LRE.L - Lancashire Holdings Ltd

[twacowfca]

Twacowfca (and others), is this a case where we can just focus on the earnings and pay less attention to the premium to book?  Or said another way, is there a reason not to just focus on earnings for this company?

 

Yes and no.  Book value as a margin of safety floor is less important because of the quality of their business, compared to other insurers.  However, book value is very important as a limit on their potential earnings because they write business exposed to large losses.  Rating agencies look at capital levels in relation to exposures as estimated by, for example projected maximum losses for different types of business. If a company like LRE greatly increased the amount of premiums written without increasing capital or reducing the PML profile, that company would be at risk of a downgrade, especially after a large loss.  LRE keeps doing astute things to lower their PML's and permit them to write more business without increasing the risk of a big hit to their capital.  Even so, it would be hard for me to imagine that their normalized ROE will go much higher than 22% or so, compared to their long term average of 19.5%.  Therefore the amount of their earnings available for a DCF analysis will always be relative to their capital base.

[giofranchi]

Twacowfca (and others), is this a case where we can just focus on the earnings and pay less attention to the premium to book?  Or said another way, is there a reason not to just focus on earnings for this company?

 

Yes and no.  Book value as a margin of safety floor is less important because of the quality of their business, compared to other insurers.  However, book value is very important as a limit on their potential earnings because they write business exposed to large losses.  Rating agencies look at capital levels in relation to exposures as estimated by, for example projected maximum losses for different types of business. If a company like LRE greatly increased the amount of premiums written without increasing capital or reducing the PML profile, that company would be at risk of a downgrade, especially after a large loss.  LRE keeps doing astute things to lower their PML's and permit them to write more business without increasing the risk of a big hit to their capital.  Even so, it would be hard for me to imagine that their normalized ROE will go much higher than 22% or so, compared to their long term average of 19.5%.  Therefore the amount of their earnings available for a DCF analysis will always be relative to their capital base.

 

 

twacowfca,

please go on writing about Lancashire, because I always learn something new!

 

racemize,

actually, I think about LRE as I would have thought about BRK in the late ‘70s. And Mr. Buffett always said that increase in book value is a good estimate of the increase in value of BRK, though BRK’s value far exceeds its book value. Both Mr. Buffett and Mr. Brindle deal with market inefficiencies, and those inefficiencies are their competitive advantage. As long as market inefficiencies last, their competitive advantage will be durable. From an interview on Lancashire’s website:

 

What would you say then frustrates you in the marketplace? Would you say that the inefficiency in the market is a challenge for you?

Mr. Brindle: Well, in a way the inefficiency of the market is wonderful for us; the fact that almost everybody else just goes home at 17:00 on a Friday means that we've found some lovely opportunities. So, do we want a totally efficient, wonderful friction-free market? Probably not actually; we quite like the inefficiencies of the market.

 

So the question is: how big a bargain would you have made, investing in BRK during the late ‘70s at 1,5 x book value? I guess a very big one!

 

I think of my firm’s portfolio as if I were putting togheter the “Avengers Team”!  ;D ;D ;D

No, really: I extract as much cash as I can from the businesses I control, and I use it to partner with: Mr. Buffett, Mr. Watsa, Mr. Marks, Mr. Malone, Mr. Steinberg, Mr. Einhorn, and now Mr. Brindle. If I can do it at book value, very well! Otherwise, I am willing to pay a little bit more, because I think I am getting a good bargain anyway. Leaving room to average down in the future, if I get lucky!

 

giofranchi

[twacowfca]

Twacowfca (and others), is this a case where we can just focus on the earnings and pay less attention to the premium to book?  Or said another way, is there a reason not to just focus on earnings for this company?

 

Yes and no.  Book value as a margin of safety floor is less important because of the quality of their business, compared to other insurers.  However, book value is very important as a limit on their potential earnings because they write business exposed to large losses.  Rating agencies look at capital levels in relation to exposures as estimated by, for example projected maximum losses for different types of business. If a company like LRE greatly increased the amount of premiums written without increasing capital or reducing the PML profile, that company would be at risk of a downgrade, especially after a large loss.  LRE keeps doing astute things to lower their PML's and permit them to write more business without increasing the risk of a big hit to their capital.  Even so, it would be hard for me to imagine that their normalized ROE will go much higher than 22% or so, compared to their long term average of 19.5%.  Therefore the amount of their earnings available for a DCF analysis will always be relative to their capital base.

 

 

twacowfca,

please go on writing about Lancashire, because I always learn something new!

 

racemize,

actually, I think about LRE as I would have thought about BRK in the late ‘70s. And Mr. Buffett always said that increase in book value is a good estimate of the increase in value of BRK, though BRK’s value far exceeds its book value. Both Mr. Buffett and Mr. Brindle deal with market inefficiencies, and those inefficiencies are their competitive advantage. As long as market inefficiencies last, their competitive advantage will be durable. From an interview on Lancashire’s website:

 

What would you say then frustrates you in the marketplace? Would you say that the inefficiency in the market is a challenge for you?

Mr. Brindle: Well, in a way the inefficiency of the market is wonderful for us; the fact that almost everybody else just goes home at 17:00 on a Friday means that we've found some lovely opportunities. So, do we want a totally efficient, wonderful friction-free market? Probably not actually; we quite like the inefficiencies of the market.

 

So the question is: how big a bargain would you have made, investing in BRK during the late ‘70s at 1,5 x book value? I guess a very big one!

 

I think of my firm’s portfolio as if I were putting togheter the “Avengers Team”!  ;D ;D ;D

No, really: I extract as much cash as I can from the businesses I control, and I use it to partner with: Mr. Buffett, Mr. Watsa, Mr. Marks, Mr. Malone, Mr. Steinberg, Mr. Einhorn, and now Mr. Brindle. If I can do it at book value, very well! Otherwise, I am willing to pay a little bit more, because I think I am getting a good bargain anyway. Leaving room to average down in the future, if I get lucky!

