It's been a number of months since the beginning of the attempted acquisition of Aspen Insurance (NYSE:AHL) by Endurance Specialty Holdings (NYSE:ENH). I have been investing in both companies for over 5 years, although I used the price run-up in AHL as a chance to liquidate my holdings. Subsequently I have been selling out-of-the-money naked puts on both companies in order to re-acquire shares at a lower price. Below, I will elaborate on where the valuations of each company currently stand. I previously wrote about the takeover attempt shortly after it was announced here (for SA Pro readers), and I have written more generally about investing in reinsurance companies using put options here.
On July 25, 2014 it was announced that Aspen's shareholders had rejected the bid of $49.50 from Endurance in a formal vote. Some of the takeover premium was instantly deflated from Aspen stock, resulting in a 3% drop. What I think the market missed, was a fantastic quarter that was just announced the day before. Perhaps even more interesting is that Endurance stock also dropped 1.5% on the same day as the announcement. It is interesting to me, because Endurance was attempting to vastly overpay for Aspen, and the ENH shareholders should have been rejoicing that it fell through.
Comparison of valuation of both companies:
First, a brief summary of valuation methods that I use. I rely on fully diluted book value as the primary metric. Book value is only reported with quarterly earnings, so becomes a little fuzzier toward the end of a quarter, although recent run-rates of book value increases have been 2 to 5% sequential, in the absence of any major catastrophes, so one can extrapolate and not be too far off the mark.
Diluted book value (06/30/2014): $44.84
Current stock price (07/26/2014): $42.42
Price to book: 94.6%
Endurance's takeover bid: $49.50 (rejected by Aspen Shareholders)
Endurance bid to book value: 110.3%
Premium of Endurance bid to current Aspen book value: 15.7%
Diluted book value (03/30/2014): $57.53
Current stock price (07/26/2014): $54.00
Price to book: 93.9% (see note below)
Note that Endurance does not report earnings until August 5, 2014 so the book value is stale (from end of Q1). If their performance were similar to Aspen in Q2, one could extrapolate about a 5% quarter-over-quarter increase in book value which would create a more favorable price to book of 88.9%, if in fact that result materializes.
In terms of the pricing of the bid, it is a substantial premium to most companies in this sector (at a price to book of 110.3%), and seems strange to me since Aspen has historically lagged the sector on that metric. Even more strange is that Aspen shareholders did not leap at the chance to claim that valuation.
Another interesting point is from the merger arbitrage standpoint, since Aspen's price never got to higher than $47.16 on an intraday basis since the takeover attempt (bid at $49.50 cash and shares) by Endurance. It was on that basis that I never thought the takeover would materialize, and indeed I liquidated my entire position in Aspen on that thesis. In the past week I have written naked put positions at $40 strike in order to reacquire a position if shares descend below that price, meanwhile I will be somewhat on the sidelines.
Generally, what's bad for the acquirer indicates they were attempting to overpay, which makes it good for the target company shareholders. And for that reason, I think Aspen shareholders made a mistake of declining the offer of $49.50. The run-rate of QOQ book value increases has been about 3-4% the past few years, so a 15.3% premium could take up to 5 quarters to recoup on an earnings basis (and even that assumes no major catastrophes or investment bond portfolio snafus). In a yield-starved world, that kind of return doesn't come along as a lump sum very often. True, if someone cashed out of Aspen after a takeover then that lump sum has to be reinvested somewhere - but to me that is a good problem to have.
Why I don't use combined ratio as much anymore
I don't rely on combined ratio as much as I used to because most of these companies have a mix of insurance and reinsurance that varies over time (and have different risk profiles in terms of tail risk). I have found that using the combined ratio metric does not improve investment performance, probably because these companies are underwriting in a competitively-priced marketplace. Using a backward-looking combined ratio as a proxy for underwriting skill just doesn't make sense to me.
I have heard the argument that some companies consistently outperform on an underwriting basis (in fact, Warren Buffett is whom I have heard this the most from). It starts sounding like the old indexing versus active management debate - can some portfolio managers consistently outperform the broad market? And can some underwriters consistently outperform the broader market of very competitively-priced underwriting? Probably so, and I have no idea who those individuals are and what company they work for, and whether they'll still be at said company the day after I decide to invest.
As much as Warren Buffett may like to tout his underwriters and their consistent skill, he also uses price to book as a primary valuation metric in terms of setting share buy-back prices or in highlighting the growth of Berkshire Hathaway over time.
Rather than buying shares outright, I have chosen to write out of the money naked put contracts on AHL and ENH. This allows me to stand aside while the discussion of acquisition takes place, and gets me back into a position only if the price declines below the strike price ($40 for AHL, and $50 for ENH). What I like about writing puts is that someone else takes the first-dollar loss (analogous to an insurance deductible) and I only buy if the decline is larger than a set magnitude.
Risks to this conclusion
One risk is of major catastrophe losses, especially as we enter peak hurricane season in the North Atlantic. Other property catastrophe risks are even less predictable in their timing. This could put capital at risk in both companies and such is the nature of investing in this space. I believe that risk helps favor companies trading below book value, as any premium above book value tends to evaporate if the industry is put under major capital stress (especially if new stock issuance were predicted, although such magnitudes of loss are rare).
I am also concerned about the risk of Endurance either raising the bid further or moving on to acquire a second-choice company. Most other companies in the space trade at a higher price to book than Aspen and would need even higher takeover premium to peel shares out of the hands of shareholders, as Aspen shareholders just demonstrated.
If your decide to write out of the money put options on these shares, keep in mind that doing so on margin can entail a large risk so make sure you are comfortable with that. These companies can be volatile due to sporadic major losses, and put option premiums often do not reflect the potential increase in volatility.
Good luck in your investing!
Disclosure: The author is long AHL, ENH. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: My exposure is via short puts for an equivalent net long exposure. I also am long other companies in the sector including VR and MHLD.