Street Capitalist: Event Driven Value Investments

On Buffett’s successor:

“He is so good at what he does, it’s almost insulting to think that he doesn’t have a reasonable succession plan. And I frankly don’t see why he should tell anyone. And even if he did not and this was the end of Berkshire Hathaway, he’s done an outstanding job for people over many decades. Nothing lasts forever. I hope Berkshire Hathaway lasts forever, but I don’t think Fairholme’s going to last forever. I think the succession plan is a bit overblown. I know it’s important–corporate governance, public company–I understand it. But I don’t think there’s going to be another Warren Buffett. There are great people at the company–many great people at the company. And I think shareholders are just going to do fine after Warren Buffett.”

Berkowitz on his outlook for the stock market:

“I am bullish on the country. I am bullish on the markets. Government has done a great job of pulling us from the precipice and saving what I consider to be the global financial system. And now, this is just a huge opportunity for Fairholme to start to do its part and help, sort of, restructure, build a more solid foundation to help companies rebuild and move forward. I think it’s a unique time. And I’m looking forward to the next few years. It’s going to be good.”

Cara Goldenberg of Permian Investment Partners is a young fund manager that has been making some waves. A while back she mailed Warren Buffett a few investment ideas and was invited to meet with him one on one. Recently, she was featured in Fortune, where she talked a lot about her firm’s emphasis on looking at the managers behind a business:

At just 30 years old, Cara Goldenberg is at the top of her game. She is the founder and managing partner of Permian Investment Partners, a New York City-based hedge fund she launched in 2008.

Goldenberg began her career at Morgan Stanley (MS, Fortune 500) as an analyst in the investment banking division. Her strong quant skills quickly funneled her into the private equity group, a move that allowed her to circumvent the traditional analyst-associate-business school route that many of her peers would follow.

Less than two years into her stint at Morgan Stanley, Goldenberg was one of the first young investment bankers to be picked off by the hedge fund industry. She left to work for Highbridge Capital Management. Brahman Capital’s management team was so impressed with Goldenberg’s questions during an investor meeting, that they recruited her away from Highbridge.

Goldenberg focuses on European special situations / event driven investments. As markets become more efficient with quant/algorithmic strategies coming online, I think we’re going to see an increased emphasis on finding value in areas of the market where it might be difficult to discern value. Goldenberg reports that most of the companies she looks at have a history of depressed earnings which are then fixed when a new manager comes in:

Fortune: What has been the driving force for you as an investor?

Goldenberg: I was trained early on to focus primarily on management quality. If you follow brilliant management teams, it will lead you to brilliant investment ideas. It’s pattern recognition.

At Highbridge, I was able to hit the ground running because I was hardwired to look at things the way they did. I was looking at a universe of European companies that were mismanaged and had depressed earnings. They had cost-cutting and capital allocation opportunities that were far better than their U.S. counterparts. But their share prices didn’t reflect that potential. We knew that the right management teams could turn these companies around. And no one else was terribly interested in them.

These kinds of companies might have been unappealing when looked at on a screen or maybe had too much headline risk. It’s easy for companies with these characteristics to be skipped over. I always look back to McDonald’s starting in 2003 when they initiated their “Plan to Win” program. The management at McDonalds had been hit by issues with their international expansion but also the PR backlash from movies such as Super Size Me. So they decided to manage with a goal to maximize return on invested capital (ROIC). They altered the franchise/company owned store mix, sold off underperforming divisions in places such as Latin America, and revamped their menu. For shareholders it worked out well with annualized returns of about 60%.

But investors looking at the company might have missed that. Some screens can only give you a backwards picture of what is happening so it’s up to the analyst to dig deeper and determine if things are going to change.

The other thing that I think is important is asking the right questions. If you listen to conference calls, sometimes a caller will ask a question that could have been easily answered by just reading through the 10-K. Recently, I spoke to an executive who came out of retirement to head up a REIT. To me, the most pressing question to ask was why he decided to come out of retirement, he had sold his company at the top of the market which really solidified his reputation as a great real estate dealmaker. So when I called him up, I asked him why he decided to gamble with his reputation for this company. It can sometimes be very valuable to get more insight into how these executives see the world and their competitors. I like to ask two competitors the same questions and then check what the differences are.

I thought this was great:

What would you say is your competitive advantage?

