Description

Hurry up and wait! I have a pitch that you should definitely not buy if you will feel stupid owning something that might not be amazing over the next year, but if you feel comfortable owning something extraordinarily risk asymmetric that will likely produce a 10%ish IRR in a bear case scenario with more than an outside chance to make 300-400%+ over the next 5 years with limited downside WR Berkley may be for you.

Before I delve into some detail, a quick bit of background info:  We are six years into a soft insurance cycle and close to the bottom though the timing of a turn is uncertain. WR Berkley is a diversified insurance company with specialty, regional, and commercial exposures. I believe the CEO, Bill Berkley, is the smartest in the P&C business. The stock is trading near the cheapest it has in history at circa tangible book while it has often traded well above 2x TB due to its 30+ year history of maintaining a mid teens ROE. The company is structured better than any other insurance company I have come across and has the most upside to a cycle turn of any insurance operator of which I am aware. Most importantly, Bill Berkley has almost his entire net worth at stake through 18% ownership of the company ($700mm) and his 35 years of experience running WRB is invaluable. Finally, Bill runs WRB to maximize equity returns not just to protect his nest egg.

The Company:

WRB is a collection of over 40 insurance subsidiaries run in Greenwich, CT by Bill Berkley and his son Rob, who is COO. Unlike many sons who work for their father, Rob has been working hard with Bill since his teens and is one of the smartest people in insurance in his own right. I have gotten to know both well and cannot say enough positive things about the two of them.

WRB's collection of businesses is extremely important to understand. They are diversified by geography, end market, and line of business, and WRB reinsures almost every risk above $5mm so they have no catastrophe risk. Bill will tell you he "never wants to take a risk that will change their lives." To understand the firm, think of Baupost. Bill tells all employees they have to write at a 15% ROE or they will no longer be welcome at WRB. If they lose business because they price too high that is fine. Bill has 40+ units to allocate capital. If commercial trucking in Oregon is strong, he sends more capital there. If offshore rig returns are strong, he will push capital there, etc. 1/3 of their businesses are specialty operations that are able to sustain higher ROEs and some are more commodity-like but on average they have very good insurance segments. Unlike many insurance companies, when the market is weak WRB shrinks their business significantly and will not write business they are getting a good return. You will see other companies like Travelers try to keep growing through the soft market. Bill on the other hand delevers WRB and goes from writing 1.8x premiums to surplus to 1:1 and returns capital. If you look over the past few years he has bought back $1.5B of stock on a $4B market-cap instead of growing premiums. Interestingly, the top 100 employees are required to hold many multiples of their salary in restricted stock and are not allowed to sell until two years after they leave the company. What I cannot emphasize enough is that Bill and Rob are maniacal about managing risk.

The Cycle:

Insurance cycles are very long in nature lasting 5-10 years. Like most cycles people think it is different every time and the turns are near impossible to call. This cycle is no different. Pricing started to turn in 2005 so we are six years into it. The one thing I can say with certainty is we are closer to the turn now than we were six years ago, yet valuations have gone down significantly to tangible book. It is very rare to find trough multiples at the trough of the cycle. Who knows, pricing could down a few percent next year or up but we are now at a point where investment returns are nothing and the industry is not making an underwriting profit so the cycle will have to turn eventually. Industry analysts will likely tell you that there is too much capital and the cycle will never turn. Perhaps. That said, many things could cause it to turn. During a weak economy, people file fewer insurance claims. Think of a warehouse with half the number of employees than in 2006; fewer people get injured when it is less crowded and less business is being done and then the ones that might have claims won't file them in fear they won't get their job back. Think commercial truckers who aren't driving as much during a recession, etc. So, what inevitably happens is that the insurance companies that want to grow delude themselves into thinking that we are at a new level of frequency and severity and write the trend. The smart companies like Berkshire, WRB, Chubb, Markel, and Alleghany start shrinking and turning away bad business as they assume loss trends will mean revert.

This cycle could turn in a variety of ways. Loss trends could normalize. There could be a catastrophe or attack. There could be an increase in economic activity. The point is that it is impossible to time. The worst insurance companies right now are writing at losses and they do not realize it yet. They will need to see the losses come in before they understand it and then pricing starts to go up. Perhaps this cycle is different, but I would not bet on it.

The Investment Case

WRB is a 30+ year old company run by a genius that has averaged mid-teens returns trading at close to tangible book. The company has no catastrophe risk, is very conservative in its underwriting assumptions, has a short duration bond portfolio, and has a founder who owns $700mm worth of the stock and has his name on the door. It does not appear reasonable to me that one should be able to buy a fabulous company with a 30 year operating history at less than liquidation value at the trough of a cycle with an extremely shareholder friendly CEO.

