As we all know, the mortgage crisis and recent recession has resulted in a significant downturn in the housing market that still does not seem to be firmly on the path to recovery. Naturally, the industries most closely related to the housing market have also seen their results suffer and stock prices drop as a result. One of those industries, title insurance, realized reduced revenue and earnings but still made money during the housing slump and looks like a potentially great place to park your money right now.
Title insurance companies have a few factors working in their favor. First of all, they can choose not to write unprofitable insurance policies. This approach is known as "pricing discipline" and is practiced by the best insurance companies regardless of what type of insurance they actually sell (e.g., property and casualty, workers compensation, title). While it is true that some costs are fixed, the majority of expenses for insurance companies are variable. For title insurance companies, the greatest expense is personnel and title research costs. Title insurers generally manage their personnel level to be profitable based on the volume and market pricing. Also, title insurers can build up what is called "title plant," or essentially a database of information that can be used for future research efforts or even sold or leased to others.
The second factor working in any insurance company’s favor is its investment portfolio. Insurance is my favorite business in the world because customers give their money to title insurers until they need it for whatever emergency they are insuring against. The great thing is that the emergency may never come or, if it does, may not come for years. In the mean time, the insurance company gets to invest their customers’ money for its own benefit. And if the claims ultimately paid out on the policy are less than the premiums paid in by the customer, then the customer is essentially paying the insurance company to hold onto that money and invest for the insurance company’s benefit. Who wouldn’t want that gig? Therefore, insurance companies have an investment portfolio built using other people’s money and generating income for the company, which helps offset some of the loss of earnings due to the housing slump.
As a general rule of thumb, a well-run, profitable title or property & casualty insurance company should sell for about 1.5 times books value at a minimum. While I normally focus on free cash flow, book value is more appropriate for an insurance company because most of its balance sheet is comprised of financial assets and liabilities. In addition, book value can be used as a proxy for "statutory capital," which is what state regulators use as a basis for determining how much insurance a company can write. For instance, an insurance company with $1 million in net book value would not be allowed to write a $1 billion policy. That company would be deemed to pose too great a risk of not being able to honor its future obligations. Normally, state regulators allow insurers to write annual premiums equal to as much as 1.5 or even 2.0 times "statutory capital" or book value for our purposes. Furthermore, book value does not adequately state, in most cases, the true earnings-capability of assets. For instance, cash, normally a significant balance for insurance companies, is worth more to an insurance company than what is on its bank statement. That cash balance allows them to write additional insurance and can also be invested in bonds, equity, derivatives, or even private businesses.
Therefore, if I see a well-run, profitable company selling for less than book value, I tend to get excited since I have a good idea that it is worth 1.5 times book or more. This is where title insurance comes in. The housing slump has caused the stock prices of good title insurance companies to be suppressed. The top two title insurance companies in the United States, Fidelity National Finance (NYSE:FNF) and First American Finance (NYSE:FAF), are actually both available for less than book value as I write this. Of course, that is not enough for me to take out my check book. I also have to do my normal due diligence and determine a true value of the company. For insurance companies, I base that true value on projected net income. I was not surprised when my analysis and projections resulted in a valuation that was right at 1.5 times book value for FNF and 1.4 times adjusted book value (I will explain the "adjusted" part momentarily) for FAF. FNF’s higher multiple is a result of its more conservative claims loss reserve, which reduces book value, and higher margins realized on its insurance operations.
In general, I am comfortable investing in these two companies because I feel that the housing market has reached a low point and that, while it may be flat for another year, it should start improving over the following few years. I cannot tell you the exact date it will happen and I am not interested in guessing. I know that these stocks have over 50% upside right now, and I do not want to miss out on the upside because I waited so that I could better "time the market."
Detail of FNF and FAF
FNF and FAF are eerily similar in certain ways but do have some differences. FNF is the largest title insurer in the United States with a market share around 40%. FNF has made a number of major acquisitions to obtain that market share. FAF, meanwhile, is the second largest title insurer in the U.S. with a 30% market share, mostly gained organically rather than via acquisitions.
The eerily similar part is how these two insurers came to be independent companies. FNF was part of a larger company, also called FNF, along with a company called Fidelity National Information Services (FNIS), an information solutions company. In 2006, FNF was spun off from the parent company, although it still does business with FNIS. In addition, both FNF and FNIS actually share the same chairman. FAF was also part of a larger company along with what is now called CoreLogic (NYSE:CLGX), also an information solutions company. FAF was spun off in June of 2010, but FAF and CLGX also share the same chairman. FAF clearly took a page out of FNF’s book. Despite the peculiar arrangement, operations do not appear to be suffering.
Both companies are primarily title insurance but also have some specialty insurance business, mainly home warranties and homeowner’s insurance. Compared to the title insurance business for both companies, the specialty insurance business is small.
FAF and FNF do differ in certain ways. For instance, FNF is the largest provider of flood insurance through the U.S. National Flood Insurance Program. FNF actually assumes no risk of loss for these flood insurance policies. Instead, the U.S. government takes on 100% of the risk. FNF gets 30% of the premium for selling the insurance and 0.5% processing fee per claim processed. In addition, FNF’s investment philosophy allows for major investment in private businesses, such as a 33% interest in a private, $1.5 billion business and a 70% interest in a timber company.
FAF differs in that it also has major international operations. While being #2 in the U.S., FAF believes it is the largest provider of title insurance in the world outside of the U.S. In addition, FAF has some bank operations and invests customer deposits in commercial property-backed loans, primarily in Southern California. Finally, FAF’s investment portfolio appears to be much more conservative. There were no reported investments in private businesses and over 90% of the portfolio, excluding its investment in CLGX, is invested in fixed-income securities.
However, FAF’s balance sheet has a unique asset that should actually be considered separately when valuing the company. As part of the spin-off from its parent, FAF received an 11% ownership interest in the parent, CoreLogic. CoreLogic is publicly traded with the ticker symbol CLGX. FAF’s book value as of 12/31/10 is $1.98B. $240M of that is the investment in CLGX, which contributes in no way to the insurance business of FAF. In fact, as part of the spin-off, FAF has pledged to dispose of the shares within five years. So, in my opinion, it is appropriate to back out the $240M from the book value of FAF when calculating the multiple. In addition, the market price of FAF should include its 11% interest in CLGX. Therefore, the $1.68B market cap for FAF should include about $232M for the current value of the CLGX shares using prices as of 3/7/11. When you back out the value of those shares, it appears that the market is pricing the actual insurance operations at about $1.45B. Compare that to my calculated value of FAF’s insurance operations of $2.32B, and it appears that there is 60% upside from the current market price of the insurance operations. I have not separately valued CLGX, but I have looked at the business. It appears to generate a lot of cash while requiring relatively small capital expenditures. Given the industry it is tied to, its stock price is likely also suppressed. However, I have assumed no appreciation in the stock price of CLGX when determining an overall value for FAF.
FNF and FAF represent great investment opportunities at their current prices thanks to the years-long housing slump and uncertainty over a recovery in the housing market. I value FNF at $20.83 and FAF at $24.55. While I do not expect an immediate jump in the stock price to my valuation, I do expect good news about the overall economy and the housing market in particular to serve as a catalyst for these two stocks. I am content to buy now and wait for those catalysts to occur.
Disclosure: I am long FAF, FNF.