I have several written articles recently on a brief introduction to fundamental-based investing in the reinsurance sector, and on a put-writing strategy as a way to initiate positions. Now, I would like to go a little deeper into a technical strategy at timing the initiation of these positions, and summarize the entire strategy.
The 52-week high
Percent of 52-week high is another metric I follow. It is always more comfortable for me to buy something that has sold off rather than buying at a new recent high. You can usually find some companies trading at 85% or 90% of the 52-week high, even as other members of the sector are reaching their own 52-week high. Reinsurance is not a momentum sector like technology where stocks just keep running up and up. Show some discipline in your buying, and wait for the occasional sell-off, because they always seem to happen. As I have previously written, selling uncovered puts has helped instill this discipline in me, by taking the immediate buying decision out of my hands and into the options market and its expiration dates and strike prices. And by selling out-of-the-money puts, I get an additional discount on the occasional exercises, compared to an outright buy of stock at the current stock price. If selling options is too risky for you, another strategy is to hold cash and wait for an occasional catastrophe as a buying opportunity if there is a sell-off.
Putting it all together
So, having outlined the key fundamental and technical metrics I use, I will outline my screening strategy for reinsurance companies:
- Price to book better than (below) 80%
- Combined ratio better than (below) 80% over the past 4 quarters
- Discount of at least 10% to a 52-week high
Sometimes the market won't give you all of these, obviously. But insisting on having at least 2 out of 3 is a good degree of stringency. I would argue that if you aren't finding metrics as favorable as these, your best move might be to wait - there's always a catastrophe around the corner. Don't be in a panic to buy. Keep your cash, and maintain a shopping list so you can be ready to buy (or write puts) when opportunity arrives.
When ready to buy, I place limit buy orders in tranches such as 95%, 90%, and 80% of 52-week high, and/or sell out-of-the-money puts one strike price below the current stock price (at an offer that is one third of the bid/ask spread up off the bid).
As I acquire stock, I tend to hold, add more on dips, and sell the longest-dated covered calls on the total position (one strike price up from the current stock price). That summarizes my entire strategy. I hope it is clear and makes sense. And of course the same strategy can be used in other sectors (my other main sector of interest is deepwater offshore drilling, as a highly noncorrelated sector.)
Real-life example of valuation: Buyouts
A recent buyout occurred (December 19, 2012) in the reinsurance sector, in which Markel (MKL) offered to buy Alterra Capital Holdings (ALTE). The day prior to the takeover bid, ALTE was trading at 76% of book value, had a 100% combined ratio in the most recent quarter, 87% of 52-week high. So 2 of the 3 screening factors were met. The combined ratio was a miss, but this metric fluctuates widely quarter to quarter, so you may wish to use a smoothed 4-quarter average to get a better picture of underwriting skill.
Regarding the theory behind these transactions: these types of acquisitions are accretive to book value, with an acquirer using overvalued stock to acquire a relatively undervalue company, and also in a strategic area (reinsurance) in which the acquirer wanted exposure. The combined company can have synergies such as more efficient capital allocation, by gaining the ability to deploy capital in more diversified areas of risk and in accordance with pricing in different markets. Earlier in 2012, Flagstone Reinsurance (FSR) was acquired by Validus Holdings (VR). In 2010, Max Capital was acquired and renamed as Alterra Capital. Each of these buyout targets also had a price to book of below 80%.
Upcoming earnings season
The week of February 6, 2013, is when most companies in this space will be reporting earnings. The largest catastrophe in the fall quarter is Hurricane Sandy. Many companies have already posted loss estimates for this event.
This article will mark my last reinsurance article until the earnings updates. I look forward to posting continued updates with fresh book values and combined ratios as these companies report earnings.
Thanks for reading, good luck, and I wish all a prosperous and healthy 2013!