 

giofranchi

 

 

Giofranchi,

 

You are a man after my own heart.  Our capital management is the same as yours.  Our company is old media, book publishing.  About Y2K, seeing the writing on the wall by the finger of the angel of the Internet, I began to pay a lot of attention to something that formerly had been merely a hobby, passive investing in public companies.  This proved to be very successful.  Using savings plus the cash flows of our business, passive investing became the tail that wags the dog.  Our securities are about twenty times the value of the old media business that has barely held its own.

 

Many of the posters on the board are good analysts, but few really think like businessmen.  Most concentrate on factors that can move the needle in the market, but few take the time necessary to dig deeply to ferret out the strength and depth and enduring value of a business within an industry that they attempt to understand.  As a former teacher, Dr. Deming, was in the habit of saying in a voice like the voice of God: "You must seek to have profound knowledge." 

 

It's refreshing to have your perspective as a businessman.

[giofranchi]

Twacowfca (and others), is this a case where we can just focus on the earnings and pay less attention to the premium to book?  Or said another way, is there a reason not to just focus on earnings for this company?

 

Yes and no.  Book value as a margin of safety floor is less important because of the quality of their business, compared to other insurers.  However, book value is very important as a limit on their potential earnings because they write business exposed to large losses.  Rating agencies look at capital levels in relation to exposures as estimated by, for example projected maximum losses for different types of business. If a company like LRE greatly increased the amount of premiums written without increasing capital or reducing the PML profile, that company would be at risk of a downgrade, especially after a large loss.  LRE keeps doing astute things to lower their PML's and permit them to write more business without increasing the risk of a big hit to their capital.  Even so, it would be hard for me to imagine that their normalized ROE will go much higher than 22% or so, compared to their long term average of 19.5%.  Therefore the amount of their earnings available for a DCF analysis will always be relative to their capital base.

 

 

twacowfca,

please go on writing about Lancashire, because I always learn something new!

 

racemize,

actually, I think about LRE as I would have thought about BRK in the late ‘70s. And Mr. Buffett always said that increase in book value is a good estimate of the increase in value of BRK, though BRK’s value far exceeds its book value. Both Mr. Buffett and Mr. Brindle deal with market inefficiencies, and those inefficiencies are their competitive advantage. As long as market inefficiencies last, their competitive advantage will be durable. From an interview on Lancashire’s website:

 

What would you say then frustrates you in the marketplace? Would you say that the inefficiency in the market is a challenge for you?

Mr. Brindle: Well, in a way the inefficiency of the market is wonderful for us; the fact that almost everybody else just goes home at 17:00 on a Friday means that we've found some lovely opportunities. So, do we want a totally efficient, wonderful friction-free market? Probably not actually; we quite like the inefficiencies of the market.

 

So the question is: how big a bargain would you have made, investing in BRK during the late ‘70s at 1,5 x book value? I guess a very big one!

 

I think of my firm’s portfolio as if I were putting togheter the “Avengers Team”!  ;D ;D ;D

No, really: I extract as much cash as I can from the businesses I control, and I use it to partner with: Mr. Buffett, Mr. Watsa, Mr. Marks, Mr. Malone, Mr. Steinberg, Mr. Einhorn, and now Mr. Brindle. If I can do it at book value, very well! Otherwise, I am willing to pay a little bit more, because I think I am getting a good bargain anyway. Leaving room to average down in the future, if I get lucky!

 

giofranchi

 

 

Giofranchi,

 

You are a man after my own heart.  Our capital management is the same as yours.  Our company is old media, book publishing.  About Y2K, seeing the writing on the wall by the finger of the angel of the Internet, I began to pay a lot of attention to something that formerly had been merely a hobby, passive investing in public companies.  This proved to be very successful.  Using savings plus the cash flows of our business, passive investing became the tail that wags the dog.  Our securities are about twenty times the value of the old media business that has barely held its own.

 

Many of the posters on the board are good analysts, but few really think like businessmen.  Most concentrate on factors that can move the needle in the market, but few take the time necessary to dig deeply to ferret out the strength and depth and enduring value of a business within an industry that they attempt to understand.  As a former teacher, Dr. Deming, was in the habit of saying in a voice like the voice of God: "You must seek to have profound knowledge." 

 

It's refreshing to have your perspective as a businessman.

 

 

Too kind of you, twacowfca!

And Dr. Deming’s advice is really one to treasure.

This board is full of very knowledgeable money managers, and money managers tend to think of businessmen (CEOs / managers) as illiterate, rude, and overbearing… and most of the time they are perfectly right! I myself find the behavior and the perspective of many colleagues of mine to be utterly superficial and boring!

Anyway, I like to think that not all businessmen are created equal. And maybe I presume too much, but I like to put myself in the same league as twacowfca: those businessmen who seek to live by Dr. Deming’s advice everyday.

 

giofranchi

[rmitz]

racemize,

actually, I think about LRE as I would have thought about BRK in the late ‘70s. And Mr. Buffett always said that increase in book value is a good estimate of the increase in value of BRK, though BRK’s value far exceeds its book value. Both Mr. Buffett and Mr. Brindle deal with market inefficiencies, and those inefficiencies are their competitive advantage. As long as market inefficiencies last, their competitive advantage will be durable. From an interview on Lancashire’s website:

 

I really don't think this is true.  Lancashire wants to stay focussed on their underwriting, and that's how they make money.  Everything else is a return of capital, and while it's true they think about this like owners (as they are!) that is far from the Berkshire model.  Not to say it's bad at all--I think it's wonderful and have owned in the past.

 

Ultimately, I see Lancashire as unlikely being a compounding machine in the same way, though you can emulate some of it by reinvesting dividends.

[tombgrt]

Dividends are taxed heavily, at least for me, so I never saw LRE as a true compounding machine either. I'm also not sure how LRE is a great bargain at this point because of that, but then again I missed out on the opportunity to buy it at half today's price. ;) Anyway, thank you everyone for the last couple of posts, very helpful.

