Financials as a portfolio hedge against rising rates?

[kab60]

Calling this "strategy" might be a bit more than just over-extending, but I was wondering whether you guys think financials would work somewhat as a portfolio hedge (other than just plain good value) against falling stock prices when rates rise (if ever). I'm really not into macro (or hedging for that matter), but it seems pretty ABC that rising rates hit equity markets, while it strengthens the earnings power at most financial companies where companies like BAC trade just a tad above tangible book value. A guy like Allan Mecham at Arlington Value Capital has a big BAC position, a big LUK position and even a some what meaningful Alleghany position (47 percent financials in total, which includes Interactive Brokers and Berkshire). There's a reason they call him Mr. 400 percent, but I don't think any of those stocks are about to double, so could it be a bit of portfolio hedging coupled with good value, or did I miss something? (I usually do)

 

I'm not sure how rising rates would effect LUK, but it should lift BAC's ROE while Alleghanys bonds should be hit in the short run, but they do have a pretty short duration (3-4 years I believe), so I guess midterm it would help Alleghany as well.

 

As an European investor there's also the currency risk, which might be mitigated a bit by the fact, that when rates rise, and equities fall, the dollar strengtens, but there might be more effects that work negatively as well.

[Jurgis]

Your thoughts look fine. Financials are imperfect hedge for rate rise.

 

I say "imperfect" because I think (unlike most people) that economies can deal with higher rates financially just fine. But it's unclear if they can deal with them psychologically. And if the stocks drop because of psychological bond rout due to rising rates, financials won't perform well during such event. They might recover fine, but other stocks might recover fine too. In other words, you might not lessen volatility by being in financials.

[merkhet]

The question at any given time for financials during a rising rate environment is whether investors will pay attention to what happens to existing assets or what happens to future earnings power.

 

Over time, they will probably do well.

[kab60]

The question at any given time for financials during a rising rate environment is whether investors will pay attention to what happens to existing assets or what happens to future earnings power.

 

Over time, they will probably do well.

Thanks for the replies, guys. Could you elaborate a bit merkhet? I think I follow (rising rates might get people to dump financials as well even though earning power increases), but I'm not sure.

[merkhet]

Bonds struck at a low coupon will revalue downward as rates increase. On the plus side, new bonds will have a higher coupon, so reinvestment is at a higher rate.

[Mephistopheles]

Bonds struck at a low coupon will revalue downward as rates increase. On the plus side, new bonds will have a higher coupon, so reinvestment is at a higher rate.

 

Wouldn't there be greater earnings immediately? Moynihan has said that a 100bps rise would mean $3.4ish billion increase to the bottom line.

[DavidVY]

I've been thinking this through.

 

My idea is to buy an insurance company that has large % of portfolio in short-term bonds and very little equity exposure. As interests rates rise, earnings will naturally rise.

[Guest Schwab711]

I've been thinking this through.

 

My idea is to buy an insurance company that has large % of portfolio in short-term bonds and very little equity exposure. As interests rates rise, earnings will naturally rise.

 

This hedge comes with catastrophe and company-specific underwriting risk (probably others but those seem like the big ones to me) but it's not a bad plan. Will the small increase in net interest income be enough to offset slowdowns in the rest of your portfolio? Or do you not care about a full hedge? Also, insurance companies generally trade at ~10x P/E vs the market at ~16x P/E. So even if you had a perfect hedge, the increase in earnings will be levered less then the decrease from the rest of your portfolio.

[abitofvalue]

If you are only looking to hedge against rising rates, why not go for the commercial mortgage REITs? Most of them (esp the pure play ones) are geared to increasing rates.  You'll even get a nice 5-8% div yield out of it while waiting for rates to increase.

[DavidVY]

@Schwab- I'd buy a trusted large-scale coast to coast insurance company (like Progressive PGR) that pays out 2.5% dividend and buys back 2.5% in shares per year (PE 10-12) and will issue special dividends if premiums volume are in excess of what they can handle. The dividend and share buy-back will establish a natural stock floor.

 

A full hedge is beyond my understanding or value-perception. I'll leave that for the big boys.

 

Me, I just want my portfolio pieces to compliment each other so earning and purchasing power stay intact.

High/low oil, high/ low inflation, interest rates up/down, US dollar up/down. Each section of your portfolio should address one or more of those items.

