We invested in Genworth Financial (NYSE:GNW) during November 2012 after the share price fell to $5.50/share. The investment thesis [Source] discusses the company then trading at about 16% of book value ($33.52/share); 25% of estimated intrinsic value ($22/share); and 32% of net tangible assets ($17.31/share). The worst of the financial crises was behind it and at that price, equity holders were still well covered with $3 of tangible assets for every $1 they invested in the shares even after all liabilities were paid. Mr. Market was being generous.
The combination of improved macroeconomic, industry, and company specific conditions worked favorably to increase the share price to about $17.65/share today for a 220% gain. There is still potential more gains (shares have not yet reached the intrinsic value estimate of $22/share), but we are going to sell GNW and lock in the gain to reduce risk.
Through the 19 month holding period and the 1Q14 earnings report [Source], we remained positive about GNW’s prospects. Genworth has been executing and getting stronger with help from an improved housing market; reduced competition in the long term care (LTC) and mortgage insurance (MI) businesses; debt reduction; operations improvement, and cash from asset sales. These levers are still available for management to continue strengthening the company.
So then, why sell now? At the time of the investment, shares were selling far below the intrinsic value of the underlying business. Although there was a lot of moving parts and uncertainty, a rare 75% margin of safety was also offered. Then over time as the company’s improving prospects became more evident to the market, the share price reacted accordingly. As the share price improved, the value proposition shifted from each dollar spent on a share buying $3 of net tangible assets to each dollar spent today buying about $1 of net tangible assets. Going forward, share price appreciation will be less dependent on Mr. Market being rational and more on improving a lagging return on equity through capital allocation and operation improvements.
Consider the graph below where current share price to book value ratio (P/B) is compared to return on equity (ROE) using the life insurance group as peers. The arrow shows Genworth's P/B ratio has tripled since the year-end 2012 purchase from about 0.2 X to 0.6 X today. But its current 4.1% ROE, although improved, still significantly lags the peer average of 9.4%. To realize the peer average P/B ratio of 1.2 X and associated share price appreciation, Genworth needs to more than double its ROE to the peer average.
The company initiated improvements to long term care insurance pricing, recapitalized the mortgage insurance business and returned it to profitability, sold non-core assets to raise capital and become a more focused business. These steps, along with reduced competition as competitors exited the businesses and the housing market improved, changed investors' perception of GNW’s viability. The performance improvement shows as net income increased 98% in the current trailing 12 months ($641 million) when compared to the year ending 2012 ($323 million).
Even with this improvement the performance, as measured by ROE at 4.1%, is less than half the peer average of 9.4%. This can be described as mediocre at best. It is going to take a long time to double the ROE and demonstrate that it is sustainable for GNW to earn the average peer 1.2 X P/B ratio. The incremental margin improvements being made on new insurance written in LTC and mortgage insurance are impressive but will take time to show up in the ROE. These margins will be average over a large existing book and total equity of about $15.5 billion in the company.
Genworth’s turnaround has transitioned to a long-term operations improvement that requires more patience and risk tolerance for three reasons:
1. Quality and Price Tradeoff:
Warren Buffett explained the first reason in the Berkshire Hathaway 1989 Chairman’s letter when he wrote to his shareholders: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” He was discussing two of the four possible quality and price variable combinations that can be visualized with the quadrant below.
He explained how it took him years before he learned from his partner, Charlie Munger, why a Quadrant II company was a better investment than a Quadrant III company; in effect placing more emphasis on quality over price. Quadrant I, although not discussed, is of course a no brainer and Quadrant IV can be thought of as a Benjamin Graham “cigar butt” type company.
With GNW’s ROE at less than half peer average, it is at best a “fair” company that we bought at a better than “wonderful” price, putting it in Quadrant III at the time of purchase. It is still at best a “fair” company until a sustainable two fold improvement in ROE is demonstrated. At today’s $17.65/share price, however, the margin of safety is about 20%, so the price is much closer to “fair” than “wonderful.” The result is GNW, ironically partly due to its success, has migrated to Quadrant IV; the least desirable of the four combinations.
