Warren Buffett (Trades, Portfolio) has talked about how he has sometimes read a stock’s annual report year after year – like IBM (IBM, Financial) for sure and Coca-Cola (KO, Financial) I’d assume – and then suddenly something clicks, and he sees the stock differently.
It just becomes clear to him in a way it wasn’t before. The investment case becomes clear. What we are talking about here is “finding the right frame.” This is often the biggest part of any kind of problem solving. It’s easy to start brute forcing something – plugging in numbers and doing work – but that doesn’t lead anywhere. Figuring out a stock’s EPS estimate a few years hence to the last cent is not going to help much. Finding a new way to look at something familiar is the way to get a new insight.
How do you do this? The first thing I suggest to absolutely every investor is to collect all the past years of data you can. A lot of investors – and all traders, of course – find this insane. But when Quan and I were writing our newsletter, we’d sometimes include data going back to 1989, 1990 or 1991. Why’d we stop there? Usually because that’s all that could fit on one page of data using the smallest font you could still read. We crammed all those numbers in there for subscribers to read. Some appreciated it. Others didn’t. What does data from 25 years ago matter?
It can tell you a lot. Sometimes you get perspective. Two of my favorite banks – in terms of competitive position at least – are Bank of Hawaii (BOH, Financial) and Frost (CFR, Financial). Bank of Hawaii just does business in Hawaii. Frost just does business in Texas. Quan gathered about a quarter century of data for both stocks. I don’t remember exactly how many years we chose to show subscribers. But I know that when I was studying up on the stocks, I was looking at financial results – loan loss rates and that sort of thing – going back to at least the late 1980s. For these two banks, that was valuable stuff.
Everybody thinks the 2008 financial crisis was the worst thing since the Great Depression. For some states it was. For most banks it was. But it wasn’t the worst thing to hit Texas. It wasn’t the worst thing to hit Hawaii. The oil bubble that started in the 1970s and burst in the 1980s is the worst thing that ever hit Texas. It devastated Texas banks. As we mentioned in the issue we did on Frost – Frost is the only bank in Texas that was of any real size back in the oil bust and still exists as an independent Texas bank today. Everything else went under or merged with out-of-state banks. Texas was very dependent on the oil industry back in the 1980s. And a lot of banks did some energy lending. But that’s not what the problem was. The problem was land. Land values collapsed in places like Midland where it had all been driven by the boom.
Hawaii was the same way. That bubble wasn’t driven by oil. It was driven by Japan. In the late 1980s there was a huge asset bubble in Japan. The Nikkei had insane price multiples on it. Land was extraordinarily overvalued. I’d compare it to something in the U.S. like 1929, 1999 or 2008 – but the comparison wouldn’t even be close. The asset bubble in Japan was of a different scale entirely. It’s no surprise then that Japan hasn’t recovered from that binge anywhere near as well as the U.S. recovered from The Great Depression. Hawaii is most tied to the U.S., of course. But it has the second-closest economic ties to Japan. Tourism and such. Over the last 25 years, Hawaii – like Texas – has become a more diversified economy.
Today, Hawaii gets more tourists and business from outside Japan and outside the U.S. mainland. But there wasn’t much of that in the late 1980s. The people who went to Japan – as tourists and as homebuyers – were American and Japanese. And Japan was going through this crazy bubble. The Japanese bubble spread to Hawaiian land prices, too. If you take a piece of land in Hawaii circa 1991 and then look at that same piece of land in 2001 – the real value of the property would be lower in the second year. So you had a negative real return in land over 10 years. That’s a bust.
Frost and Bank of Hawaii had these periods in their past where they had been tested more than they were in 2009 and 2010. That’s important. It’s important to know that. Because if you don’t have data going back to the 1980s, you think this is the worst thing to ever happen to these banks. It’s not even the second-worst period – 2008, 2009 and 2010 – in Bank of Hawaii’s history. That bank went through a period of di-worsification. It got involved in mainland loans. Any time Bank of Hawaii has strayed from a focus on Hawaii it has lost money in those areas.
This isn’t unique to that bank. A competitor – Central Pacific Financial (CPF, Financial) – got involved in a lot of California construction lending just before the 2008 financial crisis. That basically destroyed CPF. Bank of Hawaii was completely refocused on Hawaii by the financial crisis because it went through a whole turnaround process in the early 2000s. That may have saved the bank. If it had followed in Central Pacific’s footsteps, it could have had similar losses during the crisis. My point here is that the two banks I like most – Bank of Hawaii and Frost – each had their toughest periods long before the 2008 financial crisis. If I’d been looking at just five-year or 10-year data, I wouldn’t have the right frame for the investment case. Almost no websites I’ve come across show data going back more than 10 years. They should. Focusing on just the last 10 years may force you to frame the investment in the wrong way.
I can think of two other investments where having a much longer than 10-year history was critical in finding the right frame. One is Bancinsurance. This stock is no longer publicly traded. But it was a niche insurer – so niche I’m not going to bother describing the exact kind of insurance it wrote. The company had a long history of writing this same kind of insurance. It was trading for less than book value. That interested me because in probably nine of the last 10 years it had a combined ratio in the low 90s on average.
