Description

Situation overview
Let’s invest in housing-related stocks while interest rates are significantly higher than they’ve been in years and we’re staring down the cliff of a potential economic collapse!! Sound stupid? Maybe at a broad level, but not if we’re talking about a carefully managed (capital-light) title insurer with a Fort Knox balance sheet and a history of performing well through downturns.

Investors Title Company (“ITIC”) is an attractive long. Through tight operations management, long-term full-cycle thinking and planning, and thoughtful capital allocation, the company has generated significant returns to shareholders over a very long period of time. ITIC offers meaningful cash generation, a regular dividend and occasional special dividends, and significant downside protection. These characteristics have resulted in the company returning nearly half of the current market cap via dividend over the last six years while growing book value per share at ~6% annualized. Book value per share growth over longer periods is 8-9% annualized.

So why can we purchase it at an attractive level, and why now? In short, the weak and potentially further weakening environment, which is likely to be only a temporary setback for ITIC, has been more than priced into the stock, which is now trading at a level that gives no credit for the company’s history of excellent operations and capital allocation. The stock price is nearly 40% lower than its peak toward the end of 2021. Thus we can buy an excellent company, that appears poised to boost its market share in this weak environment, for a good price.

Company and industry overview
Title insurance industry
What is title insurance? Very briefly, title insurance provides monetary compensation to property owners and lenders in the event of (usually legal) costs or property loss related to title defects. In this context title refers to the legal right of ownership to a property, and a title defect could be anything from a mechanic’s lien, an unexpected encumbrance on a property such as an unresolved mortgage, a forged or disputed document affecting a historical transfer, a mistake in a public record, a tax lien, an easement or other agreement that restricts usage of the property in some way, etc. Prior to the close of a transaction, the title insurer will engage in a thorough search through real estate records in an attempt to uncover any potential title defects.

Title insurance carries several of the marks of a good business: (i) it is required by most mortgage lenders in order to close on a home purchase, often leading to an easy sell of a second policy to the buyer in order to protect themselves in addition to the lender (ii) its cost (generally a couple thousand dollars) is small in the context of the overall home purchase transaction, and it usually comes into play near the conclusion of the transaction when both sides tend to be eager to move things along, (iii) it generally is priced based off of the value of the home allowing for premium increases when home prices increase. Although price comparison by property buyers is increasing, there is still a strong propensity for buyers to use whatever title insurance company is recommended by the buyer’s real estate agent or real estate lawyer. This means that strong relationships with local real estate professionals is of competitive importance.

According to the American Land Title Association (“ALTA”), the title insurance industry generated $21 billion in insurance premiums in 2022. While some online reading suggests that the industry is a steady ~5% grower, growth in premium written as reported by NAIC for 2013 through 2022 was +11.8%, -11.2%, +16.2%, +9.0%, +3.4%, +0.8%, +6.9%, +22.9%, +35.9%, and -17.2%. Not exactly steady year-to-year, though the 5-year CAGR was within a few percentage points of that level in each year from 2013 through 2020. Not surprisingly, annual growth for the industry was very strong in the early 2000s and saw significant declines during the global financial crisis. Title insurance premiums are driven by purchases and refinancings of residential and commercial real estate. Generally in purchase transactions title insurers will earn a premium for both a lender policy and an owner policy, while in refinancing transactions the owner maintains their existing policy and only a new lender policy is written, resulting in half the revenue relative to a purchase transaction. Refinancing volume is driven by interest rate levels i.e. how many people’s existing mortgages are priced higher than current market rates. Residential purchase transactions are driven by housing affordability and availability, and purchaser confidence/income/employment levels. Commercial purchase transactions are driven by yields, business confidence, and occupancy rates. Yikes!!! In all cases! But I’ll get to that below.

The industry is fairly consolidated. As of Q422, ALTA reported that First American generated ~22% of premiums, Old Republic ~16%, Fidelity 14%, Chicago Title ~13%, Stewart ~9% resulting in a top five market share of about 75% and top ten market share of ~88%. ITIC, with its $249mm of 2022 premium written represented about 1.2% of the market and about 25 other companies round out the remaining ten percent.