I can get a management team to articulate an idea that will cement an opportunity that other colleagues perhaps can’t get. It’s communication, but it’s stylistic. I think it stems from meeting with hundreds of CEO’s year after year and really listening to, and learning from them. And asking the right questions.

We recently met a Finnish guy who spent 18 years at P&G (PG, Fortune 500) selling laundry detergent and Sunny Delight. He’s now running a sporting goods conglomerate in Finland — with totally different products and different distribution challenges.

Instead of saying, “What the hell do you know about a sporting goods company?” We looked at it the other way. We asked, what did it take for him to step out of eighteen years at P&G, where he had $25 billion of revenue. What did he see?

I asked him, “How many opportunities did you turn down before you took this one?” The answer was over 20. But when I asked, “Why did you take this one?” It was totally obvious.

There were brands in this portfolio. Wilson for instance, with 2% market share. Not 20% like you might think. Wilson had tremendous market power that hadn’t yet been realized. There’s enormous brand equity there.

Our investment had nothing to do with the business, per se. We didn’t even identify a market opportunity. We just knew enough to talk to a guy who left P&G after 18 years.

There’s a flip side to this as well. When some people talk to CEOs, they end up drinking the Kool Aid. CEOs are good salesmen so at times they might exaggerate the truth or underplay certain problems. When I talk to a CEO or a customer or supplier, I try to remain objective and skeptical. If you talk to an ex-employee who is extremely negative, you need to qualify their arguments by talking to other ex-employees. You need to determine whether or not what he is saying is indicative of the truth or if he’s just disgruntled.

Sometimes people think that economic incentives will be enough to make sure that a CEO acts accordingly. This isn’t always true. There were a lot of bank executives during the crisis who had their banks fail or acquired at take under prices. In the case of the big investment banks, some executives had tunnel vision and didn’t truly understand the risky activities their bank was involved in, even though they personally held a lot of stock. Banks are also tricky because the CEO might just not have a whole lot of control over the business. Banks are beasts driven by the overall economy, even a great CEO can preside over a bank failure in that case.

If you have time, talking to people that are involved in the business or industry that you are looking at makes a lot of sense. It can actually be a mistake to not do this. 6 months ago I looked at a company that appeared on certain value screens, the liquidation value of the company seemed to be well in excess of the current stock price. Quantitatively, this investment made sense. But in investing, there is often a mixture of quantitative and qualitative factors at work. In this case, the CEO’s business was operating in a trough period and consuming large amounts of capital quarterly. For shareholders, the CEO should have liquidated the business slowly and distributed the proceeds. Instead though, if you had read the proxy filing and heard him speak at conferences — he seemed much more interested in trying to keep the business alive. That was bad because it meant that he might seek out a dilutive equity raise or a potential sale to another company at a price which might be below liquidation value. I chose to pass on the company and watched it fall as much as 30% in the proceeding 6 months.

So how do you get started with talking to CEOs and other executives? First, I try to read all of the public filings related to the company. The Ks, the Qs, and the proxy filings. I want to learn the business and then get an idea about the incentives at work for the people running the business. Then I usually spend a bit of time researching the CEO himself, a simple Google search might yield information regarding their spending habits (perhaps the CEO is building a lavish mansion) or their personal history, maybe the business is predominantly family owned and it’s always been passed on. Then you want to think about the drivers of the business, for a bank that might be loan growth.

So you could ask the CEO what it would take for them to start making more loans — maybe the local business climate is really bad. You could then talk to the people at the chamber of commerce and see what they are doing to try to improve the economy for the town. If a massive company is coming to town and opening up a branch, that might bring an influx of jobs and development, spurring loan demand. Or, if it is a distressed bank, you might try to talk to locals that are involved in the real estate business to get a real feel for what’s going on over there. Real estate is one area where things can differ vastly from city to city, so you can’t just look at aggregate data.

You have to dig deep. You’re best bet is just to keep at it. Chances are you wont be very good at first. One thing that might help is to read conference call transcripts and see the questions that analysts ask CEOs in the same industry. In time though, you’ll be able to develop a good rhythm and start asking the right questions.