 

I do have a definite lean towards multinationals that have western based management operating in emerging markets. The most notable ones are inflation adjusted consumer company like Nestle, Diageo, Richemont, Pernod Richard and Tupperware.

 

^^ I only own one of the above because of opportunity cost BUT they are all dream team candidates @ right prices.

 

 

 

[Guest Schwab711]

@Schwab- I'd buy a trusted large-scale coast to coast insurance company (like Progressive PGR) that pays out 2.5% dividend and buys back 2.5% in shares per year (PE 10-12) and will issue special dividends if premiums volume are in excess of what they can handle. The dividend and share buy-back will establish a natural stock floor.

 

A full hedge is beyond my understanding or value-perception. I'll leave that for the big boys.

 

Me, I just want my portfolio pieces to compliment each other so earning and purchasing power stay intact.

High/low oil, high/ low inflation, interest rates up/down, US dollar up/down. Each section of your portfolio should address one or more of those items.

 

I do have a definite lean towards multinationals that have western based management operating in emerging markets. The most notable ones are inflation adjusted consumer company like Nestle, Diageo, Richemont, Pernod Richard and Tupperware.

 

^^ I only own one of the above because of opportunity cost BUT they are all dream team candidates @ right prices.

 

I like your thoughts on insurance but with PGR in particular I'd be careful thinking there is a price floor. They have a P/B of 2.4 and just last year paid out excess funds (so they are not seeing as much underwriting opportunity). They don't break out the combined ratio but it seems like they had underwriting profit (but then investment income looks extremely small? Maybe they have a lot of debt?). I'd be concerned with the stability of the current income level. Also, 30% of their portfolio is in ABS which are rate sensitive and come with much less liquidity. I'm guessing the majority of their income comes from their portfolio with a higher risk level and longer duration (they don't break out their portfolio so I'm guessing you'll have to read presentations).

 

At first I also thought car insurance was the best way to play this but there were low interest rates in the 70's and there was huge car repair inflation that well outstripped rates/CPI. I think there is a hidden risk of car repair inflation that I wouldn't want to take compared to P&C or reinsurance (commercial construction has a lot of excess in the industry to soak up potential inflation). If you go with an auto insurer I think ALL is a much safer choice (and better fit for rising rate hedge). Outside auto insurers, I like AIG as the best P&C insurer (they also have a low duration portfolio with a lot of corporate debt) and AWH as an awesome reinsurer. AIG is still below BV (I think right around TBV?) and AWH is right at BV. AWH has been preparing for rising rates for many years so I think they should provide exactly what you are looking for without all the risk with PGR. I also like WFC/PNC/MTB outside of insurance all together.

 

On your multinationals, there's decent evidence that the majority of brands do not have pricing power. That is, they can only raise prices generally after input costs have increased. Nestle/Hershey recently had this issue. They waited nearly a year after cocoa bean price increases before raising their prices and gross margins for Hershey were slightly lower. You mentioned some interesting names that I'm not very familiar with but I would check their abilities to raise prices without being forced to before assuming that inflation will help. In general, equity returns are unaffected by the CPI level. There's even a pretty famous WB article (Forbes?) where he shows that equity returns are approximately 12% regardless is the CPI is 0%, 5%, or 15%. Historically, when there has been high inflation the best investments were long-term US treasuries. Companies with pricing power generally have little/no competition and sell goods or services with a high demand that usually outstrips supply or where supply is mandated. Or a company may have a patent, but again, large underlying demand would be necessary.

 

[DavidVY]

-PGR has its investment portfolio mostly in short-term bonds (under 2 years). <--- Staying away from equities

 

-It also writes premiums to net surplus at 2.4 to 1 (Compared to 1 to 1). <--- Trying to grow book faster.

 

-Pays out dividends around 25% of payout ratio. Buys back shares at higher earnings yield than bonds. <---Returning cash to shareholders predictably

 

-Some cheap long-term debt (3.5%-4.3%) on balance sheet. <--- Cheap leverage

 

Its a small stake (low conviction idea), but they really pushed the technology of insurance in a whole new direction, write insurance well over cycles (maybe it will change considering they are trying to gain market share), and they have smart ethical people on board.

