered.
It might mean, particularly if the “fiscal cliff” stuff turns into as partisan and foolish a fight as the last debt ceiling debate, that we go back into a recession. But recessions mean that the country’s economy is contracting, they don’t mean that we’ll face massive unrest, a debilitating fall in the value of the dollar, or a stock market that falls by 50% again. It’s possible, sure, but preparing for that possibility by being flexible, diversified, patient and cautious is different than betting on that possibility by selling everything and turning your net worth into a sack of gold coins that you bury in the back yard.
My assertion would be that fearing the big picture changes that will come in the next few decades (and pretending you know what they’ll be) … or even the next few months … is not an investment strategy — it might be a trading strategy, and there might be more risks now that you want to hedge by holding more cash or whatever it is you do to protect yourself, but it doesn’t change the fact that investing in profitable companies is the best way to build a portfolio over time.
So since I can’t predict what the market will do over the next few months or the next few years, and I have great suspicion of anyone who claims they know what will happen during that time frame, my strategy is going to continue to be: looking for companies that I think can earn better than average returns on my money with lower than average risk, and letting the best of those companies become large contributors to my portfolio and compound those earnings over time.
But I’m in my 40s, and my base expectation for entitlements is that Social Security and Medicare will kick in as last resorts for me when I’m somewhere in my mid-70s, should I be lucky to live so long, and that those programs will provide only a very low baseline to keep me from becoming homeless. Everyone has to make their own plans, but I think that expecting gold or bonds or cash-stuffed mattresses to provide better long-term returns than productive people seems foolish, given the fact that I have plenty of years to be patient — investing in corporations means you’re investing in the ability of creative and motivated people to find, produce, develop, provide, sell, and deliver the products and services that people need and want. If you think people will still need and want products and services, then the best companies will find a way to turn those needs and wants into earnings, so buy those companies when the price seems reasonable. I believe that it really is that simple if you have a decade or more of time to watch your money grow (or are willing to be very diversified or take some risks) — political transitions and arguments often overstate the amount of change we’re going to see when “reality” strikes, and what impact that change will have on companies.
That’s not true in every case, of course — there are some companies that are very directly tied to specific government programs, or where there may be a substantial company-specific risk that’s attached to something you can watch on CSPAN. That might include stuff like military spending, as with Mitt Romney’s oft-stated goal of dramatically increasing spending on new ships for the Navy … would his election have really brought that spending increase, and will sequestration really bring massive cuts to the defense budget that drive shipbuilding companies down? Those are clearly issues to get your head around if you’re investing in military contractors, like if you were wagering on Huntington Ingalls (HII), the major shipbuilder and aircraft carrier contractor that we wrote about a while back … and you can clearly see in the stock price that the shares went up in the week before the election as folks though Romney had some momentum, then fell right back down after the election, and that one will probably continue to react pretty dramatically to speculation about the size and nature of defense cuts in the “fiscal cliff” deliberations.
That was just an example of one stock that’s legitimately tied to the fiscal cliff and, arguably, to the election results, but it also happens to be one I’m keeping my eye on still, the baseline contracted revenue for refueling aircraft carriers and building the carriers that are already funded is quite substantial, so if the shares really get clobbered by sequestration worries we might be able to buy it for a song. I’ve got an alert to remind me to take a look at this one if it dips back near the mid-$30s.
And there are also market gyrations that we’re probably better off ignoring if we’re not traders — like the idea that fear of possible (or even likely, at this point) higher capital gains taxes in January means that this year investors are selling their winners to harvest capital gains instead of selling their losers to harvest capital losses, which some folks think is part of the reason for the fall in shares of Apple (AAPL), for example. If you can try to predict that and harvest in-and-out gains of five or ten percent, more power to you — that’s not my goal, I’d rather stand ready to buy stocks that seem to me like they’ve overreacted on the downside to fears or news. I don’t want to sell my stocks in January, so I’m not going to sell them two months before January just to make sure that I pay lower taxes on my gains … if I don’t sell them at all, I won’t pay taxes anyway (well, most of my portfolio is in tax-deferred accounts of one sort or another, so it really doesn’t matter much for me personally … but you get the point).
So that’s where I stand right now in terms of big-picture stuff — I would not be shocked to see some economic malaise next year, particularly if Congress, as wouldn’t be shocking, does something weak and short-sighted in just pushing off the “fiscal cliff” for a year and then spends most of that year loudly debating about which side is going to implode the economy. If politicians are going to make hard decisions that sacrifice the short term in favor of the long term, they’re going to do it right after an election.
