I recently updated my reinsurance company spreadsheet to include free cash flow (FCF), and wanted to post an update on this prior to the Q4 earnings season coming up in a few weeks. (For review, I have previously discussed reinsurance company investing in prior installments one and two).
According to wikinvest, a definition of free cash flow is that it is a non-GAAP measure that
measures the cash flow available for distribution among all the security holders of a company, including equity holders, debt holders, preferred stock holders... Many investors prefer to track free cash flow as opposed to GAAP earnings because it is much more difficult for companies to fake cash flow.
For learning the thesis behind free cash flow investing, I found a fairly simple review here, and a more technical review here. In those reviews, you will find details on how to calculate FCF yourself, summarized here:
Cash is king
One of the biggest cliches in business is "cash is king." But there is a reason for this: it works. Some industries can look very profitable but produce little free cash flow, sometimes due to the capital-intensive nature of the business. Offshore oil drilling stocks are an example of this, which I reviewed earlier this week here. One metric I didn't include in that review was free cash flow, and when I performed that analysis, I was disappointed. It turns out that much of the profitability in GAAP terms of the offshore drilling industry is due to accrual phenomena such as depreciation. Depreciation helps accrual-based earnings, but has no effect on cash-based earnings, at least per my understanding.
With reinsurance companies, free cash flow is often fantastic. This is because their profit cycles are heavily dependent on the presence or absence of large catastrophes. So it stands to reason that in quarters without large losses, there should be massive profits. Like other financial companies, the main asset of reinsurance companies is capital itself. Other industries have to invest capital into large assets like industrial plants, machinery, ships, etc. The cash is then tied up in long-term investments that constantly depreciate in value. In insurance companies, capital itself is the asset. So as soon as a profit is generated, cash is immediately available either to grow the business or to return to shareholders.
A portion of this is paid out as dividend by most companies in this sector, and the remainder is available as retained earnings, which increases book value, and is available for the following uses:
- increased underwriting (if in a good pricing market),
- dividend increases,
- buying back shares (especially if pricing of insurance is soft and company shares are trading below book value).
This is where these metrics come full circle: FCF flows back to book value - immediately. (Companies that write long-tail policies do have to maintain reserves and adjust those for likely claims, but that isn't included in free cash flow anyway.)
Sources of finding free cash flow statistics
The articles linked in the introduction give information about how to calculate FCF by backing out certain items from the cash flow statement (which itself is available from the corporate 10Q statement you can obtain from each company's investor relations site, as with AXS for example). However, when you analyze a whole list of companies, as I do, and need to update them quarterly following each earnings season, these calculations become cumbersome and I only perform them for my largest positions. Since FCF is not a GAAP-reported metric, it is not as widely available. For quicker analysis, I often use finviz.com. However, a full computation of FCF might require not only directly using the 10Q filings such as cash flow statement, but also reading the footnotes to learn about special non-recurring or non-operating items. My advice is that the more important FCF is to you as a valuation metric, the more time you probably need to invest in directly reading the SEC filings including footnotes.
At least one charting site (ycharts.com) lists free cash flow graphically, as shown in this example for Axis Capital Holdings (AXS). Even more interesting is the overlay of price-to-book-value graph on top of the FCF graph for Axis, shown here. This visually shows that AXS has become more favorably valued on a P/BV basis, even as FCF has been maintained over the years except for a catastrophe-related dip in 2010. This, coupled with the favorable Price-to-FCF ratio of 4 for AXS, and the fact that it is 12% off its 52-week high as a I write this, make this company a target for more evaluation. Indeed, I have already accumulated some in the $34.10-$35.20 range, and also had sold June $35 puts on AXS. Apparently, the company also thought its shares were appropriately price, as it announced a $750 million share repurchase program. This announcement ties together a lot of my investment thesis all in one: high free cash flow, low price to book value, excess cash, returning cash to shareholders at a share price below book value (accretive to book value), and not writing excessive insurance when market conditions did not warrant it.
Previous readers may recognize this spreadsheet, which has now been updated to include the most recently reported P/FCF from 3rd-quarter 2012. P/FCF is a way of normalizing the FCF to the share price, and allows easier comparison, just as we use with the more familiar P/E (price to earnings), and P/B (price to book).
|company||current price||P/FCF||Q3 BV||Q3 P/B||Q3 Combined Ratio||market cap (B)||% of 52wk hi|
|Arch Capital (ACGL)||$43.49||7.43||$36.79||118%||90%||5.94||96%|
|Aspen Insurance Holdings (AHL)||$31.75||7.36||$41.53||76%||87%||2.25||94%|
|Axis Capital Holdings (AXS)||$34.10||4.81||$43.57||78%||85%||4.17||88%|
|Berkshire Hathaway (BRK.B)||$89.21||20.30||$76.30||117%||-||221.16||98%|
|Endurance Specialty (ENH)||$38.82||30.66||$54.95||71%||100%||1.68||91%|
|Greenlight Capital (GLRE)||$22.84||-||$23.57||97%||114%||0.84||87%|
|Montpelier Re Holdings (MRH)||$22.68||7.51||$26.61||85%||73%||1.26||94%|
|Partner Re (PRE)||$79.10||20.66||$99.54||79%||81%||4.84||93%|
|Platinum Underwriter (PTP)||$45.58||-||$54.60||83%||61%||1.49||96%|
|Everest Re (RE)||$109.07||11.46||$131.22||83%||87%||5.64||95%|
|Validus Holdings (VR)||$33.95||6.97||$33.91||100%||70%||3.17||90%|
|XL Group plc (XL)||$24.58||10.38||$32.82||75%||92%||7.39||95%|
Based on this comparison, I would take a closer look at AXS (as discussed above) with a P/FCF the lowest at 4.81. The next ones would be VR, MRH and AHL. (ACGL and RNR look good too but trade at well over 100% of book value.) ENH looks good on price to book, but with P/FCF the highest at 30.66 signals that something may be wrong and the discount to book value may be warranted. The Berkshire Hathaway P/FCF of 20 does not look competitive, but it is company wide, and insurance segments only account for about one fourth of its profits, as I will write about in an upcoming article.
The biggest potential risk facing a reinsurer is the catastrophe-related loss, which by definition is unpredictable in timing and size. I personally believe that this risk tends to hold down the price on these stocks. In other words, it is this very ever-present risk that is the fundamental source of profits for this sector.
Another risk is losses in the investment portfolio. Since most insurance companies are heavily invested in bonds, and many commentators feel that bonds are due to tumble, this risk should be noted. In my own portfolio, I consider a major part of reinsurance sector allocation to be bond-like in nature, and reduce my bond portfolio commensurately.
This article has reviewed the basics of free cash flow investing, and summarized a number of sources for additional information. While I feel that FCF is a key reason for investing in reinsurance stocks, it is noted that part of the reason that FCF is so high in this industry is because of the nature of the companies intensely utilizing capital itself as their main asset. FCF may thus be even more important when analyzing industries that require large investments such as heavy industries and retail, as FCF can help sort out the companies that are reporting earnings that are largely based on depreciation and other accrual phenomena rather than cash profits.
Thank you for reading and I hope this has been helpful for generating new ideas in your investing.