October 24, 2011
While we are fans of insurance businesses, we respect the reality that investing in such a business can be a treacherous endeavor. You need to be as prepared and as cautious as you would be if you were taking your family hiking in the mountains.
Dear Fellow Members and Those that May Be Future Members, As recently as our last quarterly communication we wrote, “Put simply, there is too much hope and not enough skepticism priced into many stocks and other assets.” How quickly can sentiment change! The third quarter witnessed, amidst the US debt default debate, weakening economic indicators and continued European sovereign and banking issues, the second largest quarterly decline in the markets since we began operations in 2007. We have taken the opportunities afforded us by the market and our cash position to selectively deploy modest amounts of capital, while continuing to manage our affairs in a manner that we believe is prudent for an environment that we continue to view as more vulnerable than in much of the recent past. Value, Survivability and Staying Power In a March 2009 Memo, Howard Marks wrote to clients that he believed “…the investment decisions we make today must emphasize value, survivability and staying power.” As we’ve detailed to some extent in previous letters, we made a few mistakes in the 2008-to-early-2009 timeframe and they largely revolved around the things Marks wrote about emphasizing. In some cases, we put too much emphasis on growth and not enough on current value, which meant our estimates of intrinsic value were too high when the growth failed to materialize. In other cases, we didn’t give enough weight to the survivability risk that is present when one invests in companies that utilize significant debt. And on top of those mistakes, we also didn’t keep enough cash on hand to take advantage of some of the great values that presented themselves during that tumultuous period. As we wrote in our Q2 2009 Letter, we also learned that the macroeconomic environment is important. But from an investing standpoint, it is vital to separate what is important from what is knowable, and the knowable aspect of things is where the macro picture gets more complicated. As we wrote in our 2009 letter: If the macro is important but not knowable with a reliable degree of certainty except maybe at the extremes, what is an investor to do? Our view is that one should worry about the macro, but continue to invest bottom-up. Different macro scenarios should be used as a way of thinking about and managing risk in individual portfolio companies, but investment merit should still rely on factors relating to the business and not depend on any type of macro prediction coming true. The key to managing those mostly unpredictable risks lies with one of the main tenets of value investing: margin of safety. And that is still our thinking today. We are thinking a lot about the macro risks present in the market today because we think they are large and important. Most of these risks revolve around debt. Once debt is issued, it must eventually be repaid or written off. In some cases—as we’ve seen over the past few years—it gets transferred from one institution to another, but it must still eventually be repaid or written off. In the current and ongoing crisis, much of this transfer was made from private to public hands. Instead of the financial institutions and their shareholders and debt holders bearing the full responsibility for their decisions, governments and central banks transferred these risks in a variety of manners onto the balance sheets of the taxpayers. Much of those loans still linger (somewhere), unlikely to be repaid in full. But it wasn’t just homebuyers and businesses that borrowed whatever they could get from the banks and anyone else willing to make a loan or buy their bonds. Countries and municipalities leveraged themselves beyond sustainable levels too. Some countries used this lender willingness to build things and create large property bubbles (i.e., Ireland), while some used it to pay their citizens and government officials more money and more benefits (i.e., Greece and California). It isn’t just the European countries making the major headlines today that overleveraged themselves beyond repayment. Japan similarly has too much debt compared to income, as does the United States.
This leveraging was all done in the backdrop of a long-term debt cycle. One of the more important things we’ve read this year is entitled, “A Template for Understanding What’s Going On,” by Bridgewater founder Ray Dalio. What Dalio describes in that piece is the difference between a business/market cycle and a long-term debt cycle, and the difference between a recession and a deleveraging that occurs, respectively, in the down leg of each of those cycles. As Dalio writes: “…when debts and spending rise faster than money and income, the process is self-reinforcing on the upside because rising spending generates rising incomes and rising net worths, which raise borrowers’ capacity to borrow which allows more buying and spending, etc. However, since debts can’t rise faster than money and income forever there are limits to debt growth….Eventually the debt service payments become equal to or larger than the amount we can borrow and the spending must decline. When promises to deliver money (debt) can’t rise any more relative to the money and credit coming in, the process works in reverse and we have deleveragings.” When this long-term debt cycle reaches its peak and reverses, the deleveraging process begins. This process is much different than a normal recession, and policy effects are much more muted on its eventual outcome. Dalio explains further: “…recessions can be rectified by central banks changing interest rates to make it profitable for increased capital formation and economic activity to occur, while deleveragings can not be rectified by these actions, so more structural changes are required. That is why recessions are relatively brief (typically a few to several months) and deleveragings are long lasting (typically a decade or more). While in both recessions and deleveragings there are contractions in private sector credit and spending that lead the government to increase its creation and spending of money and credit, in deleveragings the interventions of the government are typically much larger, more extensive and long lasting.” Debt, deleveraging, and the government responses to the unfolding environment are the macro things we continue to worry about today. We believe overall debt levels must come down over time. In some parts of the economic world this will happen through default. In