Fortune’s Scott Cendrowski has a big profile on Bruce Berkowitz and his activities at the Fairholme Fund:

Berkowitz may not be a household name to most investors, but he should be. During the past decade, Fairholme has produced an annualized return of 11.6% over a span in which the S&P 500 (SPX) has risen a paltry 0.7% a year on average. Since the fund launched in 1999, Berkowitz has beaten the market every year except one (when Fairholme was up 24%, vs. the S&P’s 29% rise in 2003), and he’s on track (up 17% through early December) to easily beat it again in 2010. “The highest compliment I can give,” says hedge fund billionaire Leon Cooperman, who got to know Berkowitz when they both invested in telecom stocks earlier this decade, “is if he called me up to recommend a stock, I would pay attention.”

The fund’s outstanding returns — along with Berkowitz’s being crowned U.S. stock manager of the decade this year by investment research firm Morningstar — have attracted a flood of new money to Fairholme. Investors have poured in more than $4 billion over the past year. And they’ve added $330 million more to his Fairholme Focused Income Fund, which launched in January. He plans to open a third fund, one that focuses on smaller opportunities, early in 2011…

Can Berkowitz continue to beat the odds? Can a single investor, even one with singular focus and discipline, successfully manage a portfolio the size of Fairholme? “It’s a challenge for any manager to take in that kind of inflow and repeat,” says a large Fairholme investor. Says another: “You hope that when you buy a manager, it’s a seasoned team. Having a one-man band can be risky.”

Berkowitz acknowledges the concerns with his usual candor. “Right now,” he says matter-of-factly, “we’re at an interesting junction point where people can’t decide whether we’re about to blow up.”

Bruce Berkowitz: The megamind of Miami (Fortune)

Whenever you read about Berkowitz these days, the articles have consistently mentioned that Berkowitz is nearing the point when many star managers end up hitting a slump in their careers — notable examples include Bill Miller of Legg Mason and Ken Heebner of the CGM Focus Fund.

For me, I could see this going either way. Most hedge fund managers complain that as they grow larger, it becomes more difficult to find good investment opportunities. To a certain extent, I think that’s true. Just looking at Fairholme’s portfolio, you’ll mostly see investments in massive financial services companies. Citigroup is the perfect example of that. If you look at the average volume for Citigroup, almost $2.6B is traded daily. For Fairholme, that kind of liquidity is great because it means they can enter and exit positions with ease. Plus, the risk/reward break down, given the liquidity must be attractive, especially if you believe Citi is worth what Berkowitz says.

The benefit to size is that Berkowitz can really invest across the capital structure and use his size to influence the outcomes of distressed situations:

Second, stockpiling cash is in keeping with Berkowitz’s plan to evolve Fairholme from a regular, stocks-only mutual fund into a more versatile distressed-asset investment vehicle, and to profit from the coming wave of corporate restructurings he anticipates. He believes that dozens of overleveraged companies will need to fix their balance sheets in the next couple of years — commercial real estate is one industry ripe for it, he says — and he wants Fairholme to be ready to step in as a Warren Buffett-style lender of last resort, with highly favorable terms for his investors, of course. As Berkowitz puts it, “There aren’t many people in the world you can call who can write a check for $1 billion today.”

So in theory, it’s possible that Fairholme will be able to cope with its increasing size. Still, I’m a bit concerned at the lack of a real investment team at work there. From the sound of the article, it really consists of Berkowitz and Charlie Fernandez plus a support staff. It’s true that the firm will hire experts to come in and advise on different industries, but I don’t know if that’s enough. A team can help provide varying perspectives which could be critical when making a bit, concentrated bet on just one sector of the market. A team might also be more helpful going forward, as Fairholme seems poised to enter more complicated areas of the market with their restructuring and bankruptcy activities.

I recently had a chance to interview Dave Carlson of Tourmaline Advisors on his investment activities in insurance stocks. I think that insurance is a really interesting business, but some value investors totally stay away from financials because they regard them as too complicated. At the same time though, Warren Buffett has been active in the insurance industry for decades — his hiring of Todd Combs seems to indicate that he believes being able to analyze and invest in financials is important.

So I thought it would be a good idea to interview Dave and get him to shed some light on how he analyzes insurers, I hope you enjoy the interview. Feel free to post follow up questions in the comments section.