[giofranchi]

racemize,

actually, I think about LRE as I would have thought about BRK in the late ‘70s. And Mr. Buffett always said that increase in book value is a good estimate of the increase in value of BRK, though BRK’s value far exceeds its book value. Both Mr. Buffett and Mr. Brindle deal with market inefficiencies, and those inefficiencies are their competitive advantage. As long as market inefficiencies last, their competitive advantage will be durable. From an interview on Lancashire’s website:

 

I really don't think this is true.  Lancashire wants to stay focussed on their underwriting, and that's how they make money.  Everything else is a return of capital, and while it's true they think about this like owners (as they are!) that is far from the Berkshire model.  Not to say it's bad at all--I think it's wonderful and have owned in the past.

 

Ultimately, I see Lancashire as unlikely being a compounding machine in the same way, though you can emulate some of it by reinvesting dividends.

 

 

rmitz,

I did not mean to say that the BRK model and the LRE model are the same. Everyone can see they are actually quite different:

BRK concentrates on long tail insurance contracts, which enable Mr. Buffett to invest an ever increasing amount of float (plus, of course, shareholder equity) for the long term, taking advantage of the stock market short term inefficiencies.

While LRE concentrates on short tail insurance contracts (“the stuff we do is very immediate” says Mr. Brindle), taking advantage of the insurance market inefficiencies (“One of the things we try and do after an event is come in and take advantage of the pricing. In our industry you want to try and move in the reverse direction from the herd if you can - and it is a very herd-like industry. People tend to just increase levels of risk, more and more and more - then something really big happens, and they go "Oh, better get out of that particular line of business". And out they all go - and then smarter people (hopefully including ourselves) will then go into that niche, or pocket of opportunity as Jonny would say, and take advantage of that.” says Mr. Brindle).

So, they clearly are two different kinds of business model.

Instead, what I really wanted to point out is that in both cases I do understand where their competitive advantage come from (very unique men taking advantage of market inefficiencies) and why it should be durable for a long time in the future (I just don’t see market inefficiencies disappear anytime soon). And that understanding gives me confidence that twacowfca’s assumptions of future ROEs, which at least for the next 16 years are in line with the ROEs achieved in the past, are possible. And, if so, LRE is still a very good bargain.

As far as dividends are concerned, with a company like LRE I surely prefer stock buybacks, but I am also fine reinvesting the dividends received.

One more thing: LRE doesn’t really have to replicate BRK’s success, to prove itself a rewarding investment and a satisfying asset to hold for the very long term.

 

giofranchi

[frog03]

Like tombgrt, dividend taxation is a problem for me.

 

Assuming 20% ROE, 7% retained at the company and 13% in dividends annually.

Assuming a 30% tax on dividends

Return on book value assuming no sale becomes like 7% + 13%*70% or 16,1%

With currently at 1,6-1,7x, the after tax return becomes like 10% or so.

 

Not bad at all, but of course nowhere near as good as buying at book or less a few years agao.

[racemize]

Like tombgrt, dividend taxation is a problem for me.

 

Assuming 20% ROE, 7% retained at the company and 13% in dividends annually.

Assuming a 30% tax on dividends

Return on book value assuming no sale becomes like 7% + 13%*70% or 16,1%

With currently at 1,6-1,7x, the after tax return becomes like 10% or so.

 

Not bad at all, but of course nowhere near as good as buying at book or less a few years agao.

 

you do get to compound the taxed dividend though, so that should add a bit more to it.

[giofranchi]

Like tombgrt, dividend taxation is a problem for me.

 

Assuming 20% ROE, 7% retained at the company and 13% in dividends annually.

Assuming a 30% tax on dividends

Return on book value assuming no sale becomes like 7% + 13%*70% or 16,1%

With currently at 1,6-1,7x, the after tax return becomes like 10% or so.

 

Not bad at all, but of course nowhere near as good as buying at book or less a few years agao.

 

 

That surely is a way to look at future returns. Another way is to look at the history of LRE and project similar returns into the future. The question is: are historical returns achievable for the next 10 years? twacowfca thinks so, and I am inclined to agree with him.

So, let’s do the math:

 

BV per share at the end of 2005: $4.84.

BV per share at the end of first half 2012: $8.46.

Delta BV per share: DBV per share = $8.46 - $4.84 = $3.62.

CAGR in BV per share: 9%.

Total dividends distributed: $5.05.

Total dividends distributed / DBV per share = 139.5%.

Assuming CAGR in BV per share for the next 10 years stays at 9%, at the end of year 10 BV per share will be $20.03.

Assuming dividends distributed / DBV per share stays at 139,5%, at the end of year 10 total dividends distributed (for the next 10 years) will be: ($20.03 - $8.46) x 1,395 = $16.14.

My firm pays 15% in taxes on dividends, so all I get to reinvest is: $16.14 x 0.85 = $13.71.

Here I have to make an assumption on “how” those dividends will be distributed: I assumed that they will grow at the same rate BV per share is supposed to grow, 9% each year. That means in year 1 I will receive $0.9 in dividend after taxes, funds that I can reinvest and compound for the next 9 years. In year 2 I will receive $0.98 in dividend after taxes, funds that I can reinvest and compound for the next 8 years. Finally, in year 10 I will receive $1.95 in dividend after taxes.

Let’s assume I can compound the dividends I receive at 10% annually.

Let’s assume that at year 10 LRE price will be 1.3 x BV per share.

Then, at the end of year 10 my investment will be worth:

1.3 x $20.03 = $26.04 +

$13.71 +

$6.70 (wealth created reinvesting dividends at 10% annually) =

$46.45.

Investing today at $14.00, that equates to a compound annual return of 12.75%.

Moreover, if I get to compound dividends at 13.5% annually, my investment at the end of year 10 will be worth $49.69: a compound annual return of exactly 13.5%. That is the case in which I reinvest the dividends in LRE.

 

Now, if you think that the September 2012 GMO 7-Year Asset Class Forecasts show a 0% annual return for US large caps and a negative –0,5% annual return for US small caps, then I think the opportunity to get a 13.5% compound annual return (and a relatively safe one! Because you partner with Mr. Brindle) is something not bad at all! If you leave some room to average down, in case the market hits an “air pocket” (paraphrasing Mr. Dalio), better still!

 

giofranchi

[frog03]

giofranchi,

 

Agree with you that Lancashire has very nice expected returns vs the average US large cap per GMO's numbers.

