Transcription
So today we're going to be talking about one of the most exciting topics known to mankind, and that is insurance companies. Now, the reason I want to talk about insurance companies is because, one, I feel like no one else ever really talks about insurance companies unless you're talking about one that is about to go bankrupt or one that's about to collapse the entire world economy. And two, because I feel it's an area of the market that can be pretty easily misunderstood. So my goal of this video is to get you guys more informed on how you can analyze insurance companies and, more specifically, how you can understand why an insurance company is valued the way it is. We're going to be looking at Fairfax Financial as kind of a case study on what not to do as an insurance company, but at the same time, what can make an insurance company pretty unique from an investment standpoint.
So I'm going to try to keep this video relatively short and to the point. It's probably not going to be the most entertaining video that you're going to find on YouTube today, but I promise you, if you stick around until the end, you will learn something new. So without further ado, let's just dive right in.
So within the overall insurance sector, there's different types of insurance companies: you have property and casualty, you have life insurance, reinsurance, and then the larger, more diversified insurance companies. And since we're using Fairfax as our example here, we're going to be focusing on P&C insurers. That's Fairfax; it's a Canadian-based P&C insurer, but really the points that I make throughout this video are applicable to all types of insurance companies.
So the easiest way to think about insurance companies is really two distinct operations: one is the actual underwriting of insurance policies, or in other words, deciding who to extend insurance coverage to based on analysis of the risk of that client. And then the other one would be investing the premiums that you receive from extending insurance coverage, which is commonly called the float. So throughout this video, whenever you hear me use the term "investing the float," I'm referring to basically how the insurance company decides to invest the money that they receive, because that's really how they make a lot of their money. It's, you know, getting the money from their policyholders and then investing it wisely before they have to pay out claims to those policyholders in the future.
So, and by the way, if you're wondering what website that I'm using here, it's a website called tickernomics.com. It's the website that I created myself, which is currently free to use, and I'll leave a link in the description of this video in case any of you guys watching want to give it a try. And what I'm using here is the custom tables feature. So this allows you to basically just enter a ticker symbol here, and then you can also enter what metrics you want to compare here. So here I have the market cap, price-to-book ratio, return on equity, and then this one here is year-over-year revenue growth. So I will add Fairfax to this list so we can see how they how they stack up to some comparable companies, like you can see Markel is here, Intact Financial is also here as well.
One key valuation multiple that you really care about with insurance companies is the price-to-book ratio. And really, when people are analyzing insurance companies, what they want to know is what rate has book value per share compounded over a given time, and then, of course, what is it going to do in the future. And companies that have proven their ability to compound book value per share are going to be awarded with a higher price-to-book ratio. And there are many different ways that you can see that happening. And just to kind of demonstrate this relationship a bit, I want to show you—this is a scatter plot, and this basically maps what we have down here, which is the five-year book value per share compound annual growth rate versus the price-to-book ratio. And it's not a perfect one-to-one relationship, but you can generally see that companies that have been historically growing their book value per share higher in the past have a higher price-to-book value ratio. But again, there's a lot more that goes into this; it's not just simply looking at the past and then taking that, extrapolating it into the future. It's really understanding the context of the individual insurance company.
Okay, so here what I have on screen now is a list of factors that can influence the valuation of different insurance companies, and you can see that some of these factors are both financial numbers-based type factors, and then some of them are qualitative and more subjective type of factors. So what I want to do now is go through each of these. So number one is cost efficiency, or really this is just cost advantages. So this can be in the form of low expenses, which companies can achieve maybe because they make better use of technology, so they're more efficient, or maybe they're just better at retaining their employees, so they don't have to invest as much money into constantly retraining new employees. And what you're going to see is this is going to flow through into a high return on equity because companies are going to be more profitable; they're going to have higher net income relative to their book value, which is essentially what return on equity is. And then just to illustrate this relationship a bit, what I have done here is another scatter plot that maps, again for property and casualty insurance companies, the return on equity down here versus the price-to-book ratio here. And generally we can see it is a positive relationship where companies that have a higher return on equity are going to be awarded with a higher price-to-book ratio, meaning investors are, you know, just value the company's assets more greatly versus other companies. But this doesn't explain the whole thing, right, because even within here there are a few outliers, for example, the ones that are kind of down here, the companies that have high return on equity but relatively low price-to-book ratio. So it doesn't explain everything, so we'll go back to our list here.
