LRE.L - Lancashire Holdings Ltd

[nwoodman]

Q1 results in

 

CR OF 74.0% IN Q1 2012

 

http://www.lancashiregroup.com/media/releases/2012/2012-05-04.aspx

 

Richard Brindle, Group Chief Executive Officer, commented:

 

“Lancashire has achieved another solid performance during the first quarter and has once again increased book value per share, including dividends. We have now produced a compound annual return of 19.4% over six years of trading in markets that have experienced very volatile losses in both risk and catastrophe lines.

 

As anticipated, the new year renewal season produced attractive opportunities in our property retrocession and catastrophe reinsurance lines. The Accordion facility was well utilised during the January renewals and I am also pleased to report a successful Japanese and Asian reinsurance renewal season at 1 April 2012, where we saw attractive opportunities supporting established and well-respected insurers within the region. Pricing in energy underwriting lines has also strengthened during the quarter.

 

Despite the firming of premium rates in certain key classes, we have yet to witness a wide-scale hardening of rates across all classes. While the Costa Concordia loss affected our combined ratio, as it has many others in the industry, it has been frustrating to see industry-wide pricing in marine lines failing to show the improvements that might have been expected following such a loss....."

[biaggio]

http://www.lancashiregroup.com/investor-relations/annual-report-2011-interview.aspx

Interview with Richard Brindle, CEO

[twacowfca]

http://www.lancashiregroup.com/investor-relations/annual-report-2011-interview.aspx

Interview with Richard Brindle, CEO

 

The recent "Underwriting comes first" video on their investors relations page is also very interesting for those who want to understand how they do so well.

 

They recently raised $130M through a 10 year note at an attractive rate, raising the leverage on their BS from 8% to a whopping 15%.  It will

be interesting to see what they intend to do with the funds.  :)

[twacowfca]

Interestingly, Howard Silverblatt, the statistician for the S&P 500 sent out an email listing the best and worst S&P 500 performers for the five years since the market peaked on October 9, 2007.  LRE isn't on that list, but if it had been included, I think  its place may have been about in the top 1% of the best total return performers, ahead of Apple, if I'm not mistaken.  :)

[rjstc]

TWA; Are you still adding to this position?

[twacowfca]

TWA; Are you still adding to this position?

 

With the reinvested dividends and share buybacks, it's grown to a huge overweight, even measured by the standards of a focused portfolio, but its normalized owner earnings yield is still about 13%, and they continue to lever up their returns while dialing down the volatility of those returns through sidecars.

 

Every year I go through this debate with myself: "Why do you have most of your eggs in this basket?"  Answer: " Why did Warren's high school pinball machine partner buy Berkshire in the 1960's and never sell a single share?"

[giofranchi]

TWA; Are you still adding to this position?

 

With the reinvested dividends and share buybacks, it's grown to a huge overweight, even measured by the standards of a focused portfolio, but its normalized owner earnings yield is still about 13%, and they continue to lever up their returns while dialing down the volatility of those returns through sidecars.

 

Every year I go through this debate with myself: "Why do you have most of your eggs in this basket?"  Answer: " Why did Warren's high school pinball machine partner buy Berkshire in the 1960's and never sell a single share?"

 

twacowfca,

if we assume a ROE of 15% for the next two years (less than the average 19% achieved in the past), we assume a required return of 10% (a 10% interest rate), and from year three on we assume that ROE falls to 10%, not exceeding our required minimum return, then we can use Professor Penman formula for valuing equity: (1) the book value + (2) the value from short-term earnings (next two years) + (3) the value of subsequent speculative growth, where we are completely disregarding (3) (value of speculative growth = 0).

It follows that LRE’s value of equity is $12,64, while today it is trading at $10,57: a margin of safety of 16,3%, with pretty conservative assumptions.

Do you think LRE could be valued that way? Or you just use normalized owner earnings yield?

Thank you,

 

giofranchi

 

[twacowfca]

TWA; Are you still adding to this position?

 

With the reinvested dividends and share buybacks, it's grown to a huge overweight, even measured by the standards of a focused portfolio, but its normalized owner earnings yield is still about 13%, and they continue to lever up their returns while dialing down the volatility of those returns through sidecars.

