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It’s Time To Buy Insurance For Your Portfolio

June 21, 2014 | About:

Like me, I am sure most investors hate to lose money. Right now, the bull market that began in 2009 is starting to look tired and valuations, while not outrageous, are no longer cheap. As a value investor, this stage of a bull market begins a difficult period for me. I want to continue making reliable returns on my capital but it becomes more and more difficult to find investment that meet my standards for capital allocation.

The other day, I got so tired of looking at businesses that would clear my bar for investing that I found myself neglecting the number one rule of my research. I don’t study stocks to find a reason to buy a business; I study stocks to find a reason not to buy them. Only when my search for a reason not to buy is unsuccessful do I pull the trigger and buy. This week, I actually found myself trying to justify an investment after I found a reason not to make it. It has been about 15 years since I found myself in that position. I shook my head in disbelief.

The Answer To My Problem Was Obvious

It occurred to me that at times like this, I should have insurance to protect myself from making bad decisions with my portfolio selections. Insurance is one of those things we can get to cover almost any risk to which we might be exposed and a product that virtually everyone purchases in one form or another. It is also a product we buy while hoping we will never need to use it. Since I love to own businesses that supply products or services that almost everyone must have and that embed themselves into the lives of their customers, I decided it might be time to consider adding insurance to my stock portfolio. I am also aware that insurance was the base business that helped Warren Buffett (Trades, Portfolio) build Berkshire Hathaway (BRK.A; BRK.B) while he became one of, if not the best, investor of all-time.

I have long been aware of The Travelers Companies, Inc. (TRV) brand and thought it might provide a good starting point due to being a large stable business that could provide some potential growth with lots of downside protection should the market stumble. Travelers offers a broad range of business and personal insurance products that its customers need to protect their assets against catastrophic loss.

When I perform due diligence on businesses to which I am contemplating allocating my capital, I like to compare their performance in key financial metrics against selected competitors and the industry averages. Even if the business is involved in an attractive industry, I don’t want to own an under-achiever. In the case of Travelers, my analysis began to reveal a business that performs pretty much in line with the industry averages. There is nothing wrong with average performance in an exceptional industry; it is not, however, good enough to warrant my investment.

But, it turns out that all was not lost. When I start a journey, I always have some thoughts as to where I am going but I always try to keep an open mind regarding my final destination; just in case something more attractive presents itself. One of the businesses that I had selected as a “competitor” to Travelers was a company called Partnerre Limited (PRE). Partnerre is engaged in a segment of the insurance market called reinsurance. This is essentially selling insurance on insurance sold by others. It might sound a bit confusing, but it basically selling insurance on insurance as a backstop against catastrophic losses for the original issuer of policies. Like all insurance, to be successful, a business must be very good at assessing risk/reward ratios and Partnerre is exceptional at it.

Above Average Performance Will Produce Above Average Price

It is easy to find businesses that are the performance leaders in their industry at any price; value investing is about finding those top performers that trade at a discount within an exceptional industry. With Partnerre, I think my search was successful. A review of the key metrics in the table below reveals how Partnerre compares not only to Travelers but to the industry as well.

Company

Partnerre

Travelers

Industry Average

P/E 2014

9.81

10.41

12.66

Price/Cash Flow

7.49

8.77

8.6

5-yr Return on Equity

10.01%

11.2%

10.09%

5-yr Return on Capital

10%

9.9%

7.83%

Debt to Equity

12%

25%

25%

Price to Book

0.85

1.31

1.18

5-yr Projected Annual Earnings Growth

9.5%

7.7%

9.9%

Even a casual review of these metrics reveals Partnerre to be equal to Travelers and the industry averages in the areas where it performs the worst and an exceptional value in the areas where it is strongest.

A View Beyond First Glance

The first criterion that is a non-negotiable for me is a degree of assurance that a business will not go broke. I can stand a small loss, even though I will not like it; but, bankruptcy is a different matter. Partnerre’s low debt to equity of 12% is very manageable and not the kind of debt load seen in financially distressed businesses.

Shares of Partnerre would have to rise by 29% in order to trade on par with the industry average. But there is a potential kicker to that number as well. Over the last 90 days, the average of the analysts’ consensus estimate for 2014 earnings has risen 12.88%, from $9.78 to $11.04/share. This provides a strong indication that the people who earn a living evaluating this business believe its prospects are on the rise.

Even though I always consider P/E multiples in my analysis work, I also understand that reported earnings are fairly easy to manipulate on a short term basis. Therefore, I really prefer to use the price to free cash flow metric for my actual valuation work. Partnerre trades at a price to cash flow ratio of only7.49 which represents a 13% discount to the industry average of 8.6.

While the 10.01% 5-year average return on equity as been right in line with the industry average of 10.09%, Partnerre’s 5-year average return on capital, at 10%, has beaten the industry average by 27.7%. This is an exceptional figure and demonstrates the skill with which management has handled the shareholders money when compared with other management teams within the same industry. I guess those who say you can’t beat the market forgot to tell the management of Partnerre.