Number two, which is a more qualitative type of one, and that is brand recognition and customer loyalty. So this is one that you won't really see flow through into the numbers, right, but it can provide benefits to a company, like them being able to retain their customers, good customer loyalty, maybe they have good customer service, or maybe they don't have to spend as much on marketing expenses because they just have strong brand loyalty and they naturally attract customers, or maybe it's not that, maybe it's something like just the longevity of the business, the fact that they've been doing this for a long time, they have robust risk management processes in place, you know, various things like that, but it all kind of ties into the same idea. Now the next one is the financial stability of the company, so their risk profile. So you really have different types of insurance companies: you have large diversified insurance companies and then smaller insurance companies that really just focus on maybe one specific geographical region or one specific type of insurance. So if you compare a large diversified insurance company like, say, Berkshire Hathaway, for example, right, they provide many different types of insurance, you know, one specific disaster isn't going to impact them that much versus, say, you have a company that provides fire insurance in California, and there's wildfires in California; that's obviously going to hurt them quite a lot. So the fact that you have smaller companies exposed to just one type of risk, that means the larger companies are going to be assigned a premium. So it also means there's more opportunity if you're able to make smart investments in smaller insurance companies, which is also interesting.
But if we go back to our scatter plot here, the one that maps the book value per share, the five-year growth in book value per share to the price-to-book ratio, let's look at some of the outliers here. So this is kind of the ones here which have historically grown their book value per share pretty high, but they don't have a high price-to-book ratio. And what we'll see here is Markel's actually one of these companies, FFH, that's Fairfax, so they're also one of these companies, but the more extreme ones are the ones here. So, for example, this company WTM. So let's let's just look up this company and see what we find out about them. See, they're probably going to be a smaller company, right, because like I said, they're going to be exposed to just one type of area. So we can see they have a market cap here about 3.5 billion dollars. We go to the details tab, we can read about what this company actually does. So they provide—they basically have five segments, so there's five different segments here. Let's just quickly go through them. So this one, it provides insurance on municipal bonds issued to finance public purposes, so that's interesting. This one here writes a portfolio of reinsurance and insurance including property, marine, and energy. So what I'm starting to get with this company is these are very specific types of insurance, like this one here operates as managing general agent and program administrator for specialty property and casualty insurance. So this is pretty complex; I'm not going to go into everything, but we can see even though they have these five different segments, it's kind of focused, you know, it's very focused, right? It's not super diverse by the way, it's different types and all these different regions. For example, we can see they just operate in the United States here. So I think you kind of start to get the idea that insurance companies that are more focused, are more susceptible to individual risks, are going to have a slight discount to their valuation.
Now the last one, which is number four, is one I've called prudent management, and this is probably the most important one, and this one can take two forms mainly: one is management that is good at investing the float, so they're smart investors essentially. So you can argue Fairfax is here, maybe Markel is here, obviously Berkshire Hathaway would be in here too, but it's basically just management's proven track record of investing the float wisely and earning outsized returns for several years. Not all insurance companies are able to do that, and that's what makes them unique, right? Every insurance company is going to take a different approach to how they manage their float, how they invest it, you know, do they invest and are they more opportunistic, for example, do they take risks, do they like to try and time the market and make smart investments, do they invest more of their float into equities and, you know, private companies versus say a more safe approach like what you would see with Allstate or State Farm where they really just invest in safe, highly liquid investments like U.S. treasuries and they place more of their focus on their actual underwriting than being consistently profitable through their underwriting. And that's the other one, right, which is, you know, companies that focus more on the underwriting and staying profitable through the ups and downs of the insurance cycle, you know, both types, both, you know, if management has proven a specific acumen in either of those can lead to a valuation premium for a given insurance company. But if you were to ask which one is more important, is it better to have good underwriters or better to have good investors, the answer is undoubtedly good underwriters. And the reason is because good underwriting is much harder to fake than good investing, because if you have an advantage on the investing front as an insurance company, maybe you can just look good for a period of 5, 10, 15 years as management happens to make some smart investments, but if they eventually get too confident and they make one bad investment, that can really destroy shareholder value. And that's really what we saw happen with Fairfax, which is what we'll get into later. But essentially, an advantage on the underwriting front is much harder to fake than an advantage on the investing float, so that's, you know, kind of how investors that are in this space view that.