 

Every year I go through this debate with myself: "Why do you have most of your eggs in this basket?"  Answer: " Why did Warren's high school pinball machine partner buy Berkshire in the 1960's and never sell a single share?"

 

twacowfca,

if we assume a ROE of 15% for the next two years (less than the average 19% achieved in the past), we assume a required return of 10% (a 10% interest rate), and from year three on we assume that ROE falls to 10%, not exceeding our required minimum return, then we can use Professor Penman formula for valuing equity: (1) the book value + (2) the value from short-term earnings (next two years) + (3) the value of subsequent speculative growth, where we are completely disregarding (3) (value of speculative growth = 0).

It follows that LRE’s value of equity is $12,64, while today it is trading at $10,57: a margin of safety of 16,3%, with pretty conservative assumptions.

Do you think LRE could be valued that way? Or you just use normalized owner earnings yield?

Thank you,

 

giofranchi

 

 

 

The simplest way to value Lancashire which is the method I prefer is to take Brindle's long term record at Lloyds and combine it with the record of Lancashire.  Both of those records are remarkably consistent with each other, 19%+ per year which could be compounded by reinvesting the distributions from Lloyds and dividends from Lancashire.  There could be an element of good luck in these records. 

 

On the other hand,  Brindle's record his first two years at Lloyds when he was learning his craft was good but not outstanding, maybe about 10% average per year if I'm not mistaken. Also LRE's record in 2006, its first effective year of operations, was about +16% because they didn't have a stream of written premiums in the pipeline, and they didn't use all the capacity they had to write a lot of retro because they were conservative and didn't want to risk a big loss in their first year.  A little bird told me that they could have made 37% on their capital that first year of operations if they had used their full capacity in that year of extradinorily high rates after Katrina et al. 

 

All things considered, 19%+ per year normalized return on equity is probably realistic as an expectation going forward, because they stay small and nimble and their sweet spots keep getting bigger, not smaller. Then, you can put any discount rate you like on that.  :)

 

One more thing, the last few years when Lancashire has done so well have not been kind to most Insurance companies.  Now, as investment returns are going down, rates are at last going up and CRs going forward should be improving except in a big cat year.  This may be a wash for most insurers that are dependent mainly on investment returns.  Property insurers should do better in general than those that have a longer tailed book of business.  Property insurers that make most of their money on underwriting should do relatively well, compared to those that are dependent mostly on investment returns.

[giofranchi]

All things considered, 19%+ per year normalized return on equity is probably realistic as an expectation going forward, because they stay small, and their sweet spots keep getting bigger, not smaller. Then, you can put any discount rate you like on that.  :)

 

Yeah! If you really think that 19% is sustainable going forward, then LRE at the current price is a steal! Which are, in your opinion, the reasons why the market is so wrong about LRE? Is it because the market prices LRE as if it were just another insurance company? Although outstanding, maybe a 6-year track record is not long enough to convince the market that LRE is really different?

Thank you,

 

giofranchi

[twacowfca]

All things considered, 19%+ per year normalized return on equity is probably realistic as an expectation going forward, because they stay small, and their sweet spots keep getting bigger, not smaller. Then, you can put any discount rate you like on that.  :)

 

Yeah! If you really think that 19% is sustainable going forward, then LRE at the current price is a steal! Which are, in your opinion, the reasons why the market is so wrong about LRE? Is it because the market prices LRE as if it were just another insurance company? Although outstanding, maybe a 6-year track record is not long enough to convince the market that LRE is really different?

Thank you,

 

giofranchi

 

 

I don't think the market misprices LRE based on its record, after all they were underpriced drastically in their early years as a start up and now are realistically priced as they have done so well.  My evaluation is qualitative, based on the CEO's full record and the extradinory team he has built at LRE.

 

My take would be like the view of Warren's pinball machine partner who had followed Warren's outstanding record in his partnership and then realized that he could buy in to that stream of success in a small way simply by purchasing shares in a company that was in an industry that did not generally have good returns but was now controlled by someone who was building a reputation as the best investor in a variety of businesses since his mentor, the best investor of all had retired.  :)

[FrankArabia]

what are you views towards valuation though? its roughly 1.4x at the moment...

