Risk/Reward Analysis Makes Financial Insurers a Buy

In my last article I said that financial insurers could very well be the subject for another piece about financial conundrums. In fact, the conundrum here is very well explained by the unfair behavior of some folks who were shorting those securities, helped by the usual behavior of the mainstream media (a megaphone for the strongest screaming at any given time).

Since then, there have been some excellent pieces, which have done a very good job restoring the truth and exposing the bad faith of some market actors and the lunacy of the rest. As I could not do better and as I hate to waste words (there are already tons of vain words in every field of our life), I refer to them:

• Steve Lukather
• Tom Brown
• Tom Armistead

I’ll limit myself to add a different perspective, which is to point to the compelling opportunity to pick up these businesses at their current price, resorting again to plain, cool, cold numbers. These companies, MBIA (MBI), Ambac (ABK) and Radian (RDN), have been producing free cash in past years as they were linked to the US Federal Reserve. In the past ten years through 2007, RDN has delivered $4.575 of average annual FCF to shareholders, MBI has minted cash at an average of $5.39 every year and ABK has done even better: $7.154 every year on average, a figure equaling almost two times its current stock price. In the 2007 fiscal year, RDN has produced cash of $3.71 per share, MBI $8.09 and ABK $9.3. Impressive, isn’t it?

Sure, I know your objection: those were just the good old times, the party’s over now, you can forget about that free cash. Well in fact, ABK and MBI have delivered free cash even in the first half of this year, $0.4 and $1.84 respectively; just RDN has burned $2.3 of cash in that period. Not the end of the world, admittedly. Of course, in the coming years it is very well possible that they will lose cash, but I don’t think these (eventual) cash losses will be of the magnitude necessary to justify their current beaten down stock prices; in fact, a strong case could be made that actual defaults on the securities they insure will be much less than everybody seems to assume now. Moreover, the actual defaults will be paid over a long period.

The case to buy MBI, ABK and RDN isn't only about free cash flow. Apart from book value ($6.76 for ABK, $16.67 for MBI and $30.54 for RDN, but you can adjust here and the numbers are even better), and even considering a mere run-off scenario, for every share you buy of ABK you get $59.76 worth of its investments pool, $81.26 per share if you buy RDN and a whopping $159.64 per share if you choose MBI. A very conservative 4% annual return on those investments would mean $2.39 per share for ABK, $3.25 for RDN and $6.38 for MBI, per year. Again, I invite you to check their current stock price one more time.

In short, my friends, here you have the opportunity to make a bet risking 1 to get 4-5 times what you risk, and with very good risk/reward on your side - better than 75% in my humble opinion. No bookmaker would give you such a deal but Mr. Market, with its schizophrenic problems, has done just that. In fact, it’s possible to build a scheme to limit your loss to 25-30% of that 1 if things turn out for the worst. I’m working over this, there are other stocks in different sectors which present the same opportunity, and I hope to present a concrete action to readers in a few weeks.

You can play it even safer with Old Republic (ORI). This insurance company is not a pure play, as only part of its business deals with financial insurance, so it offers a cushion and a good discount at the same time. It’s a cash machine: $2.73 average annual free cash flow in the last ten years through 2007, $3.68 in 2007 and $1.43 in the first half of 2008. You can buy a share for a little more than $10 today and get $17.59 of (not adjusted) book value and $37.67 of its investments pool. It yields just shy of 7% and it has been around for a century; my guess is it will still be around a long time from now.

P.S. - To address the current and future financial crisis, a very good start would be to dismantle rating agencies and their hateful, nefarious legal monopoly. They are really a joke!

Disclosure: no personal position (yet); RDN and ORI are picks in my model portfolio.

Comments

[Jimmy Lathrop:]

Lets use a hypothetical - if we assume that most, if not all, of these companies income derived from insuring Mortgage Backed Securities, and hypothetically speaking, if the market lost their taste for MBS, or, if Congress woke up and saw that they were too dangerous by generating income at the expense of the underlying homeowners mortgages, would that change your opinion of these stocks?

Or how about this - lets say the shareholders of junior tranches brought a shareholder's derivative lawsuit against a trustee of a mortgage backed pool, and the trustee turned to the insurer to pay out on its obligation and the insurer refused. Or lets assume that they did pay out but that started a run on the insurers - would that change your opinion of these companies stock?