And to explain this a bit further, I want to go back to our comps table here, and let's look at this column here, which is the price-to-book ratio for various P&C insurers. So the one that really stands out is Progressive, right, because they've appraised a book value of 4.5, which is significantly higher than all the other ones that we have on this list, which are all pretty comparable companies. And the return on equity isn't that much higher, right? It's about 11, which is kind of middle-of-the-pack; they are year-over-year revenue growth, which is this year, is also 11, again that's kind of middle-of-the-pack. So why is their price-to-book value so high? And actually, if we look up Progressive and we actually look at what their price-to-book value ratio has been over time, it's pretty interesting because what we're going to see is that it's expanded over time, so I'll just open up the price-to-book value ratio here, so we can see pretty much over the last 12 years that their price-to-book value ratio has expanded over time; it's gotten higher and higher as they've proven to investors that they have an acumen in having consistently profitable underwriting operations, which is something in the insurance space that clearly investors value very much.
So hopefully that all helps you start to make sense of insurance companies. Now, one additional point that I want to make is about analyzing the historical results of insurance companies because normally to understand a company and how fast the company is growing, you would look at something like historical sales growth, right, to see what sales growth has been in the past, maybe that indicates what it will be going into the future. But insurance is probably the only business out there where if you see very fast top-line growth, it's actually more of a cause for concern as opposed to a positive thing. And that's because it can indicate careless underwriting. And case in point here is another scatter plot that I made which maps the price-to-book ratios down here now versus the three-year revenue growth rate on a compounded basis. And again, it's kind of similar where you see companies that have been growing revenue faster have a higher price-to-book ratio, but there's a lot more outliers in this one; it's a lot more spread out; there's a lot of companies down here. And specifically, some of these companies at the extremes are far lower than some companies that have been growing their revenue at a slower rate. And the one that's kind of very extreme over here is LMND. So what company is that? Well, it's a company called Lemonade, and if you remember back into, you know, back when the stock market was crazy in 2021, this was one of the companies that had a pretty significant bull run. If we look at their chart, you know, we could see they went public around this time, they went up significantly, and then they've since come crashing down, and their revenue growth has been extremely strong recently, but it's not a company that has actually been able to turn profitable. So maybe people are starting to get worried about their underwriting practices and how reliable they actually are and if they'll actually end up being able to turn a profit at some point in the future, which for insurance, you know, that's obviously very important. And if they've, you know, had a lot of policies that they've written that are going to cost them quite a lot of money, investors don't like that, and they're going to be selling off. And then a similar concept would be, you know, that high return on equity that we talked about, right? High return on equity can also be a bad thing in some cases because it may indicate that the insurance company's being too conservative by not taking on enough risks, only writing policies to super low-risk clients that aren't going to cost them very much, so their profits are high, but they're not optimizing for the size of their float because there's other policies out there that could be writing if they just took on, you know, more risk, right? So it's kind of that balancing, right, risk and reward; it's pretty similar to the banking business model.