[twacowfca]

what are you views towards valuation though? its roughly 1.4x at the moment...

 

That's all speculative.  I was delighted when LRE sold at +(-) 10% over/under book value during the first four years after their IPO as we continued to load up.  It's been hard to keep buying in the last couple of years as they have traded up to a range of 1.4 to 1.6 times book value.  But it still looks like a better relative value than just about anything else out there, considering the quality of the business, not to mention other things like no corporate taxes on their profits.  A US company would have to have a pretax ROE of 25% or better to do as well as LRE's 19% return without LRE's being subject to taxation of profits.

[giofranchi]

I don't think the market misprices LRE based on its record, after all they were underpriced drastically in their early years as a start up and now are realistically priced as they have done so well. 

 

Well, I guess it depends on the sustainability of that 19%+ per year normalized return on equity… If it is really sustainable for many years into the future, then I buy LRE today at 1,4x, like FrankArabia wrote, and I expect it to be trading still at 1,4x ten years from now. In the meantime I’d have achieved a compounded annual return of 19%+. Clearly the market is expecting declining ROE in the future! So, if ROE stays at the level you expect for a very long time, the market is wrong about LRE today.

As an aside, it would be quite easy to use Professor Penman formula for valuing equity, to calculate which ROE the market is factoring in for LRE in the future.

 

giofranchi

[giofranchi]

what are you views towards valuation though? its roughly 1.4x at the moment...

 

That's all speculative.  I was delighted when LRE sold at +(-) 10% over/under book value during the first four years after their IPO as we continued to load up.  It's been hard to keep buying in the last couple of years as they have traded up to a range of 1.4 to 1.6 times book value.  But it still looks like a better relative value than just about anything else out there, considering the quality of the business, not to mention other things like no corporate taxes on their profits.  A US company would have to have a pretax ROE of 25% or better to do as well as LRE's 19% return without LRE's being subject to taxation of profits.

 

Of course, at 1,4x – 1,6x you are paying for growth… And I would very much prefer to receive growth for free instead! But I guess the problem with paying for growth is that growth is “speculative”. You can almost never be sure it will really be there. And, if it fails to materialize, then you have paid for nothing! So, it is very easy to get killed, if you bet on growth… Quality, imo, is how certain future growth can be. If you think that Mr. Brindle can go on compounding for the next 20 years, like he did during the last 26 years, than I agree that LRE is very good value even at the current price.

 

giofranchi

[twacowfca]

what are you views towards valuation though? its roughly 1.4x at the moment...

 

That's all speculative.  I was delighted when LRE sold at +(-) 10% over/under book value during the first four years after their IPO as we continued to load up.  It's been hard to keep buying in the last couple of years as they have traded up to a range of 1.4 to 1.6 times book value.  But it still looks like a better relative value than just about anything else out there, considering the quality of the business, not to mention other things like no corporate taxes on their profits.  A US company would have to have a pretax ROE of 25% or better to do as well as LRE's 19% return without LRE's being subject to taxation of profits.

 

Of course, at 1,4x – 1,6x you are paying for growth… And I would very much prefer to receive growth for free instead! But I guess the problem with paying for growth is that growth is “speculative”. You can almost never be sure it will really be there. And, if it fails to materialize, then you have paid for nothing! So, it is very easy to get killed, if you bet on growth… Quality, imo, is how certain future growth can be. If you think that Mr. Brindle can go on compounding for the next 20 years, like he did during the last 26 years, than I agree that LRE is very good value even at the current price.

 

giofranchi

 

Yes. The reliability and  reproduce ability of high returns is the key question. Brindle not only has a 19% average annual return for about 20 years including his Lloyd's years, but that's without a single down year during periods when his peers had a number of down years, especially at Lloyd's.  Plus, his poorest years have been well above the break even point, and he has had only one down quarter at LRE (and another quarter that missed being down by the skin of his teeth).  Let's assume that by the luck of the draw that maybe one or two of those years should have been down.  Even so, he is still a multi sigma outlier like Buffett.