The beauty of the investment is that as long as insurance companies stay near tangible book, they can shrink and return excess capital while maintaining decent book value per share growth. So, WRB could drop premiums 10% but as long as they maintain a good ROE their book value per share will grow in line with their ROE. In other words, if they drop premiums 15%, write at a 12% ROE, and then buy in 12% of their stock with the cash they generate the BVPS will grow 12%. For companies that trade at high multiples of book like PGR, it is dilutive to buy back stock so they need to grow. It is extraordinarily risk asymmetric because if the stock goes any lower and trades below TB then stock buybacks juice book value per share growth above their ROE thus causing BVPS and the stock to rise faster.

The most important part of this investment case is to understand the way WRB operates in strong and soft cycle. As I mentioned earlier, WRB shrinks significantly during the soft cycle and buys in stock, returns capital, etc. However, what is EXCITING about WRB is that when the strong cycle comes Bill levers the company back up and makes a fortune. This leads to an ROE at the trough of the cycle that is 10-11%ish but at the peak can hit over 30%. If you look at the financials, after the last cycle turn he wrote at a 20+% ROE for five years. For arguments sake, let's say that the cycle turns in the next three years. When it does, he will likely write at an average 25% ROE for a few years w/ 30% being the peak ROE. Using the rule of 72, we know that this means that book value will double over a three year period. From now until time X, WRB will only generate 10%ish BVPS and ROEs so you will get a 10% return unless the multiple expands. Well, what happens when the ROE blows out, does it trade to back over 3x TB like it did a few years ago? Does it trade to 2x? Who knows? It would not be crazy to see it at 2x book again (which is a 13x PE multiple on a 15% ROE) and if it more than doubles book over this period of 4-7 years and the multiple doubles from TB to 2xTB you could see a 4+-bagger. If you just take their net income from last peak and divide by the new share count and put a 15x multiple on that, you get a $75 stock alone; this is interesting because they have hired new teams aggressively since then.

Risks

The risks are that WRB is levered at slightly over 3x and owns bonds. Inflation and higher interest rates are a toxic cocktail for insurers as both the asset side and liability side get hit. I am worried about both of these things in general but still really like WRB. Obviously, none of us want to own bonds right now but Bill is an extremely good investor who started his career running a hedge fund so he protects the book well and has kept a short duration at about 3.3 years. The other risk is that massive inflation makes his loss reserves inadequate. A little inflation is good as it will cause a pricing cycle and those that are less conservative than WRB, who are baking in mid-single digit inflation into their reserves, will get crushed. If inflation hits 10%, there will be many better things to own like insurance brokers (I also own Aon as of the HEW deal).

Additional Color

If you buy this, you should know that the book is going to get hit over the next couple of quarters as bonds prices get hit a bit. YE BV may be around $25ish which you should then adjust up by $60mmish for the real estate they own that is carried on their books well below value. I believe this company could be sold any day of the week to a buyer at a much higher price and could even be liquidated at a higher price as they could sell of the policy renewal rights. In fact, Bill is in his late 60's so I would not be shocked if he sold it at the peak of the next cycle but who knows.

The difference between this cycle and last cycle is that valuations are already at TB (well, if you believe the books of the various insurers that is).  It is definitely unclear when there will be a cycle turn but no new capital should come into the industry at this point. I mean, who could raise money to put in insurance or why would you when you could go with WRB at TB. The insurers are buying in loads of stock to take capital out of the system as well.

I am wary of most financials at this point but love Bill and Rob. I have gotten to know them fairly well and think the world of them both. I feel confident that they are workhorses who think of risk incessantly and are faster moving than anyone else in insurance. They are bright and creative and have been hiring teams aggressively from AIG and others to position themselves to strike when the cycle turns. I also like that many of the things that would be risks for other insurers like a catastrophic event would actually be a bonanza for WRB. As WRB reinsures cat risk, a catastrophe would cause a pricing cycle without wiping out WRB's book.

As calling a turn in the cycle is near impossible, the way I have played this is I have gradually increased my position over time. I started with a tiny stake but have been adding to it gradually over the past year as it has continued to hover around BV which is growing at circa 10ish%. My goal is that by the time the cycle has turned, my capital weighted position will have an extremely high IRR.

Disclaimer:  This does not constitute a recommendation to buy or sell the stock.  We currently hold shares in this security and may buy or sell shares without notification.  While we have tried to present facts and a write-up we believe to be accurate, we make no representation of the accuracy or completeness of any information contained in this note; ie. you should do your own due diligence and not rely on this note.  We undertake no obligation to update anything should new information arise at a future date and the reader should assume we might change our mind, buy, or sell without any further disclosure. Once again, this is not investment advice.

Catalyst