1. Can you give us some background on why you got into value investing and what got you interested in insurance stocks?

I have to say that my road to value investing has been a series of unexpected turns. Despite growing up where the men on my dad’s side of the family would talk stocks at family gatherings, and my grandfather giving me a book on stocks for my 16th birthday, I had no interest initially in investing. When I started working after college, I began plowing money into mutual funds offered by the company 401K plan as my primary means of investing. When the division that I worked for was sold to another company, I had to make a decision about rolling over my 401K monies.

After spending a month trying to find the right mutual fund, I decided that if I was willing to expend this much effort on selecting a mutual fund, I might as well buy the stocks directly. A family member recommended reading the Investor’s Business Daily and from there I bought some stocks. One of them happened to be American Capital Strategies (ACAS). This was in 1999 and I had overheard people talking about Yahoo Finance message boards. So I started reading the posts on the ACAS board and found an interesting group of fellow amatuer investors. ACAS is a business development company, which not many people fully understand. We spent a lot of time dissecting how the company worked, and this led to other discussions on investing. A group of us enjoyed it so much that we decided to leave the noise of the message boards behind. Our little study group started talking about value investing and relating it to stock decisions. That mix of theory, discussion and application was powerful. From there it just clicked – I was and am a value investor.

My interest in property and casualty insurance stocks is a much simpler story. It was an occupational hazard from working in the industry and why I tend to be cynical about the industry.

2. Why do you think there is increased M&A activity in the specialty underwriting space? Fairfax has done a few of these acquisitions. Do you think they have some kind of moat that allows them to have better underwriting operations? Or are they actually more similar to the rest of the P&C insurance business which has typically relied on investment income?

There are several dynamics influencing M&A at this point. The low valuation on insurers makes it an opportune time to be a buyer. With premiums flat, catastrophes minimal and bond yields anemic, buying another insurer represents a more attractive return. The interest in specialty insurers stems from 1) they tend to have better pricing and 2) there is less overlap because their underwriting focus is narrower. In terms of moat, the property & casualty insurance is largely a commodity business with few moats.

As for Fairfax having a moat, I would say that they have an inverse moat. Sounds crazy but hear me out. They know how to get rid of business, they know how to say no. That is not a moat but a behavior – to be disciplined. Every insurance exec says that they are disciplined underwriters, they’re all from LakeWobegon, but obviously they are not. Insurance is a product sold for which the costs of goods will not be known until a later date, so people can delude themselves by assuming better loss experience. Sort of like the mortgage securitizers who assumed that home prices could only go up. Insurance companies also have a decent amount of fixed costs because you need underwriters, claims people, etc. to support the business, whether you have 50 policies or 5,000 policies. There is a tendency to write any business just to sustain the infrastructure, something you also see in the for-profit education sector.

As for relying on investment income, yes, Fairfax does rely on it more than most. In their annual report, Prem Watsa mentions the net premiums written to statutory surplus ratio, a.k.a. the underwriting leverage ratio. The ratio at the end of 2009 was around 0.5 for Fairfax whereas most insurers are well over 1.0 and closer to 1.5. Watsa has purposely structured Fairfax so that the underwriting contributes less to results. That’s a good thing because it is a lousy business! This also means that the Fairfax insurance companies are overcapitalized relative to premiums written. Once they satisfy the regulatory/rating requirements for safe investments, they are free to invest the excess capital in things besides bonds. The Fairfax business plan comes straight from Buffett.

3. Is pricing and market position maintained through client relationships (i.e. its a small expense overall for the yacht owner and they like/trust their broker)? Is it through branding and market position (i.e. “everyone know that MKL is the place to go for yacht insurance”)?, or is there some actuarial knowledge (other participants aren’t sure they know how to price the business properly so they stay away).

Branding and marketing is a diverse subject within insurance. There are significant differences between personal and commercial, distribution method and line of business. A good portion of insurance is a commodity business, particularly personal lines. Does it matter whether I buy my car insurance from a gecko or a perky sales clerk? No, but the constant bombardment of advertising will at least drive people to get a quote from them. That is important because they rely on direct marketing.

The commercial side is where you see more relationship building, not so much with the insurance companies, but with the brokers, claims administrators, etc. When you get into specialty insurance, like yacht insurance, the number of insurance companies offering coverage shrinks dramatically. It is easier for one or two companies to dominate a market and that gives them an advantage in terms of experience and distribution. The actuarial advantage is a matter of numbers. If you insure 10,000 yachts, your loss experience will be a lot more predictable than the insurer covering 100 yachts. Insurance is all about the law of large numbers. Companies that can mine their own data can create an advantage.