 

I arrive at 10% you arrive at 13,5%.  Relatively little differences (9% in BVPS growth vs 7%, lower tax rate, reinvestment of dividends).  I think we are quite in the same ballpark.

 

Unfortunately, the tax rate of 30% on dividends is a relatively optimistic assumption on my part (the marginal rate is already quite a bit higher than this in my country and rates are very likely to go up) so, in my case, 10% is probably right.

 

Thanks giofranchi and twa on very interesting exchanges.  Now, if we could find other great compounders that don't have yet too much capital to manage and are still young...

[twacowfca]

Twacowfca (and others), is this a case where we can just focus on the earnings and pay less attention to the premium to book?  Or said another way, is there a reason not to just focus on earnings for this company?

 

Yes and no.  Book value as a margin of safety floor is less important because of the quality of their business, compared to other insurers.  However, book value is very important as a limit on their potential earnings because they write business exposed to large losses.  Rating agencies look at capital levels in relation to exposures as estimated by, for example projected maximum losses for different types of business. If a company like LRE greatly increased the amount of premiums written without increasing capital or reducing the PML profile, that company would be at risk of a downgrade, especially after a large loss.  LRE keeps doing astute things to lower their PML's and permit them to write more business without increasing the risk of a big hit to their capital.  Even so, it would be hard for me to imagine that their normalized ROE will go much higher than 22% or so, compared to their long term average of 19.5%.  Therefore the amount of their earnings available for a DCF analysis will always be relative to their capital base.

 

 

twacowfca,

please go on writing about Lancashire, because I always learn something new!

 

racemize,

actually, I think about LRE as I would have thought about BRK in the late ‘70s. And Mr. Buffett always said that increase in book value is a good estimate of the increase in value of BRK, though BRK’s value far exceeds its book value. Both Mr. Buffett and Mr. Brindle deal with market inefficiencies, and those inefficiencies are their competitive advantage. As long as market inefficiencies last, their competitive advantage will be durable. From an interview on Lancashire’s website:

 

What would you say then frustrates you in the marketplace? Would you say that the inefficiency in the market is a challenge for you?

Mr. Brindle: Well, in a way the inefficiency of the market is wonderful for us; the fact that almost everybody else just goes home at 17:00 on a Friday means that we've found some lovely opportunities. So, do we want a totally efficient, wonderful friction-free market? Probably not actually; we quite like the inefficiencies of the market.

 

So the question is: how big a bargain would you have made, investing in BRK during the late ‘70s at 1,5 x book value? I guess a very big one!

 

I think of my firm’s portfolio as if I were putting togheter the “Avengers Team”!  ;D ;D ;D

No, really: I extract as much cash as I can from the businesses I control, and I use it to partner with: Mr. Buffett, Mr. Watsa, Mr. Marks, Mr. Malone, Mr. Steinberg, Mr. Einhorn, and now Mr. Brindle. If I can do it at book value, very well! Otherwise, I am willing to pay a little bit more, because I think I am getting a good bargain anyway. Leaving room to average down in the future, if I get lucky!

 

giofranchi

 

 

Giofranchi,

 

That's a good scenario analysis going forward.  Here are a few other tidbits and a few bitter herbs to throw into the pot:

 

1) Doomsday (almost) scenarios:

 

A couple of 100 year PML events in different asset classes hit in the same year, and they lose 33%  of their capital.  That would be a much worse situation than 9/11.  Rates would go through the roof.  Many companies would have to raise capital to take advantage of the high rates, including LRE, or  e faced with contracting their underwriting at the very time it would be most profitable to expand. Some companies would go out of business.

 

In that event, Lancashire would likely be in better position for raising capital than their peers because of Brindle's reputation.

 

 

2) Brindle departs. 

 

This is certainly not doomsday, but that would call into question how long his team would continue to put up the same high returns as Brindle.  This is the same type of question that was addressed in Warren's essay "The Super Investors of Graham and Doddsville".  I revisited the records of those investors since Warren wrote that article several years ago, and other authors compiled similar lists.  Those super investors continued to do well as a group ( except for one who was a phony who actually ran a Madoff feeder fund), but not nearly as well as they had done at the time of the initial study.  However, those who worked directly with Ben Graham, Walter and Warren, continued to have awesome returns.

 

Lancashire's best underwriters have stayed with Brindle.  I think that every year that team continues to knit together increases the probable number of years that Lancashire will have a continuation of their high returns if something should happen to Brindle.  Hypothetically, if something should happen to their CEO tomorrow, perhaps those high returns would continue for X years.  But if that team under Brindle's leadership continued for a few more years and then something happened to their mentor, perhaps those high returns might be expected to continue for 2 X years.  ???  Food for thought.

[shoeless]

 

Assuming CAGR in BV per share for the next 10 years stays at 9%, at the end of year 10 BV per share will be $20.03.

 

Here I have to make an assumption on “how” those dividends will be distributed: I assumed that they will grow at the same rate BV per share is supposed to grow, 9% each year.

 

giofranchi

 

giofranchi, BV (or revenue) has hardly grown at all over last 6 years and the only reason BVPS has grown is because they were able to buy back shares cheaply. This is no longer the case and they will not be buying back shares while they trade at these prices so I wouldn't assume it.

 

Is there any reason you think the business will grow at a higher rate than it has to date? I guess one can assume the market will harden sometime? But won't it soften thereafter as well?

 

I agreed with twacowfca when he said long ago in this thread that one reasonable way to look at this situation is similar to a bond.

They now trade at around 8.5 times avg-earnings which corresponds nicely to 8.5 times 20% of book value. So you are buying a 11-12% yield with no growth. Most of this money will be returned to you via dividend.

 

[twacowfca]

 

Assuming CAGR in BV per share for the next 10 years stays at 9%, at the end of year 10 BV per share will be $20.03.

 

Here I have to make an assumption on “how” those dividends will be distributed: I assumed that they will grow at the same rate BV per share is supposed to grow, 9% each year.