ALTA reports that in 2022 the industry paid out $600mm in claims. While this implies an eye-popping ~3% loss ratio as compared to ~70% in property/casualty or ~80% in health insurance, it’s important to note that some of the key costs of selling title insurance result from the labor-intensive research that insurers and agents perform in looking for defects and are thus not captured in the loss ratio. That is all to say, it’s not free money that should attract massive capital inflows or punitive regulation. With the exception of FNF, which is very large and has an extremely profitable annuity and life insurance business, and the very well-managed ITIC, public title insurance companies such as Old Republic and Stewart Information Services are generally earning the same high-single-digit and occasional mid-double-digit net margins as property and casualty insurers. Title insurance rates are generally regulated by state insurance regulators. Pre-approval from the state regulator is generally required before implementing a rate change.

ITIC overview: the company
Investors Title was founded in 1972 in North Carolina by J. Allen Fine, who correctly foresaw, following the issuance in 1968 of the first mortgage-backed security, that MBS would drive a significant uptick in title insurance sales. J. Allen Fine today serves as ITIC’s CEO, while his son Morris W. Fine serves as President and COO and son James A. Fine Jr. serves as President & Treasurer.

~85% of ITIC’s operating income is generated by its title insurance operations, which includes title insurance premium revenue as well as escrow fees, commissions, and settlement fees. The remaining ~15% consists of a mix of a few different small business lines including exchange services (i.e. services related to 1031 transactions), investment management and trust services, and consulting and management services offered to startup title insurance agencies. In 2022, ITIC’s interest and dividends plus realized investment gains approximated nearly half of consolidated operating income though this bounces around a lot and was under 7% in 2021.

The company’s title insurance operations are concentrated in North Carolina (35.6% of premium), Texas (29.0%), South Carolina (9.4%), and Georgia (9.2%), resulting in ~83% of premium coming from these four states. While I won’t claim to be an expert on local real estate dynamics across the country and I won’t waste space talking about remote work and the move from traditional, higher price centers of commerce out to smaller, more affordable areas, these appear to be relatively attractive markets. Census data shows South Carolina and Texas were the #3 and #4 states for 2022 population growth while North Carolina and Georgia were #9 and #12, respectively. These four states contain ten of the top 50 metro areas, and yet rank 22, 23,27, and 33 for low cost of living and 18, 17, 26, and 30 for housing affordability (SC, NC, GA, TX). With regard to housing supply, Texas, Georgia, North Carolina, and South Carolina, rank 1, 5, 6, and 14 for number of housing units built in the last three years, and 48, 44, 18, and 10 for housing units available per capita.

Since 1993 (or perhaps longer, 1993 is as far back as I looked), ITIC has experienced exactly one calendar year of negative net income. Not surprisingly, this was in 2008, however it represented a net loss of only $1.2mm (on revenue of ~$70mm), bookended by $8.4mm of positive net income in 2007 and $4.8mm of positive net income in 2009. Similarly, the company has generated positive cash flow every year since 1993 with the exception of a burn of $7 thousand (yes thousand) in 1998. I could also emphasize the company’s strong margin profile (5-, 10-, and 15-year average EBITDA margins of 20.5%, 19.1%, and 15.8%) or impressive revenue growth (5-, 10-, and 15-year revenue CAGRS of 11.9%, 9.4%, and 8.4%), or increase in book value per share (5-, 10-, and 15-year BVPS CAGRs of 6.2%, 8.9%, and 8.1% while paying out cumulative dividends over the past six years representing approximately half of the company’s current market capitalization. A look through historical 10-k’s shows that the company is consistently revising _down_ its estimates for prior year loss reserves.