4. What are your top metrics to look at when analyzing an insurance company? Most people seem to hone in on combined ratios and book value — what else do you look at?

Price to book and combined ratio are good starting points. Return on equity, underwriting leverage ratio and investments to equity are other metrics that I look at. On combined ratio, it is also useful to look at the difference between what is reported on a GAAP basis and what is reported on a statutory basis. The “stat” basis is more conservative than GAAP, it’s what the regulators look at, and is a better measure.

I also look at the lines of business written because that influences the combined ratio. For short-tailed lines of business, like property and personal lines, investment income is less of a factor, so the combined ratio should be lower because the driver is underwriting profit. Long-tailed lines, like general liability, can afford higher combined ratios because the investment portfolio is larger and is held longer – the magic of compounding.

5. With most insurers trading below book and it being a soft market — are you finding a lot of opportunities or do you think this is the time to be cautious?

I am more cautious. Insurance companies are essentially levered bond funds, so the extended low bond yields have a bigger impact on earnings. My focus has turned to special situations. I bought a small insurer, Penn Millers (PMIC) after its IPO because it was trading below book value despite having a significant portion of the book value being the IPO proceeds.

Another situation arose with Donegal Goup, which has a unique capital structure. It is a mutual insurer that owns a publicly-traded holding company with two series of shares. The mutual retains control through super-voting “B” shares, which have the same economic interest as the “A” shares. There was some confusion over a deal where they offered to buy a bank, half of which involved “A” shares held by the mutual. The result was the “A” shares trading at over a 35% discount to the “B” shares, which has since narrowed. The other situation is a small specialty insurer, Seabright, which I bought at less than 50% of tangible book value. There was a lot of fear after they took a reserve hit in the 2nd quarter that seemed unwarranted.

6. When you value an P/C casuality company, how do you establish that the reserves are accurate?

When it comes to P&C insurers, reserves are a black box. Outside of being an actuary who can review their claims, there is no way to know whether the reserves are adequate. All you can do is look back over time and see how reserves have developed and whether there have been reserve additions or releases. You have to assess behavior over time. Management can play games over the short-term but eventually the claims get paid and then we find out who is covered and who is swimming naked.

7. How long do you foresee the tail before the insurers adjust their rates for the low bond yields? Do you think we will see a hard market soon?

Let me start with the last question first. Hard or soft markets are determined by capital levels. Prices will harden when capital is destroyed or removed from the space. There is no direct tie to low bond yields impacting pricing but lower investment income means underwriting results will have a greater impact on capital.

8. How do you determine if an insurer is over-concentrated?

Over-concentration is a good question. Some situations are obvious, like Universal Insurance Holdings, a home insurer with most of their business in Florida. That is a binary bet on the hurricane season. Seabright is concentrated in workers comp, with slightly less than half their business in California. The regulatory risk is known by investors, as is their ability to compensate through company-level rate changes and other rating factors. Once you get beyond regional or line of business risk, however, it is difficult to spot concentration.

Even insurers struggle with concentration in their own books. On the property side, technology has allowed insurers to do a lot more catastrophe modeling and to better monitor risk but that depends upon having detailed and accurate location descriptions. The problem on the liability side is that a relatively small segment can have significant losses, as happened with E&O/D&O coverage on financials the past three years.

9. Some insurers are limited to only a few geographic areas — do you discount these because they might face some kind of black swan risk? (e.g.: if you were to only write insurance in TX and a hurricane came, damage could be high but your operations dont have areas outside of TX to draw premiums from to offset the losses)

What I find is that most regionals are very conscious of risk and will buy reinsurance to mitigate the risk. That does not mean that a storm won’t impact earnings but it does not blow a massive hole in their capital. Plus, you do not have to be a regional to suffer major losses – look at what happened after the 2005 hurricane season. In the P&C industry, the potential for a black swan is always present, whether natural disasters, unintended coverage or legislative/judical changes. It is not limited to regionals. I have told my friends that when investing in P&C insurers, cut your normal position in half because you are betting against nature.