 

giofranchi

 

giofranchi, BV (or revenue) has hardly grown at all over last 6 years and the only reason BVPS has grown is because they were able to buy back shares cheaply. This is no longer the case and they will not be buying back shares while they trade at these prices so I wouldn't assume it.

 

Is there any reason you think the business will grow at a higher rate than it has to date? I guess one can assume the market will harden sometime? But won't it soften thereafter as well?

 

I agreed with twacowfca when he said long ago in this thread that one reasonable way to look at this situation is similar to a bond.

They now trade at around 8.5 times avg-earnings which corresponds nicely to 8.5 times 20% of book value. So you are buying a 11-12% yield with no growth. Most of this money will be returned to you via dividend.

 

That's a good point about the influence of the buybacks, but there is a nuance to that.  LRE 's buybacks were made just about at BV on average, although BV continued to grow so that repurchases were made for slightly less than BV as calculated at year end.  The point is that those repurchases were not accretive to BV per share when they were made.  The reason BV/SH then grew is that they allowed BV to grow afterwards by retaining future earnings.

 

In summary, the funds used for the share repurchases probably would have been used for even larger special dividends had not they chosen to buy back shares because that was very tax efficient.  Therefore, the cumulative dividends very likely would have been higher by the amount that they spent on share buybacks.  :)

[giofranchi]

 

Assuming CAGR in BV per share for the next 10 years stays at 9%, at the end of year 10 BV per share will be $20.03.

 

Here I have to make an assumption on “how” those dividends will be distributed: I assumed that they will grow at the same rate BV per share is supposed to grow, 9% each year.

 

giofranchi

 

giofranchi, BV (or revenue) has hardly grown at all over last 6 years and the only reason BVPS has grown is because they were able to buy back shares cheaply. This is no longer the case and they will not be buying back shares while they trade at these prices so I wouldn't assume it.

 

Is there any reason you think the business will grow at a higher rate than it has to date? I guess one can assume the market will harden sometime? But won't it soften thereafter as well?

 

I agreed with twacowfca when he said long ago in this thread that one reasonable way to look at this situation is similar to a bond.

They now trade at around 8.5 times avg-earnings which corresponds nicely to 8.5 times 20% of book value. So you are buying a 11-12% yield with no growth. Most of this money will be returned to you via dividend.

 

 

shoeless,

how could you grow BV, if you use all your earnings to pay dividends and to buy back shares? It is clearly impossible. And, if you want to maintain a steady and conservative Premiums / Surplus ratio, if you don’t grow equity, you cannot grow premiums written either, right? In insurance revenue growth is not an “ability”, instead it is almost always a “choice”: paraphrasing Mr. Buffett, if you want to make silly promises, people will find you!

And I always try to remember what Mr. Henry Singleton has so successfully shown: there is a time when the most profitable thing to do is buying back shares, and there is a time when the most profitable thing to do is growth. If you don’t use all the earnings to distribute dividends and you stop buying back shares (because shares are no longer unbelievably underpriced), equity will grow. If equity grows, revenue will follow.

The question is: how large a capital can Mr. Brindle and his team manage, before they are no longer able to find bargains in the insurance market?

At June 30, 2012, surplus capital was $1,4 billion. If it grows at 9% for the next 10 years, it will get to $3.3 billion. In 2010 global insurance premiums were $4.3 trillion. I am fully aware of the fact that Mr. Brindle and his team will never participate in many types of insurance, nonetheless I think they are still dealing with a relatively small amount of capital in a huge market.

Maybe, the most sensible way to create shareholders wealth, during the first 6 years of LRE’s existence, was to pay big dividends and to buy back shares (because they were so crazily cheap!); instead, is it so far-fetched to assume that, during the next 10 years, the most sensible way to create shareholders wealth will be to pay big dividends and to grow moderately?

Of course, twacowfca can answer this question far better than me!

 

giofranchi

[giofranchi]

 

Assuming CAGR in BV per share for the next 10 years stays at 9%, at the end of year 10 BV per share will be $20.03.

 

Here I have to make an assumption on “how” those dividends will be distributed: I assumed that they will grow at the same rate BV per share is supposed to grow, 9% each year.

 

giofranchi

 

giofranchi, BV (or revenue) has hardly grown at all over last 6 years and the only reason BVPS has grown is because they were able to buy back shares cheaply. This is no longer the case and they will not be buying back shares while they trade at these prices so I wouldn't assume it.

 

Is there any reason you think the business will grow at a higher rate than it has to date? I guess one can assume the market will harden sometime? But won't it soften thereafter as well?

 

I agreed with twacowfca when he said long ago in this thread that one reasonable way to look at this situation is similar to a bond.

They now trade at around 8.5 times avg-earnings which corresponds nicely to 8.5 times 20% of book value. So you are buying a 11-12% yield with no growth. Most of this money will be returned to you via dividend.

 

That's a good point about the influence of the buybacks, but there is a nuance to that.  LRE 's buybacks were made just about at BV on average, although BV continued to grow so that repurchases were made for slightly less than BV as calculated at year end.  The point is that those repurchases were not accretive to BV per share when they were made.  The reason BV/SH then grew is that they allowed BV to grow afterwards by retaining future earnings.

 

In summary, the funds used for the share repurchases probably would have been used for even larger special dividends had not they chosen to buy back shares because that was very tax efficient.  Therefore, the cumulative dividends very likely would have been higher by the amount that they spent on share buybacks.  :)

 

 

Ah! Ok... I had sent my previous post, before reading what twacowfca had to say about it! :)

 

giofranchi

[shoeless]

shoeless,

how could you grow BV, if you use all your earnings to pay dividends and to buy back shares? It is clearly impossible. And, if you want to maintain a steady and conservative Premiums / Surplus ratio, if you don’t grow equity, you cannot grow premiums written either, right? In insurance revenue growth is not an “ability”, instead it is almost always a “choice”: paraphrasing Mr. Buffett, if you want to make silly promises, people will find you!

 

I agree giofranchi that it was a choice not to grow revenue or book value and to return capital to shareholders, but my question is what leads you to believe they will choose differently in the future?