But companies make money in Russia, for God’s sake, and in Cuba and Venezuela and Greece and Argentina, all places with much more “uncertainty” than we have in the United States — people buy and sell stuff, and corporations adjust to the changes in laws and regulations and, at least here in the US, corporations have pretty strong input into those changes, particularly so now that corporations are allowed to stuff political piggy banks as full as they wish.
Call me a pollyanna if you like — you might not be wrong — but I see nothing to be gained from expecting collapse. Keep diversified, keep some gold, keep some cash, keep some bonds, do whatever you need to sleep well and to be prepared if we have some lousy years — but if you need your money to grow over a long period of time, then buy pieces of companies that can grow it for you. If that doesn’t work, then we’re out of luck … because over time that’s really been the only thing that works pretty well for most people.
Or if we want to say it in a shorter way: I have no idea what will happen to the economy over the next two years, but I think most of the stocks in my portfolio will be worth more in two years than they are today. And if you’re pissed about the election, as I know many people are, don’t let anger about other peoples’ political choices force you to make bad choices with your money.
So today I’m making a couple investments — one is probably going to end up being a shorter-term speculation, an activist target and arguably a turnaround or breakup candidate that depends on the fact that there are more people in the world and they’re going to want to eat, with a chance of a 50% gain or more within the next year if the activist gets his way; the other is a smaller, long-term quiet grower that accumulates cash and invests it well … but not without a substantial amount of risk. Both have dipped recently on disappointing earnings but now, I think, are at good prices to open a position. Neither one is a stock I’m betting the farm on for long-term returns, but both are worthy of a nibble and more research, at least in my mind.
[FYI, for those who have asked: My largest stock holdings are currently, in order, Sandstorm Gold (SAND), Africa Oil (AOI.V AOIFF), Apple (AAPL), Seadrill (SDRL), Berkshire Hathaway (BRK-B), Sprott Resource Lending (SILU), Sprott Resource Corp (SCP.V SCPZF), Altius Minerals (ALS.TO ATUSF), Lonrho (LONR.L LNAFF), Google (GOOG), which collectively are about 40% of my portfolio. Lonrho and Berkshire are the ones I’d be most inclined to buy more of right this moment.]
And that’s all I’m doing, opening a position in appealing stocks. I tend to build my holdings in companies pretty gradually over time — I buy a little bit, which forces me to watch them more closely, then if there are opportunities in the future when I have cash and the company looks well priced, I’ll know them well enough to commit more capital to the shares even if the market thinks they’re suddenly less valuable for some reason. If I end up being right about the worthiness of the company to be a long-term holding, I can easily hold those shares and perhaps add on from time to time for many, many years — if I end up not being right, I sometimes let small positions just languish (I tend to be a terrible seller) or sell them if my opinion finally changes.
So the two stocks I’m adding to my personal portfolio today are Agrium (AGU), which I noted briefly during the Value Investing Congress about six weeks ago, and Greenlight Re (GLRE), which was teased by Tom Dyson over at the Palm Beach Letter a couple weeks ago.
The short reason? Agrium announced disappointing earnings and the stock fell to a level that gives us a bit more of a margin of safety even if the activist hedge fund investors don’t get the company breakup that they want, and Greenlight Re also had slightly disappointing earnings which drove the shares down to what has recently been a floor for the stock, right around 1X book value. So these are “good companies got cheap enough to take a nibble” plays, and both are starting out with something less than 1% of my portfolio (the larger positions above max out at 8-10% of my portfolio). Let me talk about each one for a minute.
Agrium (AGU) is the largest direct-to-farm distributor/retailer in North America, providing seeds, fertilizer and crop protection to farms around the US and Canada (though they’re expanding a bit to Australia and elsewhere too). The folks at JANA Partners, an activist hedge fund, are arguing that the substantial value of this distribution and retail network is depressed because it’s tied to a more volatile wholesale fertilizer company (potash mines, nitrogen fertilizer plants), and they want the two to split.
AGU has often had the worst of both worlds — not getting the nosebleed valuations of the pure play fertilizer makers like Potash Corp. (POT) when fertilizers were in dramatic bull markets, as has happened a few times in the last decade, but also not always getting credit for the stable earnings of their retailing division when fertilizer prices fall. Their share price has been performing well this year, until the last earnings release, in part because of the growing pressure from JANA and the moves that Agrium has already made in response to that pressure.