So what you now probably understand is that context always matters, and that's really why I like investing in insurance companies because there's always hidden value within companies. It's not a sector where you can just take numbers at face value and make broad-based assumptions about what they mean; you have to pull back the layers and actually understand what's happening, which makes it very difficult, right? But it also makes it so that there's opportunity in this sector if you're willing to diligently research.
Okay, so now as promised, we're going to jump into Fairfax. Now, normally with any company that you're analyzing, what you do to start is you look at historical financials, right? You look at past performance to get some idea of what future performance is going to look like, but for Fairfax, that can actually be a little misleading because over the past 10-plus years they've had a pretty rocky history. And basically what happened was leading up to the Great Financial Crisis of 2008, Fairfax was shorting the S&P 500. Now, what I have on screen here is actually from their 2005 letter to shareholders where they say what they're trying to do is protect our insurance company against a 150-to-1 in 100-year equity market meltdown by hedging approximately half of our equity position. So essentially, they're shorting the S&P 500 here. Now, needless to say, this investment actually turned out very well for them, right, because their book value in the year 2008, when, you know, the market crash actually happened, their book value actually grew by 30 percent, which is crazy for that time period, right? But after that, they tried to do it again, and they tried other types of macroeconomic type bets, and they just never really worked out. And basically, over the last 10 years they've lost quite a lot of money on what you could call ill-timed bets. And if we look at Fairfax's price-to-book ratio going back really the last 12 years, we can see it's pretty much perennially traded below book value. And the reason for that really is because investors probably have just developed a lack of trust in management because they kind of gained a track record of not really making smart investments over the past 10 years.
Now, normally when I look at a company on this channel, I try to actually do a valuation of this company because I think that provides a lot of value to, you know, people watching; they can learn how to value their own companies. But in the case of Fairfax, it's very difficult to do because there's just so many moving parts that include so many different assumptions that I don't really think it's useful for me to try and do that for, you know, the viewers watching this. So instead, what I'm going to try to do is touch on three different topics, three unique topics, all relating to Fairfax that I think will help you understand the company on a more fundamental level. So if you clicked this video hoping for me to tell you whether you should buy this stock or not, then I'm sorry to tell you, after you're around 20 minutes into the video, that I won't be doing that, but this part will help you better understand the business.
So the first thing I want to talk about is their count of shares outstanding. And what I have on screen here is another metric on my website which shows the change in shares outstanding on a year-over-year basis, updating every quarter for this company. So what we see in this chart here is it's very inconsistent, right? It seems like some years they're issuing shares, some years they're buying back shares. And like I said before, management is very opportunistic, and what they like to do is issue shares when they feel their stock is expensive and then buy back shares when they feel that their stock is cheap. So in this period here, this kind of 2015 to 2018 period, we could see they're issuing quite a lot of shares. And what they were doing during this time period is they made three major acquisitions in companies called Allied World, another insurance company called Brit, and then Your Life was another one. So all of which, all those companies are insurance companies, and all of which have been very successful for them; since they bought them, all those companies have, you know, had double-digit growth rates in their book value per share. So the basis of this strategy is to issue shares when the price-to-book value ratio for Fairfax is high, so you can make those acquisitions, buy high-quality businesses, and then in the future, once your priced-to-book value ratio goes down a bit, you buy back those shares, right? So you're really issuing them high and then buying back low, and you're creating value for your shareholders by doing that. And if we go back to their price-to-book value ratio in this time...
Period of 2015 to 2018. The Price to Book value ratio was kind of in the higher range, right? Versus when they were buying back their shares around here, it was much lower. So that's kind of, you know, how management starts to think about allocating capital and interval strategy there.
Now the next thing I want to touch on is their investment in Associates. So for this one, it's accounting lesson time. Now, and basically when you see this term, uh, investment in associate, it's an investment in another company that Fairfax has significant influence over. And this can mean they own 10% or greater of the voting shares, but they own less than 50 percent. Because if they own 50% or more, than they would, you know, be considered controlling ownership of that company; they would have to consolidate it. But this is a different accounting treatment where it's called investment Associates; it's accounted for in a completely different way. And it can be—they can obtain this, like I said, by having 10 percent or greater of the voting shares in the company—or it can be something more qualitative, like maybe they are able to elect some members of the board of directors for that company; maybe there's—they just influence the company because they're a large customer of that company. It can be things like that as well, but it can't be, you know, controlling ownership of the company; then it's, you know, something else.
