Description

Cincinnati Financial (“CINF”) is a Midwestern property and casualty company that follows a Berkshire Hathaway value creation strategy. While most major insurance companies have an investment portfolio that is mainly fixed income in nature, CINF has about 75% of its investible assets in equities. This investment philosophy has allowed CINF to achieve almost 20% compound growth in book value over a 10 and 20 year period. While it is unlikely that this record will continue indefinitely, the Company’s game plan should allow it to continue to grow book per share at a rate comfortably faster than the overall market. Given the valuation of about 115% of estimated current BV and the backdrop of an improved P&C environment, this is a good entry point for making an excellent long-term investment.

CINF writes predominantly commercial P&C business, mostly in the Midwest, through a network of independent agents (about 1000 in number). Underwriting results have been excellent, close to 100 combined ratio over time. Basically the agents are the focus and heart of the underwriting operation. CINF limits its business to the best one or two agents in any area and pays them well (direct and contingent commissions are approximately 50% higher as a percentage of premiums than the industry average while other expenses are at the low end of the industry range). In return, the agents are expected to steer increased business to the Company and importantly, give CINF their best business. In addition to the 16% of the Company owned by management, agents own about 20% of CINF themselves. Quarterly underwriting results have been volatile due to storm related losses and other random events, but should be on the upswing due to the rise in P&C rates in the industry. CINF’s strategy to grow through geographical expansion into new states. Premium growth has accelerated to nearly 10% as regional competitors have backed off.

Like BRK, the CINF investment portfolio is concentrated in several blue chip names, which are truly long-term holdings. The largest position, Fifth Third Bancorp makes up almost half the portfolio, with a market value of $4.3 billion. Keep in mind that CINF’s cost for the shares was only $277 million! Other major holdings include Alltel, P&G, Exxon Mobil and a number of regional banks. At year-end 2000, CINF had about $53 per share in equity securities on the balance sheet. Over time this number is likely to grow nicely due to (I) underlying growth in the equities themselves, (ii) continued deployment of a portion of the underwriting float into equities and (iii) continued share repurchase. A well-run insurance operation that invests in equities is basically an investment fund that uses an interest-free margin line.

On an earnings basis, CINF rarely looks cheap because only dividend income from the equity portfolio is taken into income. Book value moves around with the market, but is currently probably about year-end value of $37. It should be noted that book value includes a deferred tax liability of approximately $12 per share related to the unrealized gain on equity investments. Of course the taxes will need to be paid when and if the stocks are sold, but in the meantime, the Company has an interest free loan from the government. Clearly one can make the argument that the true economic cost of this liability is considerably less than $12, which would yield an adjusted book value close to or above market.

Catalyst

Cyclical underwriting improvement, growth in book value and share repurchase.