The secret of getting rich: “Be greedy when others are fearful and fearful when others are greedy” – Warren Buffet. We all know the principle that Buffet spoke of many years ago. But the principle does not work if the trigger is pulled on the wrong stock or investment. There are times when fear is justified.
There seems to be a lot of fear in the market these days. Some of it is justified, but in our opinion this environment has created pockets of opportunity. Take Zenith National Insurance as an example. Fear of subprime losses and natural disasters have caused the stock to trade at approximately 30% lower than its all time high. Does this represent an opportunity or value trap?
Zenith National Insurance (ZNT, Financial), incorporated in 1971, is a holding company whose operations specialize in workers compensation insurance.
At its current market cap, we believe Zenith is trading at a substantial discount to its true value. The market believes that they will suffer the “sub-prime” losses in their portfolio that plagued many other financial institutions. Zenith also appears to be under selling pressure during the recent California fires even though they exited the reinsurance business in 2005. Reinsurance is basically insuring other insurers and the risk for potential losses from natural or man-made catastrophes can be large. Neither of these concerns will impact Zenith in a significant way.
Here are a few reasons why Zenith is interesting:
A solid fundamental track record
Cheap valuation
Insider buying
Conservative underwriting and investment portfolio (Minimal subprime exposure)
Business
In the past 3 years (2004-2006), Zenith had annual net revenues of approximately a billion dollars. While revenue was more or less flat, earnings grew nicely, going from 119 million (2004) to 158 million (2005) and 259 million (2006). Net income for the nine months ended, September 2007 is 194 million. The five year average for return on equity is approximately 24%.
Most of the recent growth in earning came as a result of favorable workers compensation payouts in Florida and California. The investing thesis in Zenith is whether the current environment results in a higher normalized earnings going forward. If so, the current market cap of 1.55 billion (Nov 17), is surely undervalued.
Also, keep in mind that results are inclusive of reinsurance losses as follows:
2004 – (12) Million
2005 – (56.2) Million
2006 – (20.5) Million
Reinsurance is no longer part of the operations of Zenith but they must still report residual results from past policies. If Zenith is able to maintain normalized net income of approximately 200 million, they are trading at about 8 times earnings, a bargain.
Zenith operates mainly in California and Florida; these states were undergoing intense price competition the last few years that continues to this day. It is nice to see that the management of Zenith is not going to engage in a price war to gain business. This probably attributes to the flat or declining sales growth of the last 3 years.
“Our long-term underwriting and pricing philosophy has been to forego market share in favor of maintaining profitability in a competitive price market”
Despite the price competition, profitability remains very good. Overall net income for Zenith in 2006 increased by about 100 million, this was driven mainly by underwriting profits in workers compensation. In the face of price competition, such profit improvements is a healthy sign.
In addition, the combined ratio (a key industry measure of profitability) has been steadily decreasing and currently sits at about 65%. The combined ratio is the addition of two key measures. Net Losses to net premiums earned plus Underwriting and other expenses to net premiums earned. The goal of the combined ratio is to be under 100%. Some insurers run losses on the underwriting business (combined rate greater than 100%) and rely on investment income. In the last six years, Zenith’s combined ratio for workers compensation was consistently below the industry average.
As mentioned above, a recent driver of the profits is deflation of payouts in the past 3 years. This is a reversal of the inflationary environment prior to that. The cause is the legislative reforms in California and a long term trend of declining claim frequency. The new legislation results in a decrease of expensive claims. There is every reason to believe that this reduction is permanent. However, management has decided to be conservative in their loss reserves. The inflation assumptions in their loss reserves are actually higher than the actuarial estimates.
Whether reserves are understated or overstated is one of the risks of investing in an insurer and it will take time to play out. But is a good to know that the loss reserves are conservatively estimated. If actuarial estimates prove to be correct, Zenith will have overstated their loss reserves. This could be a bonus in future years.
The investment portfolio is critical to most insurers and some rely entirely on their investment returns while running underwriting losses. Zenith’s investment portfolio is ultra conservative with limited exposure to the “sub prime” problem. Their largest holdings are cash and short term government bonds. The fluctuations in the portfolio’s value is the result of interest rate changes and do not affect day to day operations and have little risk of permanent capital losses. The investment income was approximately 100 million in 2006.