Those reactions from Agrium include a large stock buyback that has been completed — at prices above where the stock now stands, apparently — as well as a doubling of the dividend that will go into effect in 2013 (the new dividend will be $2/year, which still isn’t a dramatic yield but is almost 10X higher than the dividend was in 2011). Barry Rosenstein, who heads JANA, has had quite a bit of success as an activist investor, particularly in helping to push for the breakup of companies to unlock value and get rid of the dreaded “conglomerate discount”, so a substantial reason for getting into these shares is a belief that JANA’s pressure will continue, and that this pressure will help make sure the company tightens up their management to reduce costs and deploy capital in a more shareholder-friendly way even if they don’t get the full spinoff that they want.
What I’m doing personally is making a small bet, but I’m also splitting that bet — I’m putting half in AGU common stock with a buy right around $95, and half in call options for April (five months away) at $110, which is basically a bet that as Agrium’s acquisition of the Viterra retail network (and a few other assets) goes into effect the attention on their retail business, spurred by JANA, will intensify, and that the recent dip in the share price will reinvigorate shareholders to press for more reform and/or a real shot at a corporate split or spinoff — those call options are in the neighborhood of two bucks a contract, so it’s basically a bet that the shares will advance 20% or more by April. (Glencore’s acquisition of Viterra has been put off a couple times, but it looks like most people now expect it to close in December. Longtime readers might remember Viterra from when I suggested it about three years ago.)
You can see the presentations and analysis from JANA Partners here, they lay out their argument for the hidden value in the big AGU retail network in particular, but also note the huge cost advantages that AGU should be seeing and profiting from as natural gas prices languish (natural gas is the primary ingredient in nitrogen fertilizer, so when gas prices fall it helps margins). Buying this company at roughly 10X earnings is reasonable, and you get a 2%+ yield and no real debt and exposure to what I think will be continued growth in the agricultural economy in the US and Canada … but that doesn’t mean the company couldn’t trade down to 6-8X earnings, as it has on occasion in the past, so the near-term reason for buying is really the activist pressure and the dip in the shares.
Why did the shares dip? Well, the simple answer is that AGU had a terrible quarter — their earnings fell far short of what analysts expected. If you want to see the other side of the Agrium argument, this poster at Seeking Alpha does a good and analytical job of running through their problems. The basic spiel is that they had a potash mine shutdown that hurt, the big purchases expected by China and India have been delayed and they’re bickering over prices, and farmers cut back on investment in some products with the drought. The China and India potash buys will come over the next six months or so, with prices still to be determined, and I expect that farm spending will return to normal as we prepare for the Spring.
So with a PE of about 10 and exposure to agriculture, it’s a fine investment for possible long term returns — but this is really more of a short-term speculation to me, because I think AGU continues to be undervalued relative to its large peers and I think JANA has a good chance of spurring some more substantive moves from management, which is why I’m speculating on a 20% return by the Spring with options to juice my small investment in the shares. I might be happy building on to make this a larger position, but I’d probably want to see lower prices before I made a larger long-term investment in the common stock. Buying around $95 means we get the stock at August prices, before JANA got aggressively public with their demands, but it doesn’t mean the shares are dirt cheap — they were in the $60s earlier in the year.
Greenlight Capital Re (GLRE) is a captive reinsurance company that was set up to provide a big chunk of investment capital for David Einhorn’s Greenlight Capital, which has been one of the best hedge funds around for the past decade. This should obviously appeal to Einhorn, because he gets to invest the substantial capital reserves of a reinsurance company — which provides leveraged capital with no cost if it’s well run — and, unlike with the other investors who put money into his hedge fund (his hedge fund and his investments for GLRE use the same portfolio strategy), he doesn’t have to worry that GLRE will want to get its money back at an inopportune time (he won’t face redemptions if he has a bad year). And Greenlight Capital, in exchange for managing money for Greenlight Re, gets a (slightly discounted) hedge fund management fee in addition to the more secure investment capital. So that’s how the basic relationship works.
In order for any insurance company to do really well, they have to underwrite well and invest well. GLRE has been investing really well, but last quarter their underwriting didn’t do very well — which is probably a big chunk of the reason that the shares dropped by a few percent.
Underwriting performance in any given period is most easily represented by something called the combined ratio — which is a mysterious-sounding number, but really just identifies whether the insurance operation made money. You get the combined ratio by adding expenses and incurred losses on claims, and dividing that number by their earned premiums, but most insurance companies include the number in their earnings releases. A number above 100 means the insurance company is losing money on the insurance part of their business (they can still make money by investing the capital they hold, but they’re taking in fewer premiums than they’re paying out in losses and corporate expenses), a number below 100 means the insurance company is making money even if you ignore their investment portfolio.
