hold a respectable cash position, which as of October 24
totals approximately 25%, to take advantage of opportunitiesshould they present themselves.
Take a Hike… But Be Careful!
We’ve spent a great deal of time looking at and investing in insurance companies since we began in 2007. As we’ve devotedand continue to devote deliberate study to the business, we consider it a competency. We have come to develop what we would describe as a respect for the business. While the future is always unknowable, insurance businesses seem to have apropensity to sneak up and surprise their owners and managers. What seemed a tranquil underwriting business, suddenly becomes a destroyer of capital. Fortunately, when investment is driven by analysis, selectivity, competence, caution and amargin of safety, it can produce attractive returns over time. It seems similar in our minds to hiking. Caution, safety andpreparation would seem to prevent or reduce the probability of you and your family ending up lost in difficult terrain and inunfamiliar territory where the preservation of one’s life becomes the primary objective. If you are not careful when youinvest in an insurance business you too could end up feeling lost and helpless, facing a situation where the return of yourcapital becomes merely a hopeful objective!It is with that in mind that we begin our next hike: EGI Financial Holdings, Inc. (TSX: EFH). To us, the company represents a compelling opportunity for significant, risk-adjusted returns over the long term, even in a difficult global macrosetting. EGI is a specialty insurer headquartered in Toronto, Canada, that focuses on two markets: personal lines (non-standard automobile and other) and niche products. While most of the company’s business is Canadian, it is currently starting a non-standard automobile operation in the United States, focused primarily on the Southeast (Florida and Texas). The short version of the thesis is that EGI is a well-reserved insurer trading at approximately 60% of tangible book valueand, unlike many other lines of insurance, the Canadian non-standard automobile market appears to be strengthening.Currently profitable and sporting a fortress balance sheet, the company is the second-largest non-standard automobile writerin Canada. It boasts a management team and board that have built and sold another non-standard automobile writer in thepast. We believe that significant regulatory changes and more rational competition seem poised to help create a betteroperating environment. If we contemplate modest book value growth assumptions and a return to a more respectable valuation, the investment would deliver strong returns and more importantly do so with significant downside protection.
Return Possibilities (Five-Year IRR) –
Low AssumptionBase AssumptionHigh Assumption Assumed Annual BV Growth2.50%10.00%15.00%BV Multiple Achieved:0.70 x6%14%19%1.00 x14%22%28%1.30 x20%29%35%
Additional Items –
The company trades at a significant valuation discount (on a price-to-book-value basis) compared to its historical valuation, a direct competitor’s valuation, and the valuation of many other insurance companies in Canada and theUnited States; and at a significant discount to the value at which control transactions typically take place.
Management and board members have purchased approximately $250,000 worth of stock this year. Also, a directorat one of the company’s direct competitors purchased approximately $2 million worth of stock in his company thisyear at loftier valuations.
Risks include: the underwriting cycle does not continue to turn as we expect; the company’s US efforts are met withsignificant failures; and the company’s extremely large investment portfolio performs poorly.