Still, it is the stability of the earnings and cash flow, driven by management’s careful execution, that I believe makes this a very attractive investment in general, and especially in today’s uncertain environment, as we stare down a weak (or worse) housing (and possibly economic) backdrop. So how do they do it? Given that it’s title insurance, a relatively commoditized industry where rates are controlled by state regulators, there’s no structural competitive advantage. Rather, it is ITIC’s people and culture that appear to be behind the continuing stable profits, increasing market share, and returns to investors. No secret sauce, just five decades of refining a winning operational formula, and I think this could be more difficult for competitors to reproduce than other more typical competitive advantages. In terms of where they’re actually focusing, the annual letters from management give some good insight. Every year, management emphasizes two specific focus areas: (i) build and foster long-term, mutually successful business relationships (with respect to both agents working at their owned agencies, and to non-owned partner agencies who represent ~65-75% of premium written) and (ii) maintain “superior financial strength” in order to “capitalize on market activity regardless of the stage of the business cycle”.

A quick look at ITIC’s capitalization shows what they mean by superior financial strength. As of Q123, the company boasted no debt (~$7mm of lease liabilities) and ~$30mm of cash. On top of that, ITIC holds ~$52mm in debt securities, ~$43mm in equity securities, and ~$106mm in short-term investments such as money market funds, resulting in $223mm of cash and investments net of lease liabilities relative to a reserve for claims of ~$37mm. This results in a ratio of net investments to claims reserve of 6.1x. With Q123 stockholder’s equity of ~$242mm, ITIC carries an equity capital to reserves ratio of 6.6x.

I’m not an expert on the intricacies of insurance capital ratios. However I don’t need to be: by looking at other title insurance companies we can easily get an idea of just how well capitalized ITIC is and how much of ITIC’s cash and investments we might treat as excess. Fitch reports a “risk-adjusted capital” (“RAC”) ratio for title insurers. In 2022, this figure was 168% for the industry in aggregate, corresponding to an “A” rating. For the four largest title insurers (reminder that the five largest listed further above were specifically for Q422), Fidelity had a ratio of 129%, Old Republic of 158%, First American 186%, and Stewart 221%, with Stewart being the only one whose rating was consistent with an “AA” rating from Fitch.

How does this relate to ITIC? Relative to ITIC’s net investment to reserves ratio of 6.1x and equity capital to reserves ratio of 6.6x, Stewart carries a net investment to reserves ratio of 0.6x (yes, zero point six) and an equity capital to reserves ratio of 2.5x. Given this context, I’m comfortable that a 2x ratio of net investments to reserves (I find this ratio to be more conservative than equity capital, since fixed income and equity investments are more likely to be readily marketable) would still represent “superior financial strength” for ITIC. At 2x ITIC’s ~$37mm claims reserve, we would call ~$74mm of ITICs investments “required reserve capital” and would be left with ~$150mm of excess net investments. Subtracting that from the market cap of ~$284mm gives us an enterprise value of ~$135mm. I’ll get to valuation below, but for a preview, that’s 4.5x the company’s 2022 operating profit(!), and 2.6x operating profit if we remove the change in valuation of equity securities held that flows through the income statement(!!).

To hit one more time on the quality of ITIC’s operations, let’s take a look at market share and some of the company’s metrics vs. these much larger competitors. ITIC has taken and continues to take significant market share. Comparing NAIC annual title industry premium growth to ITIC’s performance shows that ITIC’s CAGR of premium written is 46% higher than that of the industry (12.1% vs 8.3%) over five years, 36% higher over ten years (9.3% vs 6.8%) and nearly triple over 15 years (8.8% vs 3.0%). But can they do it profitably relative to the competition? As a reminder of scale, in 2022 Fidelity reported total revenue of $11.5 billion, Old Republic reported $8.3 billion, First American reported $7.6 billion, and Stewart reported $3.1 billion. It would be impressive if ITIC, with its $284 million of revenue, could compete! This isn’t a completely straightforward question since the large public title companies (i) have additional segments outside of title operations, and (ii) mix in investment gains and losses with operating results. However, we can look at the segment-only results and back out the investment gains fairly well. In this analysis I included corporate losses with title segment results as the corporate segment functions largely to support the title operations. We find that ITIC is a standout performer even among these giants. ITIC’s five-year (investment-adjusted) title insurance operating margin of 15.6% is the highest of the group (Fidelity 13.6%, First American 10.2%, Old Republic 8.4%, Stewart 6.9%).

