4 Things I Just Don't Get

1) Liberty Mutual buys Safeco? Pays 1.75x book, and 11x estimated earnings? Mutual companies have limited access to the credit markets, and have no equity to pay with, so it is mainly a cash deal. They must have had a lot of cash lying around — might we wonder why they might not have enhanced policyholder dividends instead? This is not an economic use of capital in my opinion. Kudos to those who owned Safeco — it was cheap, though in the negative part of the underwriting cycle.

I know this diversifies Liberty Mutual geographically and from a line of business standpoint, but I don’t expect there are a lot of costs to take out here. Intellectually, it is harder to grow organically, but at this point in the underwriting cycle, it is definitely preferred to acquisitions. There are no equity investors in Liberty Mutual, but I would not lend them money on a trust preferred or a surplus note at present. There are better places to put money at interest — remember, acquirers usually underperform.

But for those with a RM subscription, check out Cramer. Off of Safeco, he likes Chubb. Okay, I like Chubb too. Great company, and cheap. I prefer Allstate, HCC, or Safety, and if I wanted to speculate, maybe Affirmative. Lots of cheap P&C names out there, but it is the wrong side of the underwriting cycle — premiums falling, losses coming in unabated.

2) I don’t get fundamental weighting on bonds. With bonds, the best one can do is get paid interest and principal, if one is buy-and-hold. With stocks, a buy-and hold investor can do better in the long run by buying better earnings streams (value), rather than accepting market value weightings. With bonds, there is no such upside, so I don’t get the fundamental weighting, except perhaps in foreign currency denominated bonds, and using purchasing power parity, which is still a weak tool. I wouldn’t go there.

3) I don’t get Bill Miller. I’m a value investor. I like companies that trade at modest multiples of book and earnings. I agree in principle with the concept of deferred performance that he mentioned in his quarterly letter:

My friend Jeremy Hosking, who has delivered around 400 basis points per year of excess return over two decades at Marathon (in London), corrected me recently when I spoke about our underperformance. “You mean, your deferred outperformance,” he said. I thought it a clever line, but it contains an important point. For investors who are trend followers, or theme driven, or who primarily build portfolios around forecasts, or who employ momentum strategies, price is dispositive. When they do badly, it is because prices moved in a direction different from what they thought. For value investors, price is one thing, and value is another. When prices move against us, it usually means that the gap between price and value is growing, and our future expected rates of return are higher.

With stable, cheap businesses, this definitely applies, but as you step out onto the growth spectrum, it no longer applies. Check out the beginning of the letter, he is only 41 basis points ahead of the S&P 500 on a ten-year basis. At this rate next year, he might be behind the S&P over ten years. Quite a flameout for one who was so lionized. Could he be fired? Yes, but not by Chip Mason. They are too close. If one succeeds unconventionally, there is less tolerance for failure, because they weren’t sure why it worked in the first place.

4) I’ll take the opposite side of this trade. Financial literacy is a good thing, and most people would be better off knowing more about finances, so long as they can mix it with humility. I’m a professional, and I think humility is a key virtue in handling money. As I say in my disclaimer:

David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent “due diligence” on any idea that he talks about, because he could be wrong. Nothing written here, or in my writings at RealMoney is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, “The markets always find a new way to make a fool out of you,” and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves.

People who are educated will still make mistakes with their money, but they will make fewer mistakes on net. Hey, I’ve paid market tuition, and it is painful. But boy, I learned a lot, and I don’t repeat mistakes often. (Repeating mistakes sometimes is bad enough… )

Full disclosure: long SAFT (not SAF)

Comments

[JeffW:]

I also own SAFT, but not because I think they are much of a company. In fact, their business is based on Massachusetts private passenger auto- they are really not good at anything else. With the recent semi-deregulation in Massachusetts, I think they are a take-over candidate (see Commerce)- and meanwhile you get a decent dividend.

2008 Apr 24 09:18 AM

[NO DooDahs:]

Insurance companies which have thrived by suckling at the teat of anti-competitive state regulation - like SAFT - can be very dangerous plays when the state opens somewhat to competition. You're basically making a bet that either (1) another company wants to enter the state through buying renewal rights, or (2) that the company, which is typically inbred and used to the status quo, has enough flexibility to respond to the changes and leverage their market share. I don't think either of those are good bets, but go ahead and play Lotto if you want to. Nobody's gonna buy a company like that for their "systems" or "market knowledge" because the market has changed and the systems are geared towards the OLD way of doing things.

Take a look at Seibels Bruce Group and the South Carolina auto insurance reform as an example of what can happen.

2008 Apr 24 09:47 AM

[Matt Blackman:]

One thing I don't get and that is value investing. You guys buy stuff on the way down because as it falls, it gets cheaper. Great if there is a turnaround in the near-term but if not, (can you say Enron, and more recently Bear Stearns?) you lose your shirt.

Traders call that trying to catch a falling knife for good reason. My research shows that the fundamentals lag price action by anywhere from 3 - 9 months so waiting for a fundamental signal to exit is a dangerous practice from where I sit (you reading this Cramer?).

Now combine the principles of value and employing the right fundamentals with an ability to read a chart... now you're talking!

2008 Apr 24 01:11 PM

[Jumboloans:]

Economic use of Capital???? you know not what you speaketh? How can you analyze a public co the same way as non-public mutual that doesn;t have "shareholders" but stakeholders with different agendas? So don't try to. Obviously they are overcapitalized, and giving out policyholder dividends kisses off funds forever. Why?? To understand the "interests of people in charge of mutual, you would have to discuss directors (you don;t), cross ownership holdings (often other local banks, insurers), likelihood of future demutualization (rationale of directors, potential beneficiaries among management and wall street I banks). Come on stop with your "5 quick ideas" every day, and back something up with analysis.

2008 Apr 28 07:48 PM