My last post, On Investment Ideas, Redux, received two good questions. Here they are, with my answers:
When using your quantitative factors, do your normally compare an investment idea relative to its sector, industry, or a custom comp group? I have dabbled in quantitative factor models in the past, and normally I start with an index, group by sector, and then compare each company relative to its sector (I use valuation metrics, liquidity, technical factors such as relative strength and price relative to moving averages, earnings volatility, earnings estimates revisions, balance sheet metrics, beta, and a proprietary risk/reward metric). How do you go about making the data relevant?
I try to look at what is overplayed and underplayed among factors and industries, and adjust my weightings accordingly. I look for companies that add to economic value relative to price. I look for companies that may benefit from an industry turnaround or a corporate turnaround. I look for pricing power, and how that is changing.
My industry and factor models are not integrated. I use industries as a screen, but I look for value via valuations and factors. Consult my eight rules for more on this.
I make the data relevant by letting my scoring model highlight promising ideas, and then killing those that are qualitatively bad ideas.
The second question:
Do you think the insurance company meme, while historically profitable, has now been over-exposed by yourself, AIG, Berkshire, etc?
Seems like the barriers to entry throughout the financial industry have collapsed (dis-intermediation by whatever name), and the trade looks pretty crowded. Every industrial concern has a financial arm as widely reported.
I have noticed a lot of de-mutualization of insurance companies, a lot of M&A / consolidation activity, and obviously asset management (new competitors) has grown all over the place. The financial sector (as a percent of the S&P) is back near all time highs.
Is the insurance meme now a crowded trade?
There have been others talking about this idea long before me, notably Tom Gaynor of Markel, a few of the CEOs in Bermuda, Eddy Elfenbein, etc. There are significant barriers to entry on this trade:
- Insurance is not a fast-growth industry. As such, many investors ignore it.
- Insurance is not sexy. Few buy insurance companies as a result.
- Insurance is the most complex industry from an accounting standpoint, if you exclude investment banks. Few follow it in detail.
- Insurance profits are volatile in the short run, but consistent in the long run, for conservatively run insurers. People get scared out of insurance stocks from the volatility.
Demutualization is a plus for the publicly-traded insurance industry, because it makes the industry more economic. That said, there are few large mutuals likely to demutualize anytime soon. They know that they have got it good. Good pay. Little oversight. Why change a good thing?
I would look at it this way. Since capital easily flows into insurers, be skeptical when insurers with short liabilities have price-to-book over 1.5x. For life insurers, and those with long liabilities, get skeptical when the price-to-book is over 2.0x.
We’re not there yet, but we are getting closer. My exposure to the insurance industry is still significant, but well below my peak, where buying discounted insurance shares was easy money, and with far less risk than buying banks. Banks were the better choice in this scenario, but insurers would have made it through uglier scenarios. Less leverage and credit risk.
I have not always been a fan of insurance stocks. In the 90s, I never owned them, because many took too much risk in investing. Today, those bad old days are gone, and underwriting is designed to make a profit, on average. And in an environment where many stock valuations are stretched, the valuations of insurers are reasonable. The only question is whether capital levels are so high that competition on premium levels will be brutal.
My view is this: it will be difficult for the general public, and even institutional investors to warm up to insurance stocks to the degree that they make relative valuations unreasonable. But if they do, I will be gone. Somebody give me a spank on the seat if we get another era like the mid-2000s where insurers trade well above their book value, some above 2.0x, and I don’t sell.
I failed to sell as much as I should in 2007. This time, I will be more measured. As for now, my overweight on insurers is still a reasonable and likely profitable trade. But as valuations go up, I will lighten the boat.