What was so special about the last five years which will be that different in the next five? For me their size isn't really reassurance enough that they will grow. Perhaps there is something about their business model or the way they are organized or.... which makes growth hard?

 

Sure, in the next 16 years the market may harden and they may grow in that period but if this occurs isn't it likely they will shrink as the market softens? I don't budget in a hard-market period because I cancel it out with any possible bad luck years..

 

I'd like very much to understand them better and gain reassurance they will grow and any insights here would be very welcome, but as long as I don't and all I have to go by are the last 5 years of no revenue growth I don't think it is conservative to perform a valuation which assumes growth.

 

So for me at the moment these guys are not compounders and are more like a bond yielding 20% of book value (i.e. around 11% at  current prices) with some speculative hope of being able to sell at a higher BV multiple in a hard market but also a risk BV and/or BV-multiple shrinking instead.

 

 

[shoeless]

 

Assuming CAGR in BV per share for the next 10 years stays at 9%, at the end of year 10 BV per share will be $20.03.

 

Here I have to make an assumption on “how” those dividends will be distributed: I assumed that they will grow at the same rate BV per share is supposed to grow, 9% each year.

 

giofranchi

 

giofranchi, BV (or revenue) has hardly grown at all over last 6 years and the only reason BVPS has grown is because they were able to buy back shares cheaply. This is no longer the case and they will not be buying back shares while they trade at these prices so I wouldn't assume it.

 

Is there any reason you think the business will grow at a higher rate than it has to date? I guess one can assume the market will harden sometime? But won't it soften thereafter as well?

 

I agreed with twacowfca when he said long ago in this thread that one reasonable way to look at this situation is similar to a bond.

They now trade at around 8.5 times avg-earnings which corresponds nicely to 8.5 times 20% of book value. So you are buying a 11-12% yield with no growth. Most of this money will be returned to you via dividend.

 

That's a good point about the influence of the buybacks, but there is a nuance to that.  LRE 's buybacks were made just about at BV on average, although BV continued to grow so that repurchases were made for slightly less than BV as calculated at year end.  The point is that those repurchases were not accretive to BV per share when they were made.  The reason BV/SH then grew is that they allowed BV to grow afterwards by retaining future earnings.

 

In summary, the funds used for the share repurchases probably would have been used for even larger special dividends had not they chosen to buy back shares because that was very tax efficient.  Therefore, the cumulative dividends very likely would have been higher by the amount that they spent on share buybacks.  :)

 

Thanks for that input twacowcfa. Could you shed some light on Lancashire's growth prospects?

 

[twacowfca]

 

Assuming CAGR in BV per share for the next 10 years stays at 9%, at the end of year 10 BV per share will be $20.03.

 

Here I have to make an assumption on “how” those dividends will be distributed: I assumed that they will grow at the same rate BV per share is supposed to grow, 9% each year.

 

giofranchi

 

giofranchi, BV (or revenue) has hardly grown at all over last 6 years and the only reason BVPS has grown is because they were able to buy back shares cheaply. This is no longer the case and they will not be buying back shares while they trade at these prices so I wouldn't assume it.

 

Is there any reason you think the business will grow at a higher rate than it has to date? I guess one can assume the market will harden sometime? But won't it soften thereafter as well?

 

I agreed with twacowfca when he said long ago in this thread that one reasonable way to look at this situation is similar to a bond.

They now trade at around 8.5 times avg-earnings which corresponds nicely to 8.5 times 20% of book value. So you are buying a 11-12% yield with no growth. Most of this money will be returned to you via dividend.

 

That's a good point about the influence of the buybacks, but there is a nuance to that.  LRE 's buybacks were made just about at BV on average, although BV continued to grow so that repurchases were made for slightly less than BV as calculated at year end.  The point is that those repurchases were not accretive to BV per share when they were made.  The reason BV/SH then grew is that they allowed BV to grow afterwards by retaining future earnings.

 

In summary, the funds used for the share repurchases probably would have been used for even larger special dividends had not they chosen to buy back shares because that was very tax efficient.  Therefore, the cumulative dividends very likely would have been higher by the amount that they spent on share buybacks.  :)

 

Thanks for that input twacowcfa. Could you shed some light on Lancashire's growth prospects?

 

 

They grow when they can put capital to productive use without raising their risk profile.  Recently, they have been doing this through sidecars which have been discussed on this thread.  These give increased upside potential with less downside than if they had taken on increased business entirely on their own in certain high risk, high return lines of business.  The sidecars also enable them to offload some of their riskiest exposures.  This should help them grow the rest of their business as the remainder should have lower PML's that will help them write more premiums for each dollar of capital.

 

They recently floated $130M in 10 year fixed notes.  It will be interesting to see what use they may have for this extra capital.  :)

 

 

 

 

[giofranchi]

 

Assuming CAGR in BV per share for the next 10 years stays at 9%, at the end of year 10 BV per share will be $20.03.

 

Here I have to make an assumption on “how” those dividends will be distributed: I assumed that they will grow at the same rate BV per share is supposed to grow, 9% each year.

 

giofranchi

 

giofranchi, BV (or revenue) has hardly grown at all over last 6 years and the only reason BVPS has grown is because they were able to buy back shares cheaply. This is no longer the case and they will not be buying back shares while they trade at these prices so I wouldn't assume it.

 

Is there any reason you think the business will grow at a higher rate than it has to date? I guess one can assume the market will harden sometime? But won't it soften thereafter as well?

 

I agreed with twacowfca when he said long ago in this thread that one reasonable way to look at this situation is similar to a bond.

They now trade at around 8.5 times avg-earnings which corresponds nicely to 8.5 times 20% of book value. So you are buying a 11-12% yield with no growth. Most of this money will be returned to you via dividend.

 

That's a good point about the influence of the buybacks, but there is a nuance to that.  LRE 's buybacks were made just about at BV on average, although BV continued to grow so that repurchases were made for slightly less than BV as calculated at year end.  The point is that those repurchases were not accretive to BV per share when they were made.  The reason BV/SH then grew is that they allowed BV to grow afterwards by retaining future earnings.