 

Then realize that extradinordinary investors experience regression in their returns with increasing size of their operations.  This is why BRK's returns recently have been poorer than their long term average. However, Graham didn't  experience a drop off in his returns before he closed his partnership.  On the contrary, his last years were some of his best because he returned all the profits due his investors to them.  This is the way Brindle and Lancashire operate.  :)

[rjstc]

TWA and others. Thanks for your answer and discussions. Very interesting. That's what helps make this a great site. Ron

[giofranchi]

twacowfca,

I experienced difficulties in posting this message, so I attach it as a word file. Could you please download it?

Thank you,

 

giofranchi

LRE_implied_valuation.doc

[twacowfca]

twacowfca,

I experienced difficulties in posting this message, so I attach it as a word file. Could you please download it?

Thank you,

 

giofranchi

 

Giofranchi, Thank you for the present value analysis for Lancashire.  When I said I don't think the market misprices LRE, I meant that as a start up only six years ago, taking only that record into account, the market prices LRE appropriately.  My own opinion, of course, is that Lancashire's true value is much greater than that because Brindle has a Buffett like record of similar returns that goes back to the mid 1980's. 

 

Your PV analysis doesn't seem to have a terminal value after a defined period of time.  If so, this makes it problematical , and a PV of @ six times the current market price is way too high in my opinion for a conservative analysis. 19.5% seems to be a realistic expectation for LRE's RoE, based on Brindle's cumulative record. I think LRE will probably do a little better than that going forward for some of the reasons I've expressed, including their use of sidecars to increase profits while lowering risk, the gradual hardening of markets as investment returns, that add only a small percentage to LRE's earnings, put pressure on other insurers etc. Even so, 19.5 % is an appropriate expectation going forward. By the way, $8.06 is their Q2 FCBV/SH. Their Q3 FCBV/SH is probably 5% to 7% higher as Q3 was likely a low loss quarter with few if any large losses. :)

 

If Mr. market were capable of a PV analysis based only on LRE's short record, It would probably have an appropriate terminal value only a few years out, perhaps six years more, after which LRE's returns would be assumed to regress to the hurdle rate.

 

The cost of capital for LRE may actually be lower than 10%.  They recent sold a ten year fixed rate note at 5.70%.  8% or 9% may be an appropriate cost of capital in today's low interest rate environment for LRE instead of ten percent.  This would tend to increase the PV in your analysis, as using an appropriate terminal date would lower the calculated PV.

 

The big unknown is the appropriate terminal date after which their returns would cease to be excess.

 

I think that terminal date should be more than six years out because Brindle's record is 20 years plus, including his time at Lloyds.  He is still in his forties, and he has built up a great team at LRE that would be expected to carry on well without him.  But 20 years may be too long because "there is many a slip, 'twixt cup and lip."  Lets assume conservatively that Brindle's tenure as CEO is 12 more years (unless there is a take out before then at a much higher P/E than now) and that his team will continue to have the same high returns for four more years after his departure, after which the returns will drop to the hurdle rate.  That would put the terminal date 16 years out if you wanted to do another calculation using a different formula for PV.

 

Thank you for your analysis that is much food for thought.  :)

[giofranchi]

twacowfca,

I experienced difficulties in posting this message, so I attach it as a word file. Could you please download it?

Thank you,

 

giofranchi

 

Giofranchi, Thank you for the present value analysis for Lancashire.  When I said I don't think the market misprices LRE, I meant that as a start up only six years ago, taking only that record into account, the market prices LRE appropriately.  My own opinion, of course, is that Lancashire's true value is much greater than that because Brindle has a Buffett like record of similar returns that goes back to the mid 1980's. 

 

Your PV analysis doesn't seem to have a terminal value after a defined period of time.  If so, this makes it problematical , and a PV of @ six times the current market price is way too high in my opinion for a conservative analysis. 19.5% seems to be a realistic expectation for LRE's RoE, based on Brindle's cumulative record. I think LRE will probably do a little better than that going forward for some of the reasons I've expressed, including their use of sidecars to increase profits while lowering risk, the gradual hardening of markets as investment returns, that add only a small percentage to LRE's earnings, put pressure on other insurers etc. Even so, 19.5 % is an appropriate expectation going forward. By the way, $8.06 is their Q2 FCBV/SH. Their Q3 FCBV/SH is probably 5% to 7% higher as Q3 was likely a low loss quarter with few if any large losses. :)

 

If Mr. market were capable of a PV analysis based only on LRE's short record, It would probably have an appropriate terminal value only a few years out, perhaps six years more, after which LRE's returns would be assumed to regress to the hurdle rate.