An insurer’s combined ratio is like an inverse profit margin. So, an insurer with a combined ratio of 92 has an underwriting margin of 8% in the sense that it collects $1 of premiums for every 92 cents it pays out in losses and all other expenses. In other words, this insurer was making a profit – before counting any income on its investments. Now, plenty of insurers trade for less than book value, and plenty should.
Let’s say a life insurer has a combined ratio of 105. That means it is paying 5% to get its float. It can invest that float. But, obviously, this can’t be as good a business as Frost or Bank of Hawaii. Those banks can get their deposits – their “float” – at closer to 3% than 5%. So, an insurer should trade for below book value when it is expensively financed. But an insurer that usually has a combined ratio below 100 shouldn’t trade below book value because it has a negative cost of float. In other words, policyholders are paying the insurer to invest their money and keep the proceeds. That’s a good deal. Why did I need to see more than 10 years of data in this case?
Bancinsurance had lost a very big percentage of its net worth. I’m going to say – I’m working from memory here – that it might have destroyed as much as 25% of its tangible equity in a single year. This isn’t necessarily the biggest deal if it’s a one-time loss (an isolated incident) and the insurer is considered well enough capitalized for A.M. Best and policyholders to be fine with it. That’s because an insurer doesn’t earn profits on equity. If it has a big underwriting profit – like Bancinsurance did – it earns its profit on premiums. So, if the insurer is going to collect $40 million in premiums and have an 8% underwriting margin, then it’s going to make $3.2 million pretax even before it makes any money on its investments.
It can build up equity quickly this way. It just has to stop paying a dividend. The question here was whether Bancinsurance did this a lot. I knew it had entered a new line of business (bail bond insurance), and it had lost a ton of money in that rather than in the line it normally wrote. So, I went back through the company’s oldest filings – the first ones to be put up on EDGAR – and found references going back about 30 years. I had the company’s combined ratio for 30 years. I saw it had a positive combined ratio in 28 of the last 30 years. In fact, it had a combined ratio below 95 (a 5% or better underwriting margin) in 18 of the last 30 years.
There were some other concerns with this stock. Its auditor had abandoned it, and the SEC had opened an investigation into the company’s top management which it hadn’t yet said was closed. While I was researching the stock, the SEC sent the company a letter saying the investigation was closed. But A.M. Best had already increased the company’s financial strength rating. That was the important one for me. Would I have bought Bancinsurance stock if I had only seen 10 years of financials?
No. I needed those 30 years of combined ratios to make the decision. Insurance is cyclical. And the macroeconomy is cyclical. When you are covering risks related to things like autos and unemployment – it is easy to think a few good years or a few bad years are the norm. Oil prices have not been normal for most of the last 15 years. Interest rates have certainly not been normal for the last seven years. You need data much longer than that to frame an investment case in a bank, oil producer, insurer, etc.
The other case I can think of where having more than 10 years of financial results was critical was Greggs (GRG, Financial). Greggs is a U.K. food-on-the-go type company. There’s no exact peer in the U.S. But if you’re imagining a cross between Starbucks (SBUX, Financial) and Subway – that’ll do. It’s not upscale stuff, and it’s not known for being healthy. Quan and I started looking at the stock when it got real cheap on some bad same-store sales numbers. The price-earnings (P/E) on the stock was reasonable. And we knew a little bit about the U.K. economy’s trends.
For example, we could see that Greggs’ reported same store sales declines weren’t bad considering what traffic patterns had to be near the stores themselves. A lot of Greggs were on “high streets.” The U.S. equivalent would be “main street.” But there’s really no U.S. equivalent anymore. Malls – both indoor malls and “power centers” – have transformed the U.S. over the last 30 to 40 years in a way they haven’t changed the U.K. So we looked at the same store numbers for Greggs and we Googled where Greggs locations were and we looked at trade association numbers for traffic in the U.K. – and we decided that relative to other stores in the same locations, Greggs wasn’t really seeing any company specific declines at all. It was just mis-located for the future. Greggs had declining sales because fewer people were walking past the stores.
What we did was collect data on Greggs going back as far as we could. This was easy because the company includes a 15-year financial summary in all its annual reports. You go and find the annual report for 10 years ago, you combine it with this year’s annual report and – between the two – you now have 25 years of financial info. What impressed me about Gregg’s long-term history is that the company had a very, very stable operating margin. It also had – this was in 2013, I think – the lowest operating margin in 25 years. If same-store sales were to rebound a bit, the operating margin would rebound even more. The stock was cheap. This was purely reversion to the mean.
Now, what did I need to make this decision? I needed the high street traffic data I found. And I needed 25 years of financial history. U.K. consumers had it easy for much of the 2003 to 2013 period. So, 10 years wasn’t going to be enough. But having data going from the late 1980s through 2013 gave me confidence that the operating margin was consistent because the business model at the store level was consistent. Even for a noncyclical retailer, having 25 years of data is a lot more helpful than having 10 years.
If you don’t believe me, consider the example of Buffett. He has said that, before he buys a business in whole, he tells it not to bother with sending him any projections at all – but please send historical financial data going as far into the past as possible. Why does he want to see data from the 1980s when making a purchase in the 2010s? He wants to find the right frame through which to see the investment.
Disclosure: Long Frost.
Start a free seven-day trial of Premium Membership to GuruFocus.