So these Investments, they're not accounted for at their fair value, right? It uses a different approach that kind of combines, you know, their earnings and the dividends received from the underlying company. But what the key takeaway here is, is that there's hidden value in these because luckily they actually break out what the fair value is of their investment Associates, which is 7.1 billion, but the value on the balance sheet is about 6 billion. So there's about 1.1 billion dollars of, you know, hidden value, and that's going to influence how this company is valued because, you know, student investors are going to see that and say, you know, well, there's an additional value that this company has, you know, 1.1 billion dollars. So that's going to elevate their valuation a little bit. Now, like I said, there's plenty of other moving factors that go into it, but that's one thing that you have to be aware of for this company.
Now the last thing they want to point out is how they manage their bond portfolio, because this is another unique feature of Fairfax. And basically the bonds that they buy are very short-term in nature, whereas other insurance companies out there will typically buy a blend of short-term and long-term bonds. The long-term bonds typically will have higher yields, so buying long-term bonds is more profitable for insurance companies versus buying short terms. So Fairfax buys very, very short-term bonds. I believe the average yield to maturity on their bond portfolio is less than two years, so it's very short-term ones. Um, so there's different advantages and disadvantages of doing this. Now, for one, longer-term bonds are more sensitive to interest rate hikes, right? Because they lose more of their value if interest rates increase. Now you'll commonly hear the term something called reaching for yield, right? And this is really what led to Silicon Valley Bank collapsing was because they had a bunch of 10-year bonds that lost a lot of value and interest rates went up, and they were forced to sell them because their depositors started fleeing, which basically led to the collapse. So the benefit that you get by having shorter-term bonds is the bond portfolio can quickly turn over into newer higher-yielding bonds, which are much more profitable if interest rates do get hiked, right? So it's kind of this Balancing Act again where, you know, they're sacrificing profitability when interest rates are low for when interest rates finally go up; they don't have to take a large write-down on their bond portfolio because it doesn't lose a ton of value, and their Bonds mature in, you know, one to two years, and they can buy the higher-yielding short-term bonds, and, you know, it's more profitable for them in those years.
So what the actual effect of this ends up being—if we go back to there—this is their Q1 2023 financial statements, and we'll scroll down to their income statement and we'll look at this here, which is their investment income. So their investment income in Q1 22, 154 million dollars, but as of this past quarter, about 1.5 billion. So it went up about 10x, right? And that is massive, and that's a huge part of what you would need to understand if you're looking to invest in this company because they do this unique thing with their bond portfolio, which means you have to understand, okay, if interest rates go up, what's the impact then? Well, for Fairfax, it's a very positive impact, right? That's going to help them a lot, and you saw that reflected in their stock price. If we go back here for Fairfax, you know, they've done pretty well, uh, the past year since year to date as well; like it's been a very strong performer, and a big reason for that is because of this one unique feature they have. And every insurance company manages their portfolio differently, so you need to understand—you need to actually look at it and peel back the layers to understand, you know, what's that—that's going to lead to under, you know, different future scenarios.
So I hope at this point you kind of start to understand all the unique things that insurance companies do, and you can kind of appreciate how nuanced it is and how it's this one unique sector of the market that it kind of plays by its own rules, and you really have to be very diligent, and you can't just make, you know, investments in random insurance companies because you see that they have a high dividend yield. You have to actually understand Management's thinking and what they want to do. But anyways, guys, that pretty much does it for this video. So I hope you did enjoy it. If you did, then please leave a like, and if you're interested in more content on this, I'll leave a video up now where I looked at Canadian Insurance stocks in the past.