So the goal, as you might imagine, is to have a combined ratio that’s usually under 100 — ideally it would always be under 100, but that’s really hard for property and casualty insurers because no one can go on forever consistently without either making mistakes or being unlucky with catastrophes.
And the magic of insurance is that if you usually have a combined ratio of under 100, or even just near 100, then you get free leverage. That’s because many premiums are paid in for risks that will take years or decades to play out, either because of litigation that delays the payout of claims, or because of long-tail policies where claims might come a decade after the premium was paid, or whatever (many insurance policy premiums, like standard car or home insurance, are earned in as little as a year and have no tail, some have very long tails and are earned over decades).
During that time between when the premium is paid and the loss claims are paid out, whether it’s six months or ten years, the insurance company gets to hold the money and earn whatever they can by investing that money. Even though it’s not really money that they’ve earned yet. That’s been a big part of the reason for Warren Buffett’s success — if you write insurance profitably, say with a combined ratio of 95 (few can do that consistently, of course), then you actually get PAID 5% to hold on to that money, in addition to earning whatever investment returns that money might make possible. If you have a combined ratio of 100, it’s like getting free loans.
Nice, right? Well, it used to be super easy when treasury bonds could consistently get you a 5% return — with risk-free returns like that, there were plenty of insurance companies who were happy to lose a couple points on the combined ratio and still make money because the safe return of treasuries, combined with leverage, made it profitable to be an unprofitable underwriter. That dynamic has brought waves of good and bad markets to insurance — insurers call a market with very competitive pricing a “soft market”, and a market where premiums are rising a “hard market,” and they’re forever fielding questions from analysts on conference calls about whether the market is hardening or not.
There’s a tendency to get a “hard market” after catastrophes or when the market is weak — because catastrophes give insurance companies religion and make them worried about losses, so they stop trying to desperately underwrite everything and start looking at what they can actually underwrite profitably, and because weak investment returns or low interest rates mean they have fewer options to make a profit from investing the “float” (that’s the premium money they’ve taken in but not yet paid out in claims), so they actually have to make money at their core business if they’re going to make money at all.
Earnings are usually very unpredictable for insurance companies, and that’s especially true for reinsurers like Greenlight Re, who insure insurance companies (taking some of the risk, either the risk of catastrophic loss above a particular number or threshold, or a portion of all the risk) … so in my experience it’s better to monitor for general performance in terms of cash flow and premiums written and investment performance, all of which can be very volatile from quarter to quarter, but to really focus in on the combined ratio and the book value. GLRE just hit book value, at right around $24, so that’s encouraging — the company does not have a long history, but it has rarely traded below book value for very long, so that’s part of the reason for my purchase today.
But GLRE’s combined ratio is awful for this year — which is probably why it traded down to book value. I read through their filings, and I like two things: Einhorn has brought very good investment performance, as you might expect; and the company explained the failure in underwriting, learned from it, has already gotten out of the business that they misjudged, and has set aside what sound like good reserves to handle those losses.
I’ve also, in reading through their materials, gotten comfortable with the general strategy they’re using as reinsurers — focusing more on “frequency” than on “catastrophe” business, where they take a share of the potential losses for non-catastrophic events (your house catches fire or a tree falls on the garage), but don’t focus on insuring against, say, big one-time events like a hurricane washing away all the houses in the neighborhood.
They do still have reinsurance contracts with catastrophe exposure, and they’ll probably end up losing money from Hurricane Sandy, for example, but catastrophe reinsurance — which requires a strong stomach but generates huge returns when we go a few years without a major hurricane — is not their goal. Their goal is to have specialized relationships with key customers and to try to sell lower risk, lower volatility recurring business in niche areas where they have some underwriting expertise.
They said in the last quarter’s conference call that they don’t expect to have current-quarter losses from Hurricane Sandy unless and until the insured property damage exceeds $20 billion (not the total loss, which includes a lot of uninsured stuff like flooding and infrastructure damage that will fall on the government, but the insured property loss), so that may or may not play out as they expect but they don’t have an immediate hit coming from that disaster.