It's not enough that you promote the upside of these companies. A balanced article would disclose the downsides as well.

2008 Aug 25 07:46 AM

[Ishortyou:]

You can assume whatever you want but the balance between the pros and cons will speak for itself, thats reflected on their book value.

2008 Aug 25 08:20 AM

[Shorts.Distort:]

Finally, finally, finally.
I was beginning to worry...Lately we have not be hearing "The Long and Short of it"...
Longs have gotten the 'Short' end of the stick in Market Analysis flooded with constant negative jargon.
Slowly words of upbeat commentary are starting to emerge...
FINALLY!!

2008 Aug 25 08:32 AM

[Shyam Maniyar:]

I agree with the analysis and have personally took some positions in these stocks alongwith PMI. Check out my post on similar topic at:

smaniyar.blogspot.com/...

2008 Aug 25 01:27 PM

[Tom Armistead:]

Good article, I am long ABK and MBI based on the same type of thinking, and I am starting to believe that the chance of a zero outcome is zero.

I had forgotten ORI, I owned it a few years ago with good results, I will have to check it out again.

2008 Aug 25 04:21 PM

[lou hannen:]

Free cash flow is a largely meaningless term for an insurance company. They write insurance and collect CASH long before LOSSES cost cash. The bad business written in the last few years will be costing cash for the next 3-10 years. The real key is book value, but the stated book has to be doctored to reflect the losses expected to be incurred which have not yet been reserved. That said, I own toe dipping quantities of 4 of these dogs.

2008 Aug 26 02:46 PM

[Castrese Ti...:]

Yeah, sure! Who needs cash?

Going back ten years ando more, almost every insurance company has delivered tons of free cash, EVERY YEAR, with high and low of course, but never presented a cash loss. That time span includes catastrophes like 9/11 and 2005 hurricane season. Some others have had cash burned one or two years, but still a little part of what they delivered before and after those years.

I don't think it will be that much different for financial insurers. They will probably burn some cash in the next few years, but their current stock prices more than discount those losses, which moreover I expect to be much less than it's currently assumed.

By the rest, there's no better contrary move than going the other side of what the rating clowns say.

2008 Aug 27 06:43 AM

[dhart:]

My comment is for Tom. From what I understand about insolvency as it relates to the insurers, they would need to present a plan to Dinallo about how they are addressing the situation. Meanwhile, they will still be earning a lot from their embedded book of business correct? In other words, say they have more liabilities than assets by 300 million....this could reverse very easily could it not? Not sure what the procedures are but as long as they can weather the storm, this seems like a no brainer. Thank You!

I own ambac

2008 Aug 27 02:25 PM

[Tom Armistead:]

Ambac is domiciled in Wisconsin and would fall under the supervision of Commissioner Sean Delwig if it became insolvent. Insurance has its own accounting system, the so-called statutory accounting, which does not consider mark to market losses. Ambac is strongly capitalized by statutory standards and Delwig has said as much publicly.

As of 6/30, Ambac's statutory Surplus as regards policyholders was 3.45 billion: adding the Contingency reserve of 3.26 billion, Qualified Statutory capital stood at 6.71 billion compared to GAAP shareholders equity of 1.9 billion. Delwig would look at statutory figures rather than GAAP.

So, even if Ambac's GAAP shareholders equity were for example negative 300 million, which many would consider to be insolvency, from a statutory point of view they would still be OK.

I think the danger of statutory insolvency is extremely remote.


On Aug 27 02:25 PM dhart wrote:

> My comment is for Tom. From what I understand about insolvency as
> it relates to the insurers, they would need to present a plan to
> Dinallo about how they are addressing the situation. Meanwhile, they
> will still be earning a lot from their embedded book of business
> correct? In other words, say they have more liabilities than assets
> by 300 million....this could reverse very easily could it not? Not
> sure what the procedures are but as long as they can weather the
> storm, this seems like a no brainer. Thank You!
>
> I own ambac

2008 Aug 27 06:48 PM

[MistaWhite:]

I own ABK calls, and was up 133% today on them (in 1 day). I sold half the position, and kept the paper profits in the there for future upside.

2008 Aug 28 08:33 PM