Everest Re Group, Ltd (RE) combines a strong historical record of shareholder value creation with bargain basement multiples. After increasing book value per share at 12.19% annualized from 1995 to 2010, the company trades at a P/B ratio of 0.82. and a forward P/E of 8.68. Investors who can stay focused on the process of value creation will reap ample rewards on Everest Re.
The Value Creation Proposition
From the 2010 Annual Report: (Click to enlarge)
Reinsurance is coverage that insurance companies take out to protect themselves from catastrophe losses. While the business is generally profitable, results can be uneven. For the first quarter of 2011, RE experienced losses of $9.77 per share due to the disasters in Japan, New Zealand and Australia.
Sine the financial crisis, reinsurers have been trading at a discount to book value, perhaps because investors have become more sensitive to fat tail risk. As a practical matter, if the industry goes a long time without serious catastrophes, premium rates go down. After catastrophe losses become serious enough, premium rates rise to levels that are very profitable going forward. It's a cycle.
Based on results over the past 15 years, RE has been successful in dealing with this aspect of the business.
From the 10-K: (Click to enlarge)
For insurance companies that have volatile operating results, it's important that investments be conservative in nature. Otherwise, the potential of taking a hit on both sides of the balance sheet at once creates an unstable risk profile. RE's investment portfolio is sufficiently conservative to comply with this requirement.
Financial Strength Ratings
The operating subsidiaries (where rated) carry Financial Strength ratings of A+ (Superior) from A.M. Best, A+ (Strong) from S&P, and Aa3 (Excellent) from Moody's. The company's Senior Debt is rated A- (Strong) by S&P, while Trust Preferred Securities and Long Term Notes are rated BBB (Adequate). All are considered investment grade.
From the 2010 Annual Report, Letter to Shareholders:
The breadth and quality of our underwriting portfolio coupled with strong investment returns provided net income of more than $600 million during the year, even after absorbing $445 million of net after-tax catastrophe losses. With current soft market conditions leaving little room to deploy this capital, we opportunistically repurchased almost $400 million of our shares at a significant discount to book value, as our stock and the overall industry remained out of favor with the investment community. These share repurchases, which we believe to be a very effective and efficient use of capital, represented 9% of the Company’s outstanding shares. Together with dividends, we returned more to our shareholders during the year while still providing for growth in our capital base to $6.3 billion.
This removes several potential reservations. Insurance company management over the years has not been able to handle prosperity. If the company made money, it would then squander it by cutting the heart out of the rate and trying to gain market share. In almost any industry, there is the danger that management will do buybacks at inflated prices, destroying shareholder value while artificially pumping up the stock.
In this case, CEO Joseph Taranto spells it out: The company will maintain underwriting and pricing discipline, and if it can't deploy capital in the business profitably, it will return it to shareholders, effectively and efficiently, with an eye on book value.
As Taranto says, the stock and the industry are out of favor with the investment community. For an investor who takes a long term view, this is as much an opportunity as it is a problem. If the stock remains undervalued, management will create value by buying back the shares at prices below book.
Book value stood at 109.07 as of March 31. Assuming it increases at 10% for the next two years (below the long term average), it would be 131.97 at the end of that period. Applying a 10-year average P/B of 1.04, a mid-range target would be 137 within two years. From a recent share price in the $90 area, that would return 23% annualized, to which one could add the dividend, currently 2.13%.
Strategy and tactics
At today's prices, an investor has a realistic expectation of receiving 2% dividend income and eventual share price appreciation, totaling somewhere between 13% and 25% annualized. This outcome would require that management maintain performance equal to the 15-year period cited, and that valuation multiples revert to the norm. Patience is required, and position size could be held on the small side, with an eye on the fat tail risk.
Implied volatility checks in at 19.76%, with beta at 0.5. The stock is optionable, no LEAPS. Deep in the money calls are relatively inexpensive and can be used as a substitute for share ownership. The options are thinly traded and the spreads are wide, particularly for deep in the money calls.
The following vertical call spread makes sense to me. It's presented with the static and best case outcomes: (Click to enlarge)
Options strategies are frequently presented in terms of the possible outcomes at expiration. As a practical matter, a longer term position may be regarded as an opening gambit, subject to adjustments as the situation develops over time.
My strategy in this case involves using the options as a substitute for share ownership, in the context of an opinion that the most likely outcome is along the lines discussed earlier in the article under valuation. With that in mind, I plan to roll both legs of the spread up, down, or out as long as the shares remain below target. The rule of thumb is, to adjust in ways that make me a net seller of time premium, or in ways that increase the internal rate of return to expiration.
Disclosure: I am long RE.
Additional disclosure: Long a RE vertical call spread, Oct. 75/95