You may be surprised that the most that I have ever been invested in insurance was back in 2009 following the March meltdown. I had about 30% of my personal account in insurance, with P&C being about 3/4th of that. Currently, I am about 15% in insurance, all of it P&C. Did I mention that P&C is a lousy business?

10. Have you ever looked at insurance brokers? Do you think they are a better way to invest if you assume the market will start hardening?

I have looked at insurance brokers but have not spent much time looking at them. The top 5 brokers represent something like 85% of the publicly traded market cap and you have at least a dozen analysts covering them. I am not going to add any value to the discussion. Of course, that won’t prevent me from expressing an opinion! My impression is that the brokers are focusing on client needs and have moved away from pure commission fee structures to using a mix that includes flat fees. The brokers will benefit from a hardening market but not to the degree that they once did.

11. Do you ever look at reinsurance companies? How do you get comfortable with the cat risks? Are there any metrics you focus on with a reinsurer that you might look at less when analyzing a short tail P/C insurer?

I do look at reinsurers on a periodic basis. As a group, they tend to track together, depending upon which way the wind blows. As for cat risk, you can see over time how they have diversified into other lines, particularly after 2005. Still, the concern is there and is why they trade at single digit P/E ratios. When it comes to metrics, I use the same ones for reinsurers as for insurers. The only difference is that they tend to trade at cheap than regular insurers.

12. When you value an insurer, what methods or models do you typically use? Is it mostly a matter of looking at multiples and comps? Or is there more to it.

Price to book is really the first metric that I look at, followed by price to earnings. It is simple and objective, as I want to know my margin of safety and then the earnings power. If it is cheap enough that I would be a buyer, then I start digging deeper. Usually, there is a reason that an insurer is trading cheap, so then I try to determine what can change with regard to investment income, underwriting results and expenses. That part is subjective. I do look at comps as a point of reference but not as a buying point.

The Washington Post has a neat infographic on the different budget deficits of the PIIGS:

One day after requesting a bailout worth more than $100 billion, financially troubled Ireland plunged deeper into a political crisis that could complicate a rescue deal with the International Monetary Fund and European Union.

At the same time, concern mounted that attempts to prevent a broader regional debt crisis by shoring up near-bankrupt Ireland may not be enough to prevent the need for more bailouts in ailing Portugal, and perhaps even for the far larger economy of troubled Spain. Coupled with the worsening political turmoil in Ireland, those fears dashed hopes of a market rebound on Monday, rattling stock markets and causing the euro to lose ground against the dollar after initially posting a slight rise.

In Dublin, Prime Minister Brian Cowen, under fire for mishandling the crisis, said he would step down early next year. But he resisted calls to tender his resignation immediately, vowing late Monday to remain in office and push through an austerity budget next month that is considered essential to clinching the rescue deal.

The political crisis potentially poses a new complication in efforts to shore up Ireland. With banks buckling under the weight of a colossal real estate bust, the government is in tense negotiations with the IMF and E.U. over the bailout’s size and conditions. European leaders are pressuring Ireland to reach agreement quickly to bolster market confidence in other debt-wracked countries in the region, as well as to prevent the euro from destabilizing. Britain and Sweden pledged direct loans to Dublin on Monday.

Irish political turmoil complicates financial-system fix (Washington Post)

A friend of mine has been looking at what’s happening in Ireland and passed along the following idea:

I think the Irish crisis for now will play in a similar way to the US one. Liquidity figures globally is pretty strong and these politicians won’t let these banks go under.

I don’t recommend playing the banks. Their upside is going to be ripped to shreds as the Irish/Euro politicos won’t let the outsize profits captured by US banks to happen again in that area.

What people should pick up is companies whose deposits/counterparty/financial risks were tied to banks. So, it would be good to find leasing companies and big users of financial hedges to go long in the Irish space.

I think that this is a great idea in theory because in the US, a number of aircraft leasing companies fell tremendously as worries spread about the risk of their lines of credit vanishing if banks failed (but bounced back when financing fears proved overblown). The problem is I just can’t see a good way of implementing the idea. Yesterday, I paged through the listings on the Irish Stock Exchange, in hopes of finding a company in some kind of business that would be affected similarly. Unfortunately, I didn’t have much luck. I know that aircraft leasing is big in Ireland but it seems as if many of their top companies have been acquired — for example, Genesis Leasing was recently bought by AerCap back in March. Moreover, you need a company with liabilities specifically tied to Irish banks.