While I’ve already mentioned the qualitative side of “how do they do it?”, a look at each company’s per-employee metrics provides a good illustration. While of this group of five companies, ITIC is only the second highest generator of consolidated (investments-excluded) revenue per employee, and only 26% higher than the lowest in the group (for prior five years average: ITIC ~$453k, Old Republic ~$749k, Stewart ~$408k, Fidelity ~$394k, First American ~$359k), ITIC’s _profit_ per employee is off the charts. Operating profit per employee (again investments excluded) for this group was: Fidelity ~$62k, Old Republic ~$38k, First American ~$34k, and Stewart ~$30k while ITIC boasted an amazing ~$149k. That’s more than double the highest of the large players, and 3.7x the group average!! This speaks to the kind of excellent execution that carries companies to ever-increasing success across business cycles. This is the kind of horse you want to be riding during a downturn.

How we got here
There are two main parts to ITIC’s “how we got here” story. First is the company’s transition from (i) a quiet cash flow machine that paid out a small dividend and made the occasional buyback of a few million dollars while mostly feeding a growing pile of cash and securities, to (ii) a shareholder-return machine that has a tendency to pay out a sizable special dividend at year-end. This transition began in late 2017 and the dividends have continued through 2022. So did we see a significant bump in the stock price as a result? Actually ITIC’s stock price started rising a year earlier in late 2016 after a particularly strong third quarter (driven by operational strength as well as a favorable fundamental backdrop), moving from ~$100/share to up to ~$200/share. From there the share price bounced around from $160-200 as the company produced strong results (though generally not as strong as Q316), reaching nearly as low as $100 in the depths of 2020 (we all know why) and nearly $250 in late 2021 after reporting very strong Q221 results, all while paying special dividends per share of $2.40 in 2017, $10.60 in 2018, $8 in 2019, $15 in 2020, $18 in 2021, and $3 in 2022.

The second part of the story is hinted at by that greatly shrunken special dividend in 2022 as well as the decline in the stock price to the $130-$150 range following the late-2021 high. Between high (though apparently moderating for the moment) inflation, significantly elevated interest rates relative to recent history, a still-uncertain domestic and global economic outlook (with arguably significant risk to the downside), and slightly moderated though still-high housing prices, housing transaction volumes as a business doesn’t have the rosiest outlook right now.

Not surprisingly, ITIC’s performance has moderated as well in the last few quarters. Though the company remains net income positive, Q123 net income was significantly lower than recent history at $1.2mm and the company’s 2022 premiums written declined ~9% (vs. an industry decline of ~17% however). It is worth noting that ITIC’s results are distorted because changes in the fair value of its equity securities flow through its revenue line. In 2022 this represented a reduction of ~$21mm relative to reported net income of ~$24mm, and in Q123 $6.8mm vs net income of $1.2mm. If that all weren’t enough to scare away incremental buyers, the stock is somewhat thinly traded, and ITIC does not hold investor calls, is not covered by sellside research, and is not very responsive to investor inquiries.

Where we are now
So why would we want to invest in a company whose industry fundamentals have already declined and might get significantly worse? In short, this is a recommendation for ITIC specifically rather than title insurance companies generally. By bringing a long-term investment horizon to a company with a rock-solid balance sheet that has proven itself to be excellently managed through multiple business cycles, we can relieve ourselves of worry about near-term downturns, knowing that ITIC will emerge in good shape on the other side. But still, why invest in something that we think has a good chance of going down rather than just waiting until it’s about to go up? The answer is of course that (i) we can’t predict the timing of these things and (ii) we are rewarded now with an attractive discount to fair value, that likely will not be available when the industry outlook is more favorable.

