Description

We like to invest counter cyclically. Whether it be the trough of a product cycle or a commodity - we look for investments where we can pay a low multiple on depressed earnings power. 

Granted, timing the bottom of long-term industry trends can be notoriously difficult; however, if you pay attention to and understand the ebbs and flows of supply and demand and trust the self-correcting mechanisms of industries and economies over the long run, it is possible to invest in a business that is temporarily under-earning and ride the tail winds of multiple expansion and earnings growth.

We understand that investors prefer to avoid volatile earning streams opting instead for high-quality and steady businesses that can control their destiny by setting their own prices.  But if your time frame as an investor is long enough, it is useful to have a basic understanding and appreciation of cycles – business cycles, economic cycles, market cycles, commodity cycles, etc… 

If you can analyze booms and busts – and the security prices that usually follow – while recognizing that the world needs raw commodities and commodity-like products and services to function, one arguably can find attractive opportunities in today’s pricy market. 

A brief Econ 101 overview helps us understand how the world works, across most markets: high prices bring more supply online and destroys demand setting the stage for future price declines, while low prices attract new buyers and idles or bankrupts high cost providers leading to price resilience at some point in the future.  It all happens on a dynamic continuum that is constantly changing along with technology and shifting needs and preferences.  These cycles often undergo dramatic step-function shifts - on both the upside and downside - as structural changes occur in the supply chain or end markets of inputs.

To make money in a cyclical business one doesn't need to determine the inflection point of a cycle. As long as a reasonable margin of safety is used in underwriting an investment through conservative assumptions - basically acknowledging that things might NOT improve and remain depressed – and the purchase price still offers an attractive expected return under a less favorable scenario, buying and patiently holding will usually payoff. 

One cyclical theme we like for the next 5 years is rising interest rates coupled with aging demographics.  There are indeed some structural elements that make it less obvious that rates will rise in the short to medium term, but in our opinion it is foolish to think they will remain low forever. 

A rise in rates will hurt many industries dependent on financing but will help many financial companies that have been patiently waiting for higher rates to grow their business. 

Life insurers in particular stand to benefit.  Low interest rates tend to drive up the present value of long duration liabilities while depressing current income on shorter duration assets.  In a rising rate environment, spreads widen - which not only improves profitability on existing assets but also increases sales by improving pricing and benefits offered on new policies. 

The 10-year Treasury is at 2.12%; the big boys MetLife and Prudential, both have lowered their expectations for rates rising, and have guided slightly down on profitability but keeping with ROEs of 11 to 13% in this difficult environment.  The whole sector has reset expectations and so have analysts.  We like this setup. 

One life insurer we really like that is selling at a significant discount to peers is National Western Life Insurance. 

NWLI thesis

National Western is a family operated life insurance business.  I recommend you read Spike945’s write-up from a couple of years ago for a good overview of the business. The message board also has some great color and background on the Moody family. 

In a nutshell, this is a hyper-conservatively managed – to a fault – operation that has grown book value at a 10-year CAGR of 8%.  The company has no debt, impeccable credit and A.M. Best ratings and operates with significant excess capital.  Most of its revenue is interest income on existing policies but new policies are consistently underwritten along with asset & capacity growth.

Not much has changed from the original write-up; book value has grown nicely from $1330 MM to $1530 MM while the discount has narrowed from 0.40x to 0.59 - but it still persists. 

In that timeframe those who bought the stock have done well while waiting for the insurance cycle to turn, or company-specific catalysts to take place.  Notwithstanding the price appreciation and narrowing of the discount, I believe NWLI offers very attractive returns going forward. 

While one can get excited about the “hidden value” of the HTM portfolio, it is worth noting that a rising rate environment will erase some of these gains, but improve EPS performance – which will have a larger impact on the stock price. 

Demand for life insurance and annuities are largely a function of interest rates and demographics.  The products basically provide protection from illness or death, but increasingly are used as a vehicle for retirement.  In 2013 the industry received $677 billion of written premiums or which 48% were generated by annuity contracts.  

During the last decade, as baby boomers have aged, the life insurance industry has done a reasonable job of positioning its products as investment / saving vehicles as opposed to ordinary vanilla death benefit policies.  Marketing and sales channels – basically an army of third-party distributors and brokers – have adapted to this model and we believe the demand for retirement products will improve in the next few years leading to better pricing and improved net-interest spreads as interest rates rise. 

A hard sell

Despite the impact of a difficult interest rate environment on income, NWLI has expanded the business & float in recent years as total assets have grown faster than book value.  With declining net interest spreads, a slight uptick in policy leverage has kept ROE in the 6% to 7% range – which explains the discount.  To preserve profitability and avoid underwriting losses the industry as a whole has also scaled back on benefits somewhat.

Selling life insurance in a low interest rate environment is equivalent to selling a high duration zero-coupon bond to a fixed income investor when the 10-year rate has plummeted.  It’s a hard sell. 

The sales process involves an army of 18,000+ independent agents that help underwrite NWLI’s new business.  While the US business is pretty commoditized, the international division continues to expand its strategy of selling to an affluent segment that carries higher margins.

As the interest rate cycle turns these dynamics should change.  It will remain a commodity business, but pricing as a whole will improve, and the attractiveness of these products from a financial and demographic standpoint will also help NWLI expand margins.

While we don’t expect any imminent company-specific catalysts to re-rate the stock, there are a few things worth noting that could help NWLI. 

The recent roll-up of three life and annuity companies by Athene Holdings – owned by Apollo, which might be IPO’d at premium to book someday giving it fresh powder to buy more life insurers, sell off their bond portfolios, and reinvests in higher return assets.  Might the Moody’s be tempted to sell? 

Anecdotally, we’ve talked to other NWLI shareholders who have had one on one’s with Ross Moody – the son – and he has indicated he would make some changes from a capital allocation and capital structure standpoint.  His father isn’t getting any younger… 

With book value expected to hit ~$465 in 2015 and possibly $500 in 2016 and a single digit P/E we see little downside.  More importantly, when the cycle turns NOT if, ROA should improve, sprinkle a little more leverage, better allocation, possibly see an acquirer sniffing around…this could easily be a double in the next 2 years.

Catalyst

Old man retires, either professionally or permanently...