 

In summary, the funds used for the share repurchases probably would have been used for even larger special dividends had not they chosen to buy back shares because that was very tax efficient.  Therefore, the cumulative dividends very likely would have been higher by the amount that they spent on share buybacks.  :)

 

Thanks for that input twacowcfa. Could you shed some light on Lancashire's growth prospects?

 

 

They grow when they can put capital to productive use without raising their risk profile.  Recently, they have been doing this through sidecars which have been discussed on this thread.  These give increased upside potential with less downside than if they had taken on increased business entirely on their own in certain high risk, high return lines of business.  The sidecars also enable them to offload some of their riskiest exposures.  This should help them grow the rest of their business as the remainder should have lower PML's that will help them write more premiums for each dollar of capital.

 

They recently floated $130M in 10 year fixed notes.  It will be interesting to see what use they may have for this extra capital.  :)

 

 

Thank you twacowfca,

I think that shoeless’s worries about future growth are very well understandable and any insight that could help us answer the crucial question “Are they compounders, or are they not?” is so much welcomed!

 

shoeless (by the way, great nickname! ;)),

I tend to believe that Mr. Brindle recognized in the last 6 years they could have compounded shareholders capital just buying back a lot of cheap shares. Too rapid a growth wasn’t necessary to achieve that goal, so he behaved conservatively and settled for low growth. I also tend to believe that in the future he will work hard to replicate past performance: if buying back shares will cease to work as a strategy, he will seek opportunities (e.g. sidecars) to grow a little bit faster.

I have said to grow a little bit faster, because actually there has been some growth in the past: in December 2005 surplus capital was $0.947 billion, by June 2012 it has grown to $1.422 billion. That equates to a 6.45% compound annual growth rate.

 

So, as far as I can see, excluding some unforeseeable catastrophic event or Mr. Brindle’s premature departure, three scenarios are possible:

1) You are right, there will be no growth in the future, and an investment in LRE is like a bond that at the current price yields 11%. If you reinvest the coupon in LRE, what you get is an 11% compounder.

2) Mr. Brindle succeeds in growing BV per share 9% each year, like he did in the past, but growing the business a little bit more quickly and buying back less shares. Then, if you reinvest the dividends in LRE, what you get is a 13.5% compounder.

3) Somewhere in between 1 and 2: Mr. Brindle grows the business at 6% each year and buys back less share. If you reinvest the dividends in LRE, you get a 12% compounder.

 

This analysis doesn’t change much my thesis on LRE: what’s not to like about the prospect to partner with someone as reliable as Mr. Brindle and get the chance to achieve a 12% compound annual return, in a world where US Large Caps are priced to return nothing for the next 7 years, and US Small Caps are priced for a negative return?

 

giofranchi

 

[twacowfca]

 

Assuming CAGR in BV per share for the next 10 years stays at 9%, at the end of year 10 BV per share will be $20.03.

 

Here I have to make an assumption on “how” those dividends will be distributed: I assumed that they will grow at the same rate BV per share is supposed to grow, 9% each year.

 

giofranchi

 

giofranchi, BV (or revenue) has hardly grown at all over last 6 years and the only reason BVPS has grown is because they were able to buy back shares cheaply. This is no longer the case and they will not be buying back shares while they trade at these prices so I wouldn't assume it.

 

Is there any reason you think the business will grow at a higher rate than it has to date? I guess one can assume the market will harden sometime? But won't it soften thereafter as well?

 

I agreed with twacowfca when he said long ago in this thread that one reasonable way to look at this situation is similar to a bond.

They now trade at around 8.5 times avg-earnings which corresponds nicely to 8.5 times 20% of book value. So you are buying a 11-12% yield with no growth. Most of this money will be returned to you via dividend.

 

That's a good point about the influence of the buybacks, but there is a nuance to that.  LRE 's buybacks were made just about at BV on average, although BV continued to grow so that repurchases were made for slightly less than BV as calculated at year end.  The point is that those repurchases were not accretive to BV per share when they were made.  The reason BV/SH then grew is that they allowed BV to grow afterwards by retaining future earnings.

 

In summary, the funds used for the share repurchases probably would have been used for even larger special dividends had not they chosen to buy back shares because that was very tax efficient.  Therefore, the cumulative dividends very likely would have been higher by the amount that they spent on share buybacks.  :)

 

Thanks for that input twacowcfa. Could you shed some light on Lancashire's growth prospects?

 

 

They grow when they can put capital to productive use without raising their risk profile.  Recently, they have been doing this through sidecars which have been discussed on this thread.  These give increased upside potential with less downside than if they had taken on increased business entirely on their own in certain high risk, high return lines of business.  The sidecars also enable them to offload some of their riskiest exposures.  This should help them grow the rest of their business as the remainder should have lower PML's that will help them write more premiums for each dollar of capital.

 

They recently floated $130M in 10 year fixed notes.  It will be interesting to see what use they may have for this extra capital.  :)

 

 

Thank you twacowfca,

I think that shoeless’s worries about future growth are very well understandable and any insight that could help us answer the crucial question “Are they compounders, or are they not?” is so much welcomed!

 

shoeless (by the way, great nickname! ;)),

I tend to believe that Mr. Brindle recognized in the last 6 years they could have compounded shareholders capital just buying back a lot of cheap shares. Too rapid a growth wasn’t necessary to achieve that goal, so he behaved conservatively and settled for low growth. I also tend to believe that in the future he will work hard to replicate past performance: if buying back shares will cease to work as a strategy, he will seek opportunities (e.g. sidecars) to grow a little bit faster.

I have said to grow a little bit faster, because actually there has been some growth in the past: in December 2005 surplus capital was $0.947 billion, by June 2012 it has grown to $1.422 billion. That equates to a 6.45% compound annual growth rate.

 

So, as far as I can see, excluding some unforeseeable catastrophic event or Mr. Brindle’s premature departure, three scenarios are possible:

1) You are right, there will be no growth in the future, and an investment in LRE is like a bond that at the current price yields 11%. If you reinvest the coupon in LRE, what you get is an 11% compounder.

