|Shares Out. (in M):||61||P/E||6.3x||5.9x|
|Market Cap (in $M):||3,440||P/FCF||NMF||NMF|
|Net Debt (in $M):||725||EBIT||650||685|
Almost exactly 5 years ago, Gary9 recommended Arch Capital, the Bermudian insurance company. For anyone interested in this idea I would recommend reading his thoughtful analysis before going on. In the ensuing period, the stock has been a decent performer—up over 40% (and much more only last fall) in a down market. But the performance of the company has been much stronger than the stock. Two figures of merit: Book value/share has almost doubled to $54.61 at 3/31. More strikingly, investments (netting out debt and preferred) have grown from $58/share to $157/share, or a CAGR of 22%/year. Qualitatively, Arch has successfully navigated through a soft underwriting cycle that now appears to be hardening, continued to demonstrate its conservative reserving philosophy and avoided major investment losses.
Arch is an excellent company at a bargain price. Management has practiced underwriting discipline—shrinking important lines of business where they believed a 15% ROE was unattainable and, hence, produced an average corporate ROE of 18% since inception in 2002. As CEO Dinos Iordanou said at the AIFA Conference in March, “ We want to grow the business significantly when we [can] produce an adequate return. And we want to shrink the business when the market gets extremely competitive.” This is easy to say but hard to do when most analysts and investors are preoccupied with top-line growth.
It’s worth spending a little more time scrutinizing the investment portfolio given the recent travails of many other insurance companies. As of March 31, Arch had $10.24 billion in total investments. As noted above, for every dollar you invest today you get $2.80 in invested assets. The entire portfolio is held at market value. There are no public equities, no hedge funds and no private equity funds. Duration is 3 years (down a little from recent quarters), the average credit rating is AA+ and the embedded book yield is 4.17%. Arch does have $1.2 billion in CMBS (62% non-agency), $1.7 billion in RMBS (24% non-agency) and $331 million in bank loans (held at 64% of par. See http://www.archcapgroup.com/docs/ACGL-1Q-2009-Financial-Supplement.pdf for more detail.
Could there be more impairment in the portfolio? Of course, but I wouldn’t think that the magnitude would be great in the scheme of things. Furthermore, given the reinvestment of income and continued powerful cash flow from underwriting, it is highly likely that the portfolio will grow over time.
Buffett famously described insurance reserves as a self-graded exam. Particularly in long-tailed companies like Arch, reserve deficiencies have been crippling to countless investors over the years. So why am I confident that reserves are unlikely to become an issue here? First, a word on the origins of Arch: it was a corporate shell reorganized in the wake of September 11 to take advantage of reinsurance opportunities. Accordingly, the company has no meaningful pre-2002 liabilities (asbestos). Second, in recent years Arch has demonstrated a history of favorable reserve development:
Third, 70% of Arch’s reserves fall into the Incurred but Not Reported category, suggesting that over time further favorable reserve development is likely (and current book value is understated).
Hard vs. Soft Market:
Anecdotal evidence suggests that insurance pricing is firming. Here is CEO Iordanou in February, “We have seen significant deterioration of the [industry] balance sheet because of the financial crisis. And at the same time we saw prospects of the insurance cycle turning. And for that reason we suspended our share repurchases, preserving our excess capital because we truly believe that over ’09, ’10 and beyond we will be able to deploy that capital in the business of underwriting.”
In discussing Q1 results in April he noted that the “environment for reinsurance is actually better than we had anticipated” and that the “pricing environment continues to improve in the reinsurance sector and become more stable in the insurance sector.” This is the ultimate supply/demand business. While demand is somewhat muted because of the worldwide recession, supply is down more for a variety of factors—most importantly balance sheet destruction at a number of prominent companies.
Continued demonstration of pricing power in upcoming quarters should result in strong price performance. In both its early days in 2002-03 and again in the wake of Hurricane Katrina, Arch traded between 1.2-1.5X book. Sell-side analysts will get excited and momentum buyers will renew their interest. But what if this is a head fake and the market remains soft? I think management will remain disciplined—using both the excess capital they currently have and the significant capital which Arch can generate in an environment of flattish premiums to shrink the balance sheet. In 2007 and 2008 Arch bought back over 15MM shares of stock at roughly $69/share. Note that the two key metrics determining executive comp are ROE and growth in book value/share. This management understands the power of capital management.
1. Firming market and continued evidence of price increases.
2. Underlying value.
|Subject||P&C Insurance Companies|
|Entry||06/24/2009 02:11 PM|
It appears that most of the mid-cap P&C insurance companies are trading between 80-105% of book. Are there any others that you would recommend or see as well positioned? Thanks
|Subject||RE: RE: P&C Insurance Companies|
|Entry||06/24/2009 03:20 PM|
What are the concerns that cause ACGL to trade at book value? And the group to trade below book value?
|Subject||Why the superior ROE?|
|Entry||06/24/2009 04:24 PM|
I've looked at ACGL a number of times going back a couple years, mostly recently after it was highlighted in Grant's Interest Rate Observer last month. I've never understood why these guys generate a mid-to-high teens ROE. They're fairly diversified by line and primary vs reinsurance; does it really just boil down to management being smarter and more disciplined in their underwriting? Are there any competitive advantages I'm missing?
