Two Good Questions About Investment Ideas And Process

My last post, On Investment Ideas, Redux, received two good questions.  Here they are, with my answers:

Two Good Questions About Investment Ideas And Process

When using your quantitative factors, do your normally compare an investment idea relative to its sector, industry, or a custom comp group? I have dabbled in quantitative factor models in the past, and normally I start with an index, group by sector, and then compare each company relative to its sector (I use valuation metrics, liquidity, technical factors such as relative strength and price relative to moving averages, earnings volatility, earnings estimates revisions, balance sheet metrics, beta, and a proprietary risk/reward metric). How do you go about making the data relevant?

I try to look at what is overplayed and underplayed among factors and industries, and adjust my weightings accordingly.  I look for companies that add to economic value relative to price  I look for companies that may benefit from an industry turnaround or a corporate turnaround.  I look for pricing power, and how that is changing.

My industry and factor models are not integrated.  I use industries as a screen, but I look for value via valuations and factors.  Consult my eight rules for more on this.

I make the data relevant by letting my scoring model highlight promising ideas, and then killing those that are qualitatively bad ideas.

The second question:

Do you think the insurance company meme, while historically profitable, has now been over-exposed by yourself, American International Group Inc (NYSE:AIG), Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B), etc?

Seems like the barriers to entry throughout the financial industry have collapsed (dis-intermediation by whatever name), and the trade looks pretty crowded. Every industrial concern has a financial arm as widely reported.

I have noticed a lot of de-mutualization of insurance companies, a lot of M&A / consolidation activity, and obviously asset management (new competitors) has grown all over the place. The financial sector (as a percent of the S&P) is back near all time highs.

Is the insurance meme now a crowded trade?

There have been others talking about this idea long before me, notably Tom Gaynor of Markel, a few of the CEOs in Bermuda, Eddy Elfenbein, etc.  There are significant barriers to entry on this trade:

  1. Insurance is not a fast growth industry.  As such, many investors ignore it.
  2. Insurance is not sexy.  Few buy insurance companies as a result.
  3. Insurance is the most complex industry from an accounting standpoint, if you exclude investment banks.  Few follow it in detail.
  4. Insurance profits are volatile in the short-run, but consistent in the long-run, for conservatively run insurers.  People get scared out of insurance stocks from the volatility.

Demutualization is a plus for the publicly traded insurance industry, because it makes the more industry more economic.  That said, there are few large mutuals likely to demutualize anytime soon.  They know that they have got it good.  Good pay. Little oversight.  Why change a good thing?

I would look at it this way.  Since capital easily flows into insurers, be skeptical when insurers with short liabilities have price-to-book over 1.5x.  For life insurers, and those with long liabilities, get skeptical when the price-to-book is over 2.0x.

We’re not there yet, but we are getting closer.  My exposure to the insurance industry is still significant, but well below my peak, where buying discounted insurance shares was easy money, and with far less risk than buying banks.  Banks were the better choice in this scenario, but insurers would have made it through uglier scenarios.  Less leverage and credit risk.

I have not always been a fan of insurance stocks.  In the 90s, I never owned them, because many took too much risk in investing.  Today, those bad old days are gone, and underwriting is designed to make a profit, on average.  And in an environment where many stock valuations are stretched, the valuations of insurers are reasonable.  The only question is whether capital levels are so high that competition on premium levels will be brutal.

My view is this: it will be difficult for the general public, and even institutional investors to warm up to insurance stocks to the degree that they make relative valuations unreasonable.  But if they do, I will be gone.  Somebody give me a spank on the seat if we get another era like the mid-2000s where insurers trade well above their book value, some above 2.0x, and I don’t sell.

I failed to sell as much as I should in 2007.  This time, I will be more measured.  As for now, my overweight on insurers is still a reasonable and likely profitable trade.  But as valuations go up, I will lighten the boat.

By David Merkel, CFA of alephblog



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.