 

The cost of capital for LRE may actually be lower than 10%.  They recent sold a ten year fixed rate note at 5.70%.  8% or 9% may be an appropriate cost of capital in today's low interest rate environment for LRE instead of ten percent.  This would tend to increase the PV in your analysis, as using an appropriate terminal date would lower the calculated PV.

 

The big unknown is the appropriate terminal date after which their returns would cease to be excess.

 

I think that terminal date should be more than six years out because Brindle's record is 20 years plus, including his time at Lloyds.  He is still in his forties, and he has built up a great team at LRE that would be expected to carry on well without him.  But 20 years may be too long because "there is many a slip, 'twixt cup and lip."  Lets assume conservatively that Brindle's tenure as CEO is 12 more years (unless there is a take out before then at a much higher P/E than now) and that his team will continue to have the same high returns for four more years after his departure, after which the returns will drop to the hurdle rate.  That would put the terminal date 16 years out if you wanted to do another calculation using a different formula for PV.

 

Thank you for your analysis that is much food for thought.  :)

 

twacowfca,

I think your assumptions regarding Mr. Brindle’s tenure of just 12 more years are very conservative! He is just 49! And clearly is extremely passionate about his work!

Anyway, even taking into account your assumptions, my thesis does not change much. If you explicit Professor Penman’s formula (“Accounting for Value”, page 68, Columbia Business School Publishing) that I used before, what you get is the following:

 

Present value of equity = B0 + [(ROE1 – r) * B0] / (1 + r) + [(ROE2 – r) * B1] / (1 + r)² +[(ROE3 – r) * B2] / (1 + r)³ + etc.

 

Until you get to the 16th year (12 of Mr. Brindle’s tenure + 4 more years after his departure). According to your assumptions, I used $8.46 as B0, a ROE of 19.5% and a cost of capital of 9%. Then, even assuming terminal value equal to zero, we still get a PV of equity of $36.85.

 

My idea is not really to get to a “number”… what I would like to discuss is the inability of the market to value properly a machine that can compound capital at high rates of return for a very long time. I think the greatest inefficiencies in the market are there. And that’s why I don’t really like to jump from an undervalued security to another: because short term mispricings (and for “short term” I mean 3-5 years) are much less remarkable than long term mispricings (and for “long term” I mean 15-20 years).

 

giofranchi

 

[twacowfca]

twacowfca,

I experienced difficulties in posting this message, so I attach it as a word file. Could you please download it?

Thank you,

 

giofranchi

 

Giofranchi, Thank you for the present value analysis for Lancashire.  When I said I don't think the market misprices LRE, I meant that as a start up only six years ago, taking only that record into account, the market prices LRE appropriately.  My own opinion, of course, is that Lancashire's true value is much greater than that because Brindle has a Buffett like record of similar returns that goes back to the mid 1980's. 

 

Your PV analysis doesn't seem to have a terminal value after a defined period of time.  If so, this makes it problematical , and a PV of @ six times the current market price is way too high in my opinion for a conservative analysis. 19.5% seems to be a realistic expectation for LRE's RoE, based on Brindle's cumulative record. I think LRE will probably do a little better than that going forward for some of the reasons I've expressed, including their use of sidecars to increase profits while lowering risk, the gradual hardening of markets as investment returns, that add only a small percentage to LRE's earnings, put pressure on other insurers etc. Even so, 19.5 % is an appropriate expectation going forward. By the way, $8.06 is their Q2 FCBV/SH. Their Q3 FCBV/SH is probably 5% to 7% higher as Q3 was likely a low loss quarter with few if any large losses. :)

 

If Mr. market were capable of a PV analysis based only on LRE's short record, It would probably have an appropriate terminal value only a few years out, perhaps six years more, after which LRE's returns would be assumed to regress to the hurdle rate.