Valuation
Based on Zenith’s past performance, we fully expect that they will continue to deliver good results. After the third quarter in fiscal 2007, they are on track to earn in excess of 200 million. If we look at 200 million as a cash flow annuity using a capital cost of 8%, Zenith would be valued at about 2.5 billion.
It can be argued that earnings are very conservative at the moment because their loss reserves are greater than actuarial estimates. Also, reinsurance is currently a drag on earnings but as time passes, reinsurance will be less and less significant. Although they continue to report negative earnings from reinsurance, in fact, all their contracts expired in 2006 and they are no longer writing or renewing any contracts. Most of the reinsurance losses are adjustments to the loss reserve account.
All Zenith needs to do is maintain the current earnings and eventually the market should give it a valuation of at least 2.5 billion (PE of about 12). This valuation is about 65% over the current market cap.
Another indicator is insider action and it has hinted that Zenith is currently under valued. During the summer months of 2007, four insiders have made purchases.
Risks
As with any insurer, there is the risk that the Reserve for losses will need to be adjusted up. The reserve is an estimate and although management is conservative relative to actuarial estimates, there is no guarantee that the reserves are sufficient.
There is the risk that medical costs could go once again on an inflationary spiral and that affects all insurers. Current legislation limits expensive payouts and is beneficial for insurers, but no guarantees that this will not change in the future.
Catalyst
The basic investment thesis for Zenith is that their value is dropping for things that do not apply to them (Subprime, Reinsurance) and eventually the market will reward continued profitability. Based on their history, the company should continue to have good results:
Conservative underwriting
Conservative loss reserves
Conservative Portfolio management
Consistently superior profitability measures
If Zenith can continue to deliver profits at current levels, it will eventually drive the stock price up. There is also the dividend yield which is around 4.0%. Forward yield is estimated at 4.9%. At the very least the dividend yield should limit downside risk.
We currently do not hold a position in ZNT.
- by Chris Ng
Chris Ng is a professional accountant who currently runs a private investment partnership “Link Capital LLP”
There seems to be a lot of fear in the market these days. Some of it is justified, but in our opinion this environment has created pockets of opportunity. Take Zenith National Insurance as an example. Fear of subprime losses and natural disasters have caused the stock to trade at approximately 30% lower than its all time high. Does this represent an opportunity or value trap?
Zenith National Insurance (ZNT, Financial), incorporated in 1971, is a holding company whose operations specialize in workers compensation insurance.
At its current market cap, we believe Zenith is trading at a substantial discount to its true value. The market believes that they will suffer the “sub-prime” losses in their portfolio that plagued many other financial institutions. Zenith also appears to be under selling pressure during the recent California fires even though they exited the reinsurance business in 2005. Reinsurance is basically insuring other insurers and the risk for potential losses from natural or man-made catastrophes can be large. Neither of these concerns will impact Zenith in a significant way.
Here are a few reasons why Zenith is interesting:
A solid fundamental track record
Cheap valuation
Insider buying
Conservative underwriting and investment portfolio (Minimal subprime exposure)
Business
In the past 3 years (2004-2006), Zenith had annual net revenues of approximately a billion dollars. While revenue was more or less flat, earnings grew nicely, going from 119 million (2004) to 158 million (2005) and 259 million (2006). Net income for the nine months ended, September 2007 is 194 million. The five year average for return on equity is approximately 24%.
Most of the recent growth in earning came as a result of favorable workers compensation payouts in Florida and California. The investing thesis in Zenith is whether the current environment results in a higher normalized earnings going forward. If so, the current market cap of 1.55 billion (Nov 17), is surely undervalued.
Also, keep in mind that results are inclusive of reinsurance losses as follows:
2004 – (12) Million
2005 – (56.2) Million
2006 – (20.5) Million
Reinsurance is no longer part of the operations of Zenith but they must still report residual results from past policies. If Zenith is able to maintain normalized net income of approximately 200 million, they are trading at about 8 times earnings, a bargain.