 

I spoke to a C-level guy at Marsh McLennan. He mentioned progressive is trying to do the "geico" manuevere". Basically get tons of young people and grow their insurance book organically as they mature. It'll take 10 years to reach fruition (in his words), but its a smart long-term strategy. He recommended me to stay away as short-term tactics might give it poor results, BUT when I brought up how they run their investment side (mostly short-term bonds) he was very impressed. He thinks they are running a super conservative investment side so they can execute as best they can on the under-writing side.

 

Difficult to say which way it'll turn, but I added a small chunk based on it being cheaper than the market and because I want to keep an eye on it.

 

------------------

Nestle has gone through tons of inflationary and deflationary events across the world. Its perserved across the board. Short-term it might take a hit, but its has 29 brands earning 1 billion CHF/year. Covers tons of consumer products (Perrier, Pellegrino, Purina, Kit Kats, Crunch, Drumsticks, Dreyers, Nestle water, Digiornos, Nesquick, Nestle ice tea). They might take a hit in 1 category, but they will adjust. It might take a year or two, but they have a fortress balance sheet and irreplaceable brands. They also owns stakes in other companies (shampoo etc). Its just a monster conglomerate that reaches world-wide. As standard of living goes up, their products will be consumed by a greater portion of the world.

[wknecht]

-PGR has its investment portfolio mostly in short-term bonds (under 2 years). <--- Staying away from equities

 

-It also writes premiums to net surplus at 2.4 to 1 (Compared to 1 to 1). <--- Trying to grow book faster.

 

-Pays out dividends around 25% of payout ratio. Buys back shares at higher earnings yield than bonds. <---Returning cash to shareholders predictably

 

-Some cheap long-term debt (3.5%-4.3%) on balance sheet. <--- Cheap leverage

 

Its a small stake (low conviction idea), but they really pushed the technology of insurance in a whole new direction, write insurance well over cycles (maybe it will change considering they are trying to gain market share), and they have smart ethical people on board.

 

I spoke to a C-level guy at Marsh McLennan. He mentioned progressive is trying to do the "geico" manuevere". Basically get tons of young people and grow their insurance book organically as they mature. It'll take 10 years to reach fruition (in his words), but its a smart long-term strategy. He recommended me to stay away as short-term tactics might give it poor results, BUT when I brought up how they run their investment side (mostly short-term bonds) he was very impressed. He thinks they are running a super conservative investment side so they can execute as best they can on the under-writing side.

 

Difficult to say which way it'll turn, but I added a small chunk based on it being cheaper than the market and because I want to keep an eye on it.

How will the auto insurers adopt to autonomous vehicles? This doesn't seem like science fiction anymore. Granted it will take a while yet to be ubiquitous.

 

GEICO insures many other things than cars (motorcycles, ATV, recreationals, homeowners, renters, collectibles etc), but still their revenues could fall significantly. I'm not sure how PGR compares from a diversification standpoint.

[bbarberayr]

Buying life insurers seems to be a very smart way to play the bounce in interest rates, in my opinion.

 

Valuation for life insurers are very low both relative to their market and to their historical valuation levels, generally because of 2 things:

 

1. Low ROE's, driven a lot by the low interest rate environment

2. Worries about long term risks after the bad business written by some companies in the variable annuity space prior to the financial crisis

 

If you look at P&C companies, many of their valuations are fairly close to the pre-financial crisis valuations because most P&C claims are short term and better defined and their investment horizon is shorter.

 

If we do get rising rates though, the life insurers will be able to invest in higher return securities, but premiums sill stay the same and drive higher profits - all policies which have been written the last few years were priced based on very low rates.  Because life insurers are so cheap, this increase in profits will also drive an increase in their valuations, so you will get a double uplift from higher earnings and higher p/e's and p/b's because people will see that.

 

The risk to life insurers is that rates rise too quickly.  If this happens, new policies will be quite a bit cheaper than older ones (think if a policy assumes a 5% long term rate versus a 2.5%) and then people will cancel existing policies to buy new ones.  Most insurance companies have penalties in their policies to offset this, so that will help somewhat.

 

The other good thing about life insurers is that you have some pretty strong downside valuation support as they are very cheap, so unless something dramatic and unexpected occurs, it will be very hard for them to go down further.  So you've got the very favourable investment situation where downside is fairly limited and upside is high due to the combination of likely increasing profits and valuations.