Value Is Nice; Deep Value Is Better

Buying well-run businesses in necessary industries at fair prices is always worth consideration. However, only compelling is ALWAYS worth buying. What makes Partnerre compelling at this time? This very profitable business can be purchased today at $0.81 for each dollar of depreciated value of the business. That’s right, you can buy shares of this business today for 81% of the stated current book value of the assets. That means that share would have to rise 25% just for the business to trade at what would essentially be the liquidation value of the company. The industry average price to book value is currently a very reasonable 118%. Partnerre would have to rise 45.68% in order to trade at the same premium to book value as the rest of an industry that produces financial results that are certainly no better than Partnerre and in many cases inferior.

The comparable performance measures in a critical industry make Partnerre a very attractive opportunity with solid upside potential over the long term. The discount to book value compared to the industry premium make this, in my view, a truly compelling value.

If Partnerre Is Such A Steal, Why Is It So Cheap?

While most investors would probably deny it, I think there are large numbers of people with money in the stock market who are hoping to hit the next big thing and get rich overnight. They confuse gambling with investing. One of my early mentors told me: “Virtually nobody gets rich overnight; everyone should get rich in their lifetime.” I have always remembered those words of wisdom.

I understand the power of mathematical compounding and I know my biggest ally in that realm is time. I also know that achieving 12% total returns over the long haul will trounce the long-term performance of the overall market and make me very wealthy. However, that takes a level of patience that most people simply do not have. They crave the excitement of a owning a stock that is screaming higher like a rocket.

Insurance is a boring steady business. The 5-year projected earnings growth rate for Partnerre is only 9.5% per year, a real yawner. It pays a reasonable, but also boring, dividend of 2.48%. Those are not numbers that get most people adrenaline flowing. However, two of my favorite measures of projected annual price appreciation for a stock are the 5-year projected earnings growth rate plus the dividend yield and 5-year average return on equity plus the dividend yield. In the case of Partnerre, those number work out to 11.9% and 12.5% respectively. I think an investment that plods along at 12% a year just simply does not attract the “hot money” that will drive prices higher very quickly. Therefore, slower growth, less exciting stocks tend to be priced more attractively. But, $10,000 invested at a 12% annualized rate of return will become $96,462.93 over 20 years. I do not invest to get an adrenaline rush; I invest to make money. If you are still reading about this boring reinsurance business, I am guessing you are more interested in making money than owning flashy stocks as well. We can always take our boring profits and go purchase some exiting entertainment later, if we so chose.

Final Thoughts And Actionable Conclusions

For investors seeking the comfort and safety of a familiar name, Travelers presents a reasonable investment opportunity inside of an excellent industry. This stock would serve many investors quite well and should produce reasonable 6% to 8% annualized total returns for years to come. For me, good is just not quite good enough.

I might not always end up where I start to go but I always end up where I need to be. I started out my due diligence expecting to find an opportunity to buy stock in Travelers and I thought insurance in my portfolio would provide some insurance for my portfolio. I ended up in a different destination when I discovered the compelling value of Partnerre but I was still able to discover a compelling value.

Partnerre currently trades at around $108.34/share; but I believe the fair value to be much closer to the industry average of 8.6 times cash flow or around $124 to $125/share on the conservative side and $135/share if it were simply to be priced at book value. At book value this business would still carry a very conservative value.

Given the forward growth prospects and improving current year estimates, this is certainly a business that should produce 10-12% per year capital gains over the next 4 or 5 years even if the current conservative valuation remains unchanged. This business appears to offer an attractive opportunity at worst and a compelling one at best.

About the author:

Ken McGaha
Ken McGaha has been managing his own investment portfolios for over 20 years. On July 20, 2012 he launched the Self-Made Millionaire Tracking Portfolio with a portion of his capital as an aid to teach younger members of his extended family how he built his own investment portfolios and maintains them today.

Ken's Self-Made Millionaire website now has subscribers in at least 13 countries and the Self-Made Millionaire Tracking Portfolio has delivered a 28.36% annualized rate of return on capital between July 20, 2012 and June 21, 2014.

In late December of 2013, Ken added the Maggie's Money Mountain Tracking Portfolio to his website to show young investors with limited capital how he would invest and trade an account with $4,500 in order to grow it at a compounded rate of 12% annually. From December 30, 2013 through June 21, 2014, this account has produced an actual return of 26.05%.

Visit Ken McGaha's Website


Rating: 5.0/5 (4 votes)

Voters:

Comments

kfh227
Kfh227 premium member - 6 months ago

Opportunities but they are hard to find.

The only places I have found opportunity are a few comapnies with growth catalysts that everyone is ignoring (BBRY, ZINC, RFP). Everyone is also ignoring Oil&NG companies like SD.

If you look at my thoughts and look at Monish and Prem bought recently, you'll see where my ideas came from. Go give them a look.

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