 

The cost of capital for LRE may actually be lower than 10%.  They recent sold a ten year fixed rate note at 5.70%.  8% or 9% may be an appropriate cost of capital in today's low interest rate environment for LRE instead of ten percent.  This would tend to increase the PV in your analysis, as using an appropriate terminal date would lower the calculated PV.

 

The big unknown is the appropriate terminal date after which their returns would cease to be excess.

 

I think that terminal date should be more than six years out because Brindle's record is 20 years plus, including his time at Lloyds.  He is still in his forties, and he has built up a great team at LRE that would be expected to carry on well without him.  But 20 years may be too long because "there is many a slip, 'twixt cup and lip."  Lets assume conservatively that Brindle's tenure as CEO is 12 more years (unless there is a take out before then at a much higher P/E than now) and that his team will continue to have the same high returns for four more years after his departure, after which the returns will drop to the hurdle rate.  That would put the terminal date 16 years out if you wanted to do another calculation using a different formula for PV.

 

Thank you for your analysis that is much food for thought.  :)

 

twacowfca,

I think your assumptions regarding Mr. Brindle’s tenure of just 12 more years are very conservative! He is just 49! And clearly is extremely passionate about his work!

Anyway, even taking into account your assumptions, my thesis does not change much. If you explicit Professor Penman’s formula (“Accounting for Value”, page 68, Columbia Business School Publishing) that I used before, what you get is the following:

 

Present value of equity = B0 + [(ROE1 – r) * B0] / (1 + r) + [(ROE2 – r) * B1] / (1 + r)² +[(ROE3 – r) * B2] / (1 + r)³ + etc.

 

Until you get to the 16th year (12 of Mr. Brindle’s tenure + 4 more years after his departure). According to your assumptions, I used $8.46 as B0, a ROE of 19.5% and a cost of capital of 9%. Then, even assuming terminal value equal to zero, we still get a PV of equity of $36.85.

 

My idea is not really to get to a “number”… what I would like to discuss is the inability of the market to value properly a machine that can compound capital at high rates of return for a very long time. I think the greatest inefficiencies in the market are there. And that’s why I don’t really like to jump from an undervalued security to another: because short term mispricings (and for “short term” I mean 3-5 years) are much less remarkable than long term mispricings (and for “long term” I mean 15-20 years).

 

giofranchi

 

 

Thank you very much, Giofranchi. 

 

I have shied away from PV analyses because assumptions about how long excess returns will continue are usually over optimistic.  However, this dialog has helped me get comfortable using 12 + 4 = 16 years as a reasonable and conservative period for returns about equal to Brindle's long term record to continue (unless there is a take out before then at a much higher multiple than their recent multiple has been).

 

This supports my gut feeling that this company is a treasure that shouldn't be sold at the current valuation, merely because it has had a great ride.

[giofranchi]

twacowfca,

I experienced difficulties in posting this message, so I attach it as a word file. Could you please download it?

Thank you,

 

giofranchi

 

Giofranchi, Thank you for the present value analysis for Lancashire.  When I said I don't think the market misprices LRE, I meant that as a start up only six years ago, taking only that record into account, the market prices LRE appropriately.  My own opinion, of course, is that Lancashire's true value is much greater than that because Brindle has a Buffett like record of similar returns that goes back to the mid 1980's. 

 

Your PV analysis doesn't seem to have a terminal value after a defined period of time.  If so, this makes it problematical , and a PV of @ six times the current market price is way too high in my opinion for a conservative analysis. 19.5% seems to be a realistic expectation for LRE's RoE, based on Brindle's cumulative record. I think LRE will probably do a little better than that going forward for some of the reasons I've expressed, including their use of sidecars to increase profits while lowering risk, the gradual hardening of markets as investment returns, that add only a small percentage to LRE's earnings, put pressure on other insurers etc. Even so, 19.5 % is an appropriate expectation going forward. By the way, $8.06 is their Q2 FCBV/SH. Their Q3 FCBV/SH is probably 5% to 7% higher as Q3 was likely a low loss quarter with few if any large losses. :)

 

If Mr. market were capable of a PV analysis based only on LRE's short record, It would probably have an appropriate terminal value only a few years out, perhaps six years more, after which LRE's returns would be assumed to regress to the hurdle rate.

 

The cost