2) Mr. Brindle succeeds in growing BV per share 9% each year, like he did in the past, but growing the business a little bit more quickly and buying back less shares. Then, if you reinvest the dividends in LRE, what you get is a 13.5% compounder.

3) Somewhere in between 1 and 2: Mr. Brindle grows the business at 6% each year and buys back less share. If you reinvest the dividends in LRE, you get a 12% compounder.

 

This analysis doesn’t change much my thesis on LRE: what’s not to like about the prospect to partner with someone as reliable as Mr. Brindle and get the chance to achieve a 12% compound annual return, in a world where US Large Caps are priced to return nothing for the next 7 years, and US Small Caps are priced for a negative return?

 

giofranchi

 

 

You have expressed Lancashire's philosophy very well, giofranchi.  Before long, I'll be asking you for more details about Lancashire.  :)

 

In Lancashire's early years, Brindle declared that their size was about right. His philosophy is that they won't chase business unless they think they can earn about 20% on the extra capital needed to support that extra business without changing their overall risk profile.  This is why he refers to share repurchases and dividends as "returning capital to shareholders".

 

The amount of premiums they write is much less than half a percent of the worldwide reinsurance and specialty market.  They have a lot of room to maneuver to find the best opportunities worldwide.  However, they are very conscious of keeping their expenses down which gives them another advantage that hasn't been discussed much here.  They closed their Dubai office recently.  They access the far east market by flying out there to see their clients.  Not having a Singapore office was a conscious decision because Brindle thought that most of the premiums written there didn't have the required margin for them until recently.  He was right.  The Thai floods last year wiped out all the profits that international insurers had ever made from policies written out of Singapore.

 

Their conundrum is this: about half the time year after year they could probably underwrite risks that meet their standards for risk adjusted return if they had more capital.  But then they would have to sit on that extra capital some of the time or go for more high risk high return business like retro that would raise their risk profile.  Therefore, growth merely for the sake of growth would either lead ultimately to lower ROE or more volatility in their results because they have increased exposure to cats or other large loss events.

 

What they have done, instead is cut the Gordian Knot by growing a little bit into things like sidecars.  :)

[giofranchi]

You have expressed Lancashire's philosophy very well, giofranchi.  Before long, I'll be asking you for more details about Lancashire.  :)

 

It will take years, before I even approach your knowledge of Lancashire!! ;D

 

The amount of premiums they write is much less than half a percent of the worldwide reinsurance market.  They have a lot of room to maneuver to find the best opportunities worldwide.  However, they are very conscious of keeping their expenses down which gives them another advantage that hasn't been discussed much here.  They closed their Dubai office recently.  They access the far east market by flying out there to see their clients.  Not having a Singapore office was a conscious decision because Brindle thought that most of the premiums written there didn't have the required margin for them until recently.  He was right.  The Thai floods last year wiped out all the profits that international insurers had ever made from policies written out of Singapore.

 

Their conundrum is this: about half the time year after year they could probably underwrite risks that meet their standards for risk adjusted return if they had more capital.  But then they would have to sit on that extra capital some of the time or go for more high risk high return business like retro that would raise their risk profile.  Therefore, growth merely for the sake of growth would either lead ultimately to lower ROE or more volatility in their results because they have increased exposure to cats or other large loss events.

 

What they have done, instead is cut the Gordian Knot by growing a little bit into things like sidecars.  :)

 

I really like it very much! Thank you! "Take care of the downside, and the upside will take care of itself"

 

giofranchi

[shoeless]

twacowfca, giofranchi, thank you for the great discussion and information

 

[biaggio]

Enjoyed reading discussion. Have followed story + hoped I could buy at cheaper price that never came (yet?)

 

Would it be unrealistic to expect a "real rate of return" of 12% compounded annually? i.e 12% is nominal rate + inflation -seeing that it is a short tail insurer who insures opportunistically + prudently

-with all the money printing, all the real things we need to insure will need to be insured for higher replacement cost-maybe not this year, next year or the year after but eventually. (Giofranco, I know you like to consider macro trend-this is one that concerns me long term)

 

I would take a real rate of return annually of 12% (would make investment within tax defered account)

[giofranchi]

Enjoyed reading discussion. Have followed story + hoped I could buy at cheaper price that never came (yet?)

 

Would it be unrealistic to expect a "real rate of return" of 12% compounded annually? i.e 12% is nominal rate + inflation -seeing that it is a short tail insurer who insures opportunistically + prudently

-with all the money printing, all the real things we need to insure will need to be insured for higher replacement cost-maybe not this year, next year or the year after but eventually. (Giofranco, I know you like to consider macro trend-this is one that concerns me long term)

 

I would take a real rate of return annually of 12% (would make investment within tax defered account)

 

 

biaggio,

if I understood you well, you are concerned about future inflation, because inflation can be greatly detrimental to insurance performance. I think the last sentences in the Q3 2012 Hoisington Quarterly Review and Outlook express very well my own view on inflation:

 

“As commodity prices rose initially in all the QE programs, long-term Treasury bond yields also increased. However, those higher yields eventually reversed and generally continued to ratchet downward, reaching near record lows. The current Fed actions may be politically necessary due to numerous demands for them to act to improve the clearly depressed state of economic conditions. However, these policies will prove to be unproductive. Economic fundamentals will not improve until the extreme over-indebtedness of the U.S. economy is addressed, and this is in the realm of fiscal, not monetary policy. It would be more beneficial for the Fed to sit on the sidelines and try to put pressure on the fiscal authorities to take badly needed actions rather than do additional harm. Until the excessive debt issues are addressed, the multi-year trend in inflation, and thus the long Treasury bond yields will remain downward.”

 

I think it is still many years down the road, before we succeed in reducing overall debt to a sustainable level.

 

Furthermore, Mr. Brindle mostly concentrates on the short tail of the insurance and reinsurance markets, so I don’t see how inflation could turn out to be a significant concern. Of course, if he wants to grow Lancashire a little bit faster than he did until now, he might venture into underwriting longer lasting contracts, but he said many times he will consider doing so only if those contracts hold the promise to be solidly profitable. I am sure he will eventually consider the inflation threat very carefully!

 

giofranchi