Description

In an effort to find a value investment in the current market, I am re-posting one of my previous ideas with updates (E-L Financial). Although the price has risen, there is still further upside. Given the continued hard market in the property and casualty market and the consolidation occurring in the life insurance sector, E-L Financial is an undervalued long-term wealth creation investment.

E-L Financial (ELF) is a Canadian investment holding company (all numbers in this write-up are in Canadian dollars) that trades at a substantial discount to the sum of its parts. ELF’s strategy is to accumulate wealth within each area of investment. ELF has investments in 3 areas:
1)an investment portfolio of publicly traded fixed income and equity securities, owned both directly and indirectly through a number of closed-end investment fund corporations and other investment companies
2)a 100% interest in the Dominion of Canada General Insurance Company, a property and casualty underwriter,
3)an 81% interest in the Empire Life Insurance Company, a life and health underwriter.

Investment portfolio
First, this investment portfolio is outside of and in addition to the investment portfolios of ELF’s two insurance companies. The following table summarizes the market values of the investment portfolio (pre-tax) at December 31
2002 2001 2000
Short-term investments $46.6mm $57.3mm $31.1mm
Bonds and debentures 132.2mm 118.5mm 118.7mm
Common and preferred stock 411.0mm 439.4mm 406.7mm
Total $589.8mm $615.1mm $556.4mm

The investment portfolio is carried at market value on the balance sheet and the difference between cost and market value is recorded as unrealized appreciation of investments (net of taxes) in shareholders’ equity. As at June 30, 2003, the market value of the investment portfolio net of taxes was $582mm or $152 per share.

Dominion of Canada General Insurance Company
In existence since 1887, Dominion is a mid-sized Canadian property and casualty insurer offering both personal and commercial products, distributed solely through its network of approximately 600 independent brokers. Dominion participates in all major lines of business in the property and casualty marketplace. Business line and geographic mix have been relatively consistent over the past few years. Automobile insurance comprises 62% of the business; personal property is 20% and commercial property and casualty lines account for 17%. Approximately 70% of Dominion’s business in based in Ontario, 14% in Alberta, 10% in the Atlantic provinces and 6% in British Columbia. The following table (in Canadian $ millions) summarizes Dominion’s operations:

Auto Pers. Property Comm Prop&Cas Total
2002 2001 2002 2001 2002 2001 2002 2001
Gross written
premium $507 $415 $164 $142 $141 $104 $812 $661
Growth 22.2% 4.8% 14.7% 2.2% 34.4% 10.8% 22.7% 5.1%
Mix of business 62% 63% 20% 22% 17% 15% 100% 100%
Net earned
premium $452 $403 $139 $133 $111 $90 $702 $626
Net income $26.4* $36.5
Return on avg equity 6.8% 10.2%

* Investment gains were $15.7 mm higher in 2001 than in 2002.

Dominion’s combined ratio declined to 104.2% in 2002 from 106.4% in 2001. The company is still working to get the combined ratio down. Management is disciplined and should be able to get the ratio to slightly above 100% (102%-103%).

The following table (in Canadian $ millions) summarizes Dominion’s invested assets (at amortized cost for bonds; cost for other categories) as at December 31:
2002 2001
Cash and short-term investments $155.0 (13%) $89.5
Bonds and debentures 564.2 (47%) 535.1
Preferred stock 100.8 (8%) 105.1
Common stock 353.0 (29%) 324.1
Mortgages and commercial loans 27.4 (2%) 33.8
Rental properties 1.8 (1%) 1.8
Total $1,202.2 $1,089.4

Data for the six months ended June 30 is as follows:
2003 2002
Revenue $430.1mm $363.5mm

Net income before investment gains $14.3mm $5.5mm
Investment gains ($18.0mm)* $6.4mm
Total ($3.8mm) $11.9mm

* Dominion realized some losses on investment sales in order to reposition their stock portfolio

Dominion’s book value at June 30, 2002 was $426 million. Assuming a 1.3x to 1.5x book value multiple, Dominion is worth approx $554 million to $639 million or $144 to $166 per ELF share.

Empire Life Insurance Company

In existence since 1923, Empire Life is a stock company and has both shareholders and participating policyholders. Each group participates in the earnings of the Company. Shareholders are entitled to all the earnings of the non-participating section of the business and ten percent of the distributed income of the participating section of the business. ELF has an 81% interest in Empire Life.