other parts inflation will be successful in helping nominal debts to be paid down with devalued currency. In what proportion each of those occurs, we venture no guess. The guess we do venture, however, is that both deleveraging and governments’ attempts to lessen its blow will have great effects on asset prices around the world. What this likely means for the markets is volatility. What this means for those prepared for it is opportunity. As value investors who previously didn’t pay much attention to the macro, the depth of the downturn in prices in 2008 and 2009 surprised us. And as this process continues, we will likely continue to be surprised by many things. But we intend to be more prepared. Deleveraging and lower demand as a result of this process means companies must have great balance sheets to prepare for unexpected declines in business. To get back to the quote at the beginning of this section, survivability and staying power are vital. When one looks at the balance sheets of the companies currently in our portfolio, we believe these traits are clearly present. The companies we own have either no debt or very little debt, and those that have any debt at all are slightly smaller positions that we feel can easily handle their debt levels, even with substantial business slowdowns. Although we are trying to invest with great caution, it is important to remember that there is plenty of room for offense, provided one recognizes that estimating intrinsic value in this environment can be a little more difficult and committing capital may require a larger margin of safety. As Warren Buffett, Chairman and CEO of Berkshire Hathaway, mentioned on his September 30th appearance on Charlie Rose, intrinsic value is not a precise figure—it’s a guess. He said he couldn’t put a precise value on Berkshire, but that he thinks it is worth a lot more than 110% of book value, so he authorized a share buyback up to that level. Likewise, we can’t put a precise value on all of our holdings. All we can do is estimate a range and then buy when prices are well below that range. In a great piece entitled, “J.M.K., R.I.P.,” John Gilbert, the CIO of GRNEAM (General Re-New England Asset Management) notes, “…risky assets should be priced with a margin for error that is greater than that to which most people are accustomed.” We couldn’t agree more that the margin of safety one seeks ought to be adjusted in this environment and as such, we believe there are tremendous values in our portfolio positions, and these investments have the survivability and staying power needed to eventually see that value realized. The fund also continues to
hold a respectable cash position, which as of October 24th totals approximately 25%, to take advantage of opportunities should 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 devoted and 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 a propensity 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 a margin of safety, it can produce attractive returns over time. It seems similar in our minds to hiking. Caution, safety and preparation would seem to prevent or reduce the probability of you and your family ending up lost in difficult terrain and in unfamiliar territory where the preservation of one’s life becomes the primary objective. If you are not careful when you invest in an insurance business you too could end up feeling lost and helpless, facing a situation where the return of your capital 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 macro setting. EGI is a specialty insurer headquartered in Toronto, Canada, that focuses on two markets: personal lines (nonstandard 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 value and, 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 writer in Canada. It boasts a management team and board that have built and sold another non-standard automobile writer in the past. We believe that significant regulatory changes and more rational competition seem poised to help create a better operating 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 Assumption Base Assumption High Assumption Assumed Annual BV Growth BV Multiple Achieved: 0.70 x 1.00 x 1.30 x 6% 14% 20% 14% 22% 29% 19% 28% 35% 2.50% 10.00% 15.00%
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 the United 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 director at one of the company’s direct competitors purchased approximately $2 million worth of stock in his company this year at loftier valuations. Risks include: the underwriting cycle does not continue to turn as we expect; the company’s US efforts are met with significant failures; and the company’s extremely large investment portfolio performs poorly.
The company is cheap because it is a small insurance company in Canada with little visibility that is coming out of a difficult underwriting environment. The market appears to be missing that the company’s fundamentals and industry dynamics are improving; and may also be overly discounting the company’s new efforts in the US.
We have allocated approximately 7.9% of our capital to EGI, believing that this is an opportunity for offense. In our opinion EGI is a prime example of an investment in this environment that delivers value, survivability and sustainability. We head to the mountains eager for the hike and confident we are taking a prepared and cautious approach. Dealogic Update Dealogic formally announced at the end of September its tender offer for those shareholders that do not wish to own shares of an unlisted company. As we mentioned in our previous letter, we have been contemplating foregoing the option of tendering our shares in favor of continuing to own shares in what would effectively be a private company. We have in fact decided to remain shareholders following the tender and have made that decision upon review of the tender offer and the company’s indication of future liquidity options. We have developed an internal fair value procedure for valuing the investment, with input from our auditors. While information on results from the company will be less frequent and liquidity will diminish, we believe an evaluation of the upside and downside from owning this great business warrants the decision. We intend for the allocation in the portfolio to get smaller in the not-so-distant future and will bear in mind the additional liquidity constraints when making subsequent decisions about additions to the portfolio. Sincerely,
Mike Pruitt (704) 366-1535 firstname.lastname@example.org
Matthew Miller (704) 366-5078 email@example.com
Joe Koster (704) 366-0496 firstname.lastname@example.org
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