While of course every crisis has its own idiosyncrasies, we are fortunate to be investing in a time where we can look back at a couple of very weak market conditions and have real data about how companies weathered them. I’ve already mentioned that ITIC made it through covid without a single year of negative earnings or cash flow, and through the financial crisis with positive cash flow and only a small net loss in 2008, bookended by positive earnings in 2007 and 2009. For a company with no debt and significant net investments, I’m not sure what further assurance we need about a potential upcoming crisis.

In discussing where we sit now with an investment in ITIC, we should also acknowledge that it is possible that the housing picture will not get significantly worse. Thus while we’ll prepare for a very weak scenario, our probability-adjusted outcome should also benefit from the potential “easy” scenarios that might occur.

Finally, we as shareholders are in good company. J. Allen Fine and his two sons each own 9-10% of the company, while Markel Corporation owns another 11%.

Valuation
Valuation in this name is mercifully simple due to a combination of the company’s simple capital structure, relatively clean earnings and cash flow, and trustworthy cash flow management.

Although we have already looked at ITIC’s taking of market share as well as its high margins and lean operations relative to much (much) larger competitors, the microcap discount can be a real thing, so we won’t give ITIC the premium to the group that it probably deserves. Fortunately, with this cash-flowing business and competent management team that understands capital allocation, we don’t have to worry too much about valuation discounts because we’ll be rewarded with special dividends.

The group is currently trading at about 12-15x trailing earnings, which is generally inline with historical trends at the high end, while historical p/e’s have ranged as low as 8-9x. Let’s call ITIC worth 13 times earnings today, which is just above the midpoint of the historical range and seems reasonable given ITIC’s 20-yr average ROE of ~12%, compound growth, and the impressive stability of its earnings. As above, I think it’s appropriate to treat the majority of ITIC’s cash and investments as excess value on top of the value of the business, especially given the lack of debt and only a small lease liability. For any securities that we “leave in the business” we’ll include their proportion of investment profits in ITIC’s net income. Any securities that we treat as excess will not have their proportion of investment income included in the net income figure that we use for valuation. I’m excluding unrealized changes in the fair value of equity securities in all cases. With ~$230mm of total cash and securities, less 2x the ~$37mm of loss reserves, we end up with excess cash and investments of ~$156mm ($82.41/share) which, when subtracted from ITIC’s diluted market cap of ~$285mm, gives us an adjusted market cap of $128mm (or a share creation price of $67.59). A reasonable normalized net income for ITIC is $21mm plus investment income on whatever portion of the company’s securities aren’t being treated as excess. This $21mm represents about the equivalent of earnings in the 2017-2019 timeframe, before covid and in a period of rising interest rates, so it shouldn’t reflect overstated refinancing volumes. Applying our adjusted market cap of $128mm to this earnings figure (with the fraction of investment income from the non-excess securities) gives us an earnings multiple of only 5.8x! This is too low. Increasing the p/e part of this valuation from 5.8x to 13x (the securities stay valued at $156mm) gives us a stock price of $235, or 57% above the current level. Not too shabby!

Too aggressive you say? How about if we call ITIC the bottom of the barrel for title insurers and use 8x p/e (although even ignoring the comps, this multiple is too low for this business)? We still get a share price of ~$176 or about 18% above the current level!

Okay, but how about this weak environment that we’re concerned about in housing? What kind of ridiculously terrible housing environment could we come up with to test ITIC against? How about we take purchase transactions and drop them to their lowest level since early 2014? And then we’ll take refinancing transactions and drop them 85% from the high levels of early 2021 to the lowest level in over twenty years. Pretty terrible right? Surprise! The above is what ATTOM reported for Q123 for U.S residential mortgage activity. So how did ITIC perform in this terrible environment? They made money! And the business generated positive cash flow! Not a lot, mind you, but $1.2mm of net profit, and that even included the $6.8mm reduction in revenue for declining valuations in equity holdings. (It is worth noting that due to the high amount of ITIC’s premiums that run through non-owned agencies, there is a good amount of variability in the company’s cost structure. For example, from Q322 to Q123, ITIC’s total expense base declined almost 27%). So should we annualize this and put a multiple on this? I would say no. We aren’t buying this stock because of the return we’ll earn in the current environment. We’re buying this stock because they are the low-cost provider in a market with competition. I expect them to become stronger relative to the industry during this difficult period and emerge in a position where they can continue to grow the business and take market share. However, it would also be fine if they just maintain the value of the enterprise until conditions improve.

