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:
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.