Separately, what's your take on excess reserves and how are you calculating it? The Lehman, er, Barclays analyst figures $500-500m but I'm not sure how he's getting there. Last time I heard about these great excess reserves it was regarding Hartford...ugh.
Thanks, good writeup
|Subject||RE: RE: RE: P&C Insurance Companies|
|Entry||06/25/2009 09:36 AM|
I'm not really sure I have a great answer. The unpredictability of earnings turns off a lot of investors. I think there are asset quality concerns that are overblown. XL Capital, long one of the two benchmarks of the Bermudian companies, collapsed. Many investors betting on economic recovery are more drawn within financials to banks, where the rate of earnings improvement will be faster.
|Subject||ROE and Reserves|
|Entry||06/25/2009 09:44 AM|
Good questions, Utah, and I'm not sure I have great answers. I think the higher ROE comes from lots of small management decisions rather than a structural competitive advantage. To some extent, it's like asking why firms like T. Rowe Price and Capital Guardian do better over decades than most institutional investors--it's bright people and a way of doing business.
On the reserves, I wouldn't even attempt a guess as to the size. My opinion stems from observation of the industry over a long period that companies that continually have redundant reserves typically go on that way while companies with a pattern of deficient reserves stay in that position as well.
I think in the end, whether or not Arch has redundant reserves is far less important a question than whether or not it can keep writing business at attractive rates and creating float to invest conservatively.
|Entry||06/25/2009 10:33 AM|
Grant's Interest Rate Observer of May 1, 2009 had an interview with the managers of the New Vernon Insurance Fund, a small but successful hedge fund specializing in P & C companies. In the article the managers of the fund, Steve and Nate Shapiro, mentioned two companies - Arch and Axis. "Both companies, as well as many others that we like, share the characteristic that they are willing to let the top line shrink if the believe premium rates are inadequate. And that is very important. The discipline required to sustain yourself through what we call a soft market is a critical success factor in the insurance industry."
"To pay book value for a company with that track record, that likely continues to have redundant reserves which are not yet recognized, that is in position to take advantage of an improving insurance market and that is also attracting talent and business from its wounded competitors - notably, AIG and, to a lesser extent, XL and the Hartford - to us is a very attractive proposition."
|Subject||RE: ROE and Reserves|
|Entry||06/25/2009 07:37 PM|
It's a good question. I think part of it is simply superior management. Dinos, Paul Ingrey, Marc Grandisson, John Vollaro etc. are the the best in the business. They are better underwriters and better at assessing risk/reward than their peers -- no different than someone like Buffett, either in the insurance business or the investment business. They are also not flash in the pans...they have had superior track records literally for decades. Another part of it is that their underwriters have contracts that are based on long term ROE, in some cases they are paid out over a 10-12 year period. So, you avoid the issues that have plagued other insurers where underwriters will be aggressive on accounting, get paid a lot in a good year, and then skip town. A third part of it is the business model/incentives, where the Board rewards its managers solely for long term growth in book value per share and for ROE. Not for premiums written, accounting profits, unsustainable growth, etc. Arch's Board (including over the years guys like John Pasquesi, Bob Clements and several partners from Hellman & Friedman and Warburg Pincus) has done an incredible job alinging long term incentives of the company and its employees with those of its shareholders. It is a classic succesful example of the old adage "what gets rewarded gets done." The management team and Board figured out part A better than any of its competitors and part B has followed. I hope and trust that at some point the share price will catch up to the enormous business value the team has created. And fwiw, we have a very large percentage of our fund invested in Arch and have for the past six years.
|Entry||06/26/2009 10:22 AM|
A quick look at the chart shows that there is no particular seasonal pattern in the stock price. I'm never even sure what to root for (strictly from a stock standpoint; I'm not insensitive to the tremendous damage). Obviously, Arch will likely have high losses given one or more big hurricanes in populated areas. On the other hand, large losses drive up industry pricing. I know Arch is in better financial shape than many of its competitors and should fully take advantage of ensuing market conditions.
|Subject||RE: RE: Why the superior ROE?|
|Entry||07/01/2009 09:41 AM|
David (and Nassau and Tdylan), thanks for the response. This is what I figured with some of these companies, particularly Arch's closest comp Axis, as they've layered on all sorts of alternative investments to juice returns.
Insurers to me are like enterprise software firms, I can never tell them apart and it's probably better to just try to time the cycle. I feel good about buying insurance companies right now simply based on industry-wide net written premium growth, which has gone negative for two years in a row which hasnt happened since 1932. One year of negative growth by itself is very rare. We should see a huge year for the industry soon with written premiums up 15-25% (and that's the most profitable stuff written throughout the cycle) and hopefully Arch is well positioned for it...it seems like they are but it's impossible to feel 100% comfortable with these companies.
|Entry||10/29/2009 03:19 PM|
Arch reported a very good third quarter. Book value rose to $69.48/share. so while the stock has appreciated 20% since my recommendation it actually now sells at a small discount to book rather than a slight premium. Importantly, the company resumed its repurchase program, buying 1.5MM shares. On the conference call, the CEO suggested that Arch had $700-800MM of excess capital and was relatively restrained in the buyback as hurricane season had not yet ended. I believe Arch will continue to buy back stock--possibly at an accelerated rate--in the months ahead. The benign storm season is a mixed blessing; obviously Arch will have stronger earnings and capital but it helps their less well-capitalized competitors as well. The stock remains very attractive.