If you have any suggestions, feel free to shoot me an e-mail or leave a comment on the post. I think this will be a really interesting spot to watch for now.

James Montier (of GMO, author of Value Investing: Tools and Techniques for Intelligent Investment) was at the European Investment Conference recently, where he argued against the idea that mean reversion was dead. This isn’t the first time that he’s made the argument, a few months ago on his blog, he said:

In a recent article Richard Clarida and Mohamed El-Erian of PIMCO argued that the ‘New Normal’ offered at least five implications for portfolio management.

I. Investing based on mean reversion will be less compelling

II. Risk on/risk off fluctuations in sentiment will continue

III. Tail hedging becomes more important

IV. Historical benchmarks and correlations will be challenged

V. Less credit will be available to sustain leverage and high valuations

Implications IV and V seem pretty reasonable to me. However, reports of the death of mean reversion are premature. I fear that the authors are confusing the distribution of economic outcomes with the distribution of asset market returns. The distribution of economic outcomes may well turn out to be flatter, with fatter tails than we have previously experienced.

However, asset markets have long suffered such a distribution; it has proved no impediment to mean reversion based strategies. In fact, the fat tails of the asset market have provided the best opportunities for mean reversion strategies. For instance, in equity markets the fat tails associated with unpleasant outcomes (poor returns) have generally occurred as high (sometimes ludicrously high) valuations have returned towards their ‘normal’ level, and the fat tails which we all love (good returns) have occurred as low valuations have moved back towards more ‘normal’ levels.

Reports Of The Death Of Mean Reversion Are Premature (Behavioural Investing)

Anne-Louise Fogtmann has a good take down of what Montier said at the conference. Montier outlined his own views which I thought were interesting, particularly on cash:

Seven “immutable laws of investing” apply, Montier argued, as they have in the past:

-Always insist on a margin of safety.
-This time is never different.
-Be patient and wait for the fat pitch.
-Be contrarian.
-Risk is the permanent loss of capital, never a number.
-Be leery of leverage.
-Never invest in something you don’t understand.

With these rules in mind, Montier noted, somewhat bleakly, that “not very many assets have any margin of safety.” A few of his specific calls: Government bonds have no return potential; emerging markets look overvalued; and in a world where both bonds and equities could be too expensive, cash becomes a much more attractive investment, even when the yield is near zero. Not only is cash a better inflation hedge than bonds (it’s a zero duration asset), it can act as a store of value during periods of deflation.

GMO’s James Montier Says Rumors of the Death of Mean Reversion Are Greatly Exaggerated

The market’s had a pretty good run lately, making most equities more expensive for value investors. The dynamic between cash and equities is a really interesting one for us because we tend to hold portfolios that are more concentrated. Other investors might have the kind of allocations which allow them to replicate the movements of your typical indicies, but value guys tend to take a 5% to 10% position approach. This makes our allocation decision a bit more difficult. There’s a big difference between re-creating an index versus putting on 10% positions in full value/expensive stocks. This is why, for concentrated investors, it makes sense to shift to cash rather than equities. At the same time, there are pockets of value scattered throughout the market. While no one sector seems to offer compelling valuations, I have been spending most of my time analyzing select companies in industries ranging from energy to insurance.

Montier’s point about emerging markets being expensive is one that resonates with me. Take the case of Brazilian banks Bradesco (NYSE:BBD) and Itau (NYSE:ITUB). Both are priced richly at over 4x book value, but are generating high returns on equity (32% and 40%) implying an 8-10% return. If we dive deeper into the financials and analyst estimates, we can see that much of this is being driven on the prospect of loan growth. Brazil has a rapidly growing middle class and most people expect that financial services firms will be able to profit from that growth.

I agree that a developing middle class should be able to help the banks. In theory, as the banking sector in Brazil becomes more formalized, citizens should be depositing more money into banks and using them for payment transfers. That should lower the cost of funding for Brazilian banks. Plus, Bradesco and Itau are targeting for insurance income to make up 25% of their earnings in a few years. These are truly financial services supermarkets and I could see that part of the equation working out. But analysts are modeling loan growth at rates of 30% annually. I just don’t know if Brazil can sustain such growth levels. You could make the argument that much of the growth could be going to consumers, not commercial enterprises, but to me that kind of lending is much more difficult. At least when a bank loans to a business, the credit analysts can give a business a good scrubbing and have the business’ assets used as collateral. Consumer lending is an entirely different beast. They could try to increase the amount of mortgages on their books, but the problem there is consumer demand might not match up with supply, you might end up creating a mini-housing bubble.