Zenith operates mainly in California and Florida; these states were undergoing intense price competition the last few years that continues to this day. It is nice to see that the management of Zenith is not going to engage in a price war to gain business. This probably attributes to the flat or declining sales growth of the last 3 years.
“Our long-term underwriting and pricing philosophy has been to forego market share in favor of maintaining profitability in a competitive price market”
Despite the price competition, profitability remains very good. Overall net income for Zenith in 2006 increased by about 100 million, this was driven mainly by underwriting profits in workers compensation. In the face of price competition, such profit improvements is a healthy sign.
In addition, the combined ratio (a key industry measure of profitability) has been steadily decreasing and currently sits at about 65%. The combined ratio is the addition of two key measures. Net Losses to net premiums earned plus Underwriting and other expenses to net premiums earned. The goal of the combined ratio is to be under 100%. Some insurers run losses on the underwriting business (combined rate greater than 100%) and rely on investment income. In the last six years, Zenith’s combined ratio for workers compensation was consistently below the industry average.
As mentioned above, a recent driver of the profits is deflation of payouts in the past 3 years. This is a reversal of the inflationary environment prior to that. The cause is the legislative reforms in California and a long term trend of declining claim frequency. The new legislation results in a decrease of expensive claims. There is every reason to believe that this reduction is permanent. However, management has decided to be conservative in their loss reserves. The inflation assumptions in their loss reserves are actually higher than the actuarial estimates.
Whether reserves are understated or overstated is one of the risks of investing in an insurer and it will take time to play out. But is a good to know that the loss reserves are conservatively estimated. If actuarial estimates prove to be correct, Zenith will have overstated their loss reserves. This could be a bonus in future years.
The investment portfolio is critical to most insurers and some rely entirely on their investment returns while running underwriting losses. Zenith’s investment portfolio is ultra conservative with limited exposure to the “sub prime” problem. Their largest holdings are cash and short term government bonds. The fluctuations in the portfolio’s value is the result of interest rate changes and do not affect day to day operations and have little risk of permanent capital losses. The investment income was approximately 100 million in 2006.
Valuation
Based on Zenith’s past performance, we fully expect that they will continue to deliver good results. After the third quarter in fiscal 2007, they are on track to earn in excess of 200 million. If we look at 200 million as a cash flow annuity using a capital cost of 8%, Zenith would be valued at about 2.5 billion.
It can be argued that earnings are very conservative at the moment because their loss reserves are greater than actuarial estimates. Also, reinsurance is currently a drag on earnings but as time passes, reinsurance will be less and less significant. Although they continue to report negative earnings from reinsurance, in fact, all their contracts expired in 2006 and they are no longer writing or renewing any contracts. Most of the reinsurance losses are adjustments to the loss reserve account.
All Zenith needs to do is maintain the current earnings and eventually the market should give it a valuation of at least 2.5 billion (PE of about 12). This valuation is about 65% over the current market cap.
Another indicator is insider action and it has hinted that Zenith is currently under valued. During the summer months of 2007, four insiders have made purchases.
Risks
As with any insurer, there is the risk that the Reserve for losses will need to be adjusted up. The reserve is an estimate and although management is conservative relative to actuarial estimates, there is no guarantee that the reserves are sufficient.
There is the risk that medical costs could go once again on an inflationary spiral and that affects all insurers. Current legislation limits expensive payouts and is beneficial for insurers, but no guarantees that this will not change in the future.
Catalyst
The basic investment thesis for Zenith is that their value is dropping for things that do not apply to them (Subprime, Reinsurance) and eventually the market will reward continued profitability. Based on their history, the company should continue to have good results:
Conservative underwriting
Conservative loss reserves
Conservative Portfolio management
Consistently superior profitability measures
If Zenith can continue to deliver profits at current levels, it will eventually drive the stock price up. There is also the dividend yield which is around 4.0%. Forward yield is estimated at 4.9%. At the very least the dividend yield should limit downside risk.
We currently do not hold a position in ZNT.
- by Chris Ng
Chris Ng is a professional accountant who currently runs a private investment partnership “Link Capital LLP”