The bad combined ratio, in the neighborhood of 120 for the last few quarters (compared to close to 100 last year), is a result primarily of a bad strategy in one specific business line — they had what seems comparable to a bad investment thesis, and they paid for it. (The thesis was, in shorthand, that a slowing economy and higher unemployment would bring fewer trucking accident claims — less traffic and better drivers — even as dynamics in that industry meant there was briefly less price competition among insurers … they were wrong.) When it became clear to them that they had misjudged the risks, they got out of those businesses and they’re now writing down losses from policies that expired a couple years ago, so the underwriting losses should be shrinking now. I’m encouraged that they were able to react to those market dynamics and try to cut off their mistake before it led to additional losses, and by the fact that investment performance has helped to counteract the underwriting loss this year, but this is a company and management without a very long history so it will bear watching to see how their underwriting recovers over the next year or two.
Will David Einhorn end up being the next Warren Buffett, and GLRE the next Berkshire Hathaway, as was hinted at by Tom Dyson in his teaser ads? Well, I wouldn’t bet on it — his hedge funds are still considerably larger than the Greenlight Re portfolio, so I like that we’re getting access to his management through GLRE but I don’t think there’s any reason to assume that GLRE will become his core focus … and he doesn’t seem to have much if any of his personal capital invested in GLRE shares. And of course, Warren Buffett didn’t charge Berkshire Hathaway a hedge fund fee to manage its cash. Doesn’t mean it can’t work well — I think niche reinsurance is a good business to be in, with a chance to differentiate themselves with sector expertise and focus much the way Markel has in specialty insurance lines, but, again, it’s early and I’m just nibbling so far.
While we’re on the subject of insurance, by the way, Markel (MKL), which I’ve suggested to the Irregulars a couple times over the years and also own personally, has been on a tear this year and is now over its “easy” buy point — over the past five years or so it’s always been a good idea to buy MKL when it gets down to (or briefly below) 1.2X book value … right now, 1.2X book would mean buying MKL at around $460 or a hair under, so I’m certainly still holding my shares but I’d wait for better prices to nibble a bit more. Markel also judges itself on long-term growth in book value, so you’re focusing on the metric that company management focuses on (and is incentivized by — bonuses at Markel are based on rolling five-year growth in book value)
And my favorite insurance company, Berkshire Hathaway (BRK-B) is becoming less and less of an insurance company but in my opinion it’s still an obvious, easy buy when it gets down to about 1.1X book value (and book value almost certainly understates the real value of Berkshire shares) … not only because it rarely gets to that historically low valuation and because the company owns such a variety of fabulous assets and businesses, but because Buffett himself has as much as said that he’ll be buying back the stock if it gets below 1.1X book. I jumped on more shares when it last got below 1.1X book, but that was over a year ago and was before Buffett’s buyback announcement … right now Berkshire has a book value of $111,718 per A share, and 1,500 B shares equals one A share, so book value for the B shares is about $74.50.
That means 1.1X book value would be about $81 … so buying as it approaches that level or goes under it seems very wise to me. It’s at $85 now and dropping with the market, so I’m close to being willing to add to my holdings even if I’m not necessarily in a rush to buy — I would be shocked, given Berkshire’s large cash hoard ability and willingness to buy back the shares below 1.1X book value, if it got to $80 and stayed that low unless the overall market is taking a real beating between now and the next quarterly update. (Book value is reported just quarterly, but Berkshire Hathaway owns a lot of publicly traded stock, from Wells Fargo to Coca Cola, so if those shares fall hard then their book value would also drop, all else being equal … and book value can, of course, decline for other reasons as well, including poor underwriting, turns in the wrong direction on Buffett’s derivative bets, or a weak quarter of cash generation at Burlington Northern Santa Fe or MidAmerican Energy).
And Berkshire is, as it becomes less of an insurance company and more of a collection of operating companies (manufacturers, utilities, railroads) and publicly traded investments, getting a bit easier to value on an earnings multiple basis, too — Whitney Tilson, who has Berkshire as one of his largest holdings, suggests giving Berkshire a PE of 12 based on the collected earnings of their publicly traded holdings and their operating companies, including insurance earnings, and gets a value of $175,000, which is about $116 per B share. I think that presumes a pretty high multiple on conglomerate earnings, but I think Berkshire is worth closer to $116 than it is to $85 today and I expect the market will eventually recognize that value. I just don’t want to pay $116, because it might be that sometime between now and then it gets down to $70 or $75 again… or Buffett gets rushed to the hospital and the shares briefly dip lower than that.
So that’s what I’m doing — nibbling at a new insurance company and a fertilizer and farm supply company, and thinking about another bite of Berkshire Hathaway if the shares dip just a bit more. We’ll see how it all works out.
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