And if things somehow get significantly worse? We can certainly expect an impairment of some sort, but with no debt and no covenants, it’s just a question of how much of the $223mm of net cash and securities we need to burn through. I think the odds are on the cushion being more than sufficient.

I’ll finish this section up briefly by giving a normal growth case. Although year-to-year growth can be all over the place in this industry, let’s just say that ITIC returns to its ~$21mm of normalized net income (excluding all investment activity) and grows premiums at that elusive industry average of 5% for three years. It gets some leverage on its fixed expenses, which grow more slowly than revenue, and pays out increasing commissions to agents. This leaves us with net income in year 3 of just over $36mm, which at a 13x multiple gives us a value per share of ~$248, or a 65% return. Again not too shabby! But wait! We still have our excess securities of ~$82/share plus another $43/share of cash generated during the projection period, resulting in a total value per share of ~$374 or a 149% return. If ITIC never gets a reasonable multiple and instead sits at 8x p/e, we’re left with a total value per share of ~$278 or an 85% return. There are many ways to make money in this name, and it requires a quite a lot to lose a significant amount.

Key risks
Ratings downgrade: The company prides itself on its lofty A.M. Best rating and believes that the attractive partnerships they are able to form are partly due to this strong rating.

Bad investments: We are putting a value on ITIC’s investment holdings. We get category-level descriptions from them of these securities and it all seems pretty normal, but there have been times in the last couple of decades where very normal-seeming investments suddenly…weren’t.

Succession: J. Allen Fine is 88 years old. He should be passing the baton soon. Son James Fine has been at the company since at least 1987, and son Morris fine has been at the company since at least 1992. A long time to get steeped in the traditions of success. However it is always possible that the succession will be a mess and/or they won’t actually perform without J. Allen at the helm. This risk is partially mitigated by the fact that they each have a significant stock holding (about $25mm at current valuations) and thus a lot to lose.

Disruption of the industry: it’s not difficult to find people online complaining about title insurance, feeling like they were pressured into buying and feeling like they weren’t equipped (or encouraged) to price shop. Price comparison is becoming easier, however I feel this benefits a low-cost producer like ITIC. There are alternatives for the buyer side of the title insurance, such as getting an opinion from an attorney, or a data-driven startup called Doma (though they seem to be spiraling into non-existence). Blockchain has also been discussed as a way to clean up the chain of custody for properties.

There are two fundamental reasons, however, that these are all greatly inferior solutions to title insurance: First, there is a massive difference between (a) reducing the likelihood of a title-related loss (attorney opinion, blockchain), and (b) providing _coverage_ in the event of a title-related loss. In case (a), you may still be the unlucky homeowner who happens to lose it all because of a very unlikely occurrence! Secondly, solutions that reduce the likelihood of a title-related loss are limited in their effectiveness. Sure you can put the transaction on the blockchain or get an attorney’s opinion, but how does that help if it comes out years later that someone’s will was forged or doesn’t stand up in court? Or a lien pops up that everyone somehow missed? These are real-world items that occur far from the housing sale transaction. While I acknowledge that these are low probability events, a couple thousand dollars seems like a bargain to prevent the loss of what is a huge financial investment for most families. With respect to the probability, I’ll note that the first page of search results for “home title scam” presented me with two stories from within the last two weeks covering title/property ownership scams.

I do think that the industry will continue to become more tech-enabled over time, likely reducing personnel costs and premiums, but I expect ITIC to be a leader in this and it seems likely that the resulting margins would increase rather than decline.

Catalyst

-Interest rates decline and refi’s come back from the dead
-Opportunistic acquisition during a period of weak fundamentals
-Cash generation and further special dividends
-Quarterly earnings: just continuing to chug along