Empire provides a full range of life insurance, investment plans and annuities, employee benefit plans and financial services to meet the needs of individuals, professionals and businesses through a network of regional financial resource centers and group sales offices across Canada and through an independent national network of Managing General Agents and their brokers. In terms of assets, Empire ranks among the top 15 of Canadian life insurance companies.

In 2001, 58% of premium income came from Ontario, 24% from Quebec, 16% from Western Canada and the remainder from the rest of Canada. The company has strong capital ratios and an A rating from AM Best.

The following table sets out the 2002 revenue derived from major lines of business (in Canadian $ millions):
Premium Invest & Other
Income Income Total
Individual Life and Health $156.7 $41.3 $198.0
Employee Benefits 145.2 5.8 151.0
Investment Products 103.8 103.2 207.0
Other - 26.8 26.8
Total $405.7 $177.1 $582.8

The following tables summarizes the 2002 net income contribution from each of the business lines (in Canadian $ millions):
2002 2001
Segregated Funds $4.8mm $5.0mm
Investment Products 1.0 (4.3)
Employee Benefits 5.4 3.1
Individual Insurance (17.9) 3.2 (decrease due to one-time
restructuring expenses)
Capital & Surplus 19.6 21.0
Net Income $12.9mm $28.0mm
Net profit contribution
To ELF after policy-
Holder adjustment,etc. $11.6mm $29.6mm

The majority of the investment portfolio is in bonds with the majority of bonds being governments and high-grade corporates.

Data for the six months ended June 30 is as follows:
2003 2002
Revenue $331.5mm $282.9mm

Net income before investment gains $10.3mm $3.0mm
Investment gains $6.3mm $7.1mm
Total $16.6mm $10.2mm

Empire’s book value at June 30, 2003 was approx $306 million. Assuming a 1.3x to 1.5x book value multiple, Empire is worth approx $398 million to $459 million or $104 to $120 per ELF share.

Other
The Jackman family (Hal Jackman was former lieutenant governor of Ontario) owns 35.1% of ELF. Third Avenue is also a shareholder. Well-known Canadian value investors Irwin Michael of ABC Funds and Gluskin Sheff are shareholders as well.

The company is opportunistic both in terms of acquisitions and divestitures. During the Canadian bank merger mania, they sold their National Trust operations at a very good price. ELF has a strong balance sheet with no debt and almost no goodwill, ideal for acquisitions.

One of the main reasons for the low share price is the fact that not single investment analyst covers ELF. Furthermore, ELF has made little effort to make itself accessible to the average investor (high share price a la Berkshire Hathaway).

There are no options issued so there is no need to worry about options dilution.

In 2002, Hal Jackman retired as Chairman of the ELF, but stills sits on the board. His son, Duncan Jackman, was named Chairman and President of ELF. He has been well trained by his father and understands how insurance companies create wealth and how they can be destroyed through poor underwriting and/or poor investing.

The following was written in the 2002 annual report about Hal Jackman, the now retired Chairman:

The Board would like to express its tremendous gratitude towards its departing Chairman, The Honourable Henry N.R. Jackman. The Company was founded by Mr. Jackman along with his father, Henry R. Jackman in 1968, and in so doing created one of the first financial holding companies of its kind. The initial public offering was at $10 in 1968; the closing price for the Company was $230 at the end of 2002 (equates to an annualized return over the 25-year period of 14% excluding dividends). Shareholders’ equity in 1968 was $13.8 million and $1.27 billion at the end of 2002 (equates to an annualized return over the 25-year period of 20%) . It should be noted that the entire growth in shareholders’ equity derived from retained earnings and that the vast majority of this growth was during our departing Chairman’s tenure.

Downside Risk: ELF is run very conservatively and though the market price could decline, there is a sufficient margin of safety at the current market price to offset any relatively significant business deterioration.

A Small Aside: I visited the offices of the company and I don’t think the boardroom has been updated since the early 1970’s (maybe even 1968) so senior management understands what is important for shareholders.

Conclusion
Value per share
Investment portfolio $152
Dominion $144 to $166
Empire Life $104 to $120
Total $400 to $438 (midpoint = $420)

At a price of $295, ELF trades at a 30% discount to the conservative and growing $420 sum of the parts valuation. Assuming ELF can grow intrinsic value ($420) at 8% for the next 5 years, by buying at $295, this results in a double over the 5-year holding period.

Catalyst

Cheap valuation, dividend increase (current divident is $0.50 per share annually), share buyback, share split