2. Capital Allocation:
Genworth raised capital through asset sales (Wealth Management and the Australian Mortgage Insurance IPO) and through improved income. The options for the cash include: share repurchases, resumption of dividends, reinvesting in the businesses, paying off debt, anticipated capitalization requirements, regulatory changes, etc. The answer of how best to allocate capital is not always a clear one. Shareholders must rely on the board of directors and management to make the best decisions on behalf of the shareholders' interests.
It is clear, though, that management is paid to create shareholder value with the objective maximizing the value for continuing shareholders. The best measure of management’s financial performance is return on equity, and GNW’s less than half peer performance of 4.1% speaks to past management’s performance and the board of directors' stewardship. The new management team and the wake up call to the board of directors during the financial crisis was showing promise but from my perspective, it is a growing area of concern with Genworth.
For example, today some of the apparent capital allocation options for cash are:
- Reinvesting in a business with a 4.1% annual ROE (and trusting a doubling of ROE is coming).
- Pay down debt in advance that cost equity holders 7.7% to 8.7% in annual interest expense.
- Repurchase shares with a reported book value of $31.27/share and a cost of about $17/share for an immediate return of 84% to equity holders.
Is this really a difficult decision? If Genworth shares are worth buying (or in this case holding) at about $17/share, shouldn’t management be using our equity cash to do so? Of course, we are interested in better return projects if they exist, but what is available that is returning better than 84%? If share repurchases are not the most favorable allocation of capital, an explanation is owed to the owners of the company.
3. Opportunity Costs:
In investing, the opportunity cost of an investment is the value of the next best alternative that is not chosen given limited resources. We try to find an attractive risk adjusted return company that is held opportunistically, provided the investment thesis remains on track and until the intrinsic value is reached, or a better risk adjusted return investment becomes available. This is the case with Genworth, a more opportunistic investment, where the future risk adjusted return may be less than alternatives, and holding no longer makes sense in my view.
Selling is always a difficult decision, and over time I’ve learned to make that decision at the time of purchase. The one exception is on those rare occasions that a “wonderful” company with an excellent track record, shareholder friendly management, great capital allocation skills, and a sustainable defensive moat can be found at a “fair” or even “wonderful” price. These rare companies can become core holdings that are not sold. Genworth just isn’t one of those companies.
In our Genworth investment thesis [Source], we considered share buybacks as a very attractive use of capital. We did not include the share buybacks in the intrinsic value estimate, but it was viewed as a very attractive use of capital when capital became available. We wrote:
Warren Buffett, no slouch in capital allocation or the insurance industry wrote in Berkshire Hathaway’s 1984 annual report, 'When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.' Let’s hope GNW’s management listens.
In the recent GNW 1Q14 conference call, in response to an analyst question related to share buybacks, management remained uncommitted. If Warren Buffett’s views on capital allocation are worth listening to, then the lack of share repurchases at GNW begs the questions: Is GNW not viewed by management as an outstanding business? Is it not in a comfortable financial position yet? Or does management not care to benefit shareholders?
We were encouraged to see hedge fund manager John Paulson take a large position in Genworth and promote both share buybacks and the possible breakup of the company into a mortgage and a Life & LTC insurance company (for the benefit of shareholders). Management’s response continues to be no share buybacks, and in a recent Bloomberg interview, Genworth’s CEO Tom McInerney dismissed John Paulson’s breakup idea from consideration at this time [Source]: “at this point no”, citing a lot of work to do on operation improvements and improving both businesses first. For reasons discussed above, that could be a long wait.
There is no question Genworth has been executing and getting stronger, but with the share price higher, risk adjusted returns are declining until significant ROE improvements are made to support the higher share price. Incremental operating changes just don’t seem sufficient at this point. The company now sits in the least desirable Quadrant IV and appears too comfortable there.
It may be a mistake selling Genworth (admittedly, my weakness is losing patience with companies). There are better opportunities emerging and it seems most prudent to sell, lock in the nice gain and be in a position to invest in better risk adjusted opportunities as they emerge.
Full disclosure: Long GNW at the time of writing with the intention to sell all GNW holdings within three days of publication.