To me, emerging markets at this point have a lot of things going for them. I do expect the BRIC countries to do well over the long term. But as a value investor I just don’t think you will get the margin of safety that you are looking for. Everything has to go right for them to warrant such high valuations. Buying right now is akin to being a trend follower or momentum investor. I have a list of great companies in BRIC countries that I usually check every other day. The way I figure it, given the way the global economy is going — any heightened level of volatility might trigger a pull back and make some of these companies a bargain. For now, you might be better off analyzing large caps with emerging market growth exposure. Those businesses still seem to be trading at attractive valuations.

Most new investors forget about spending time on studying compound interest. They end up thinking that the best way to get rich is to do so quickly, so they seek out opportunities where they can earn massive returns without looking at their true downside risk.

I thought the following charts from East Coast Asset Management’s 3Q 2010 letter demonstrate the power of compound interest quite well:

And this:

And of course, opportunity costs:

Full article:
East Coast Asset Management 3Q2010 Letter

Yesterday, news broke that Texas-based activist value investor Sardar Biglari is bidding again for full control of Fremont Michigan InsuraCorp:

Biglari Holdings Inc. (NYSE:BH – News) today announced a proposal to acquire 100% of the issued and outstanding shares of common stock of Fremont Michigan InsuraCorp, Inc. (OTC Bulletin Board:FMMH.OB.ob – News) that it does not already own for a purchase price of $29 per share in cash. The purchase price represents a 41% premium over the closing price of Fremont’s common stock on October 11, 2010. Biglari Holdings is presenting its proposal to the Fremont Board, expecting its Board to exercise its fiduciary duties and therefore meet with Biglari Holdings to reach a mutually satisfactory transaction.

Press Release (Biglari Holdings)

To preface, I don’t own any Biglari Holdings stock anymore. Biglari’s struggle for Fremont has been well documented on my blog. Initially, Biglari offered $24.50 per share in a combination of cash and stock. At the time, many derided the offer and said it undervalued Fremont because he was only willing to pay close to 90% of book value for the company. Eventually, the management team used their political pull in Michigan to introduce legislation which would impede his ability to pursue a hostile offer against the company.

The new offer is $29 per share or about 1.1x book value, which might be fair given Fremont’s current troubles. Fremont’s underwriting has deteriorated recently and posted a combined ratio of 108 in the last quarter, which means its operations are generating losses. Combined ratios are calculated by taking underwriting expenses + loss adjustment expenses and dividing them by the amount of earned premiums. A combined ratio of less than 100 means underwriting operations are profitable. More broadly, the insurance market as a whole is feeling the pressures of the low yield environment. Most P/C underwriters have had the bulk of their profits come from their investment portfolios, not their underwriting. The problem with this is that insurance investment arms typically take a levered bond fund approach and safe bonds aren’t yielding a whole lot right now. This puts insurers who are bad at underwriting in a precarious position. They face losses on both ends and so far the soft market (weak insurance pricing cycle) is showing no signs of persisting.

So in a way, it’s possible that a capital allocator such as Biglari could be helpful. If he could adjust the company’s current allocation split between cash and bonds, Fremont might be able to generate investment gains that would offset their underwriting losses. Right now Fremont’s investment portfolio is just under $70M with about 83% of it in bonds. Biglari reportedly already has an insurance executive on staff who would be brought in to turn around underwriting operations which have so far run into losses as they’ve grown their personal lines business.

It’s easy to see why he wants Fremont. Being able to add an insurer would help diversify BH’s business from being so dependent on fast food and would also add a business line which brings recurring earnings to the table. Plus, the float from the insurance business (which is smaller because of the short-tail nature of their claims), could be used as dry powder when pursuing activist investments or takeovers. Similarly, Mark Schwarz of Newcastle Partners has taken this approach by gaining control of Hallmark Financial (NASDAQ:HALL) and using it to then gain control of Pizza Inn (NASDAQ:PZZI).

While I don’t have a stake in this situation, it’s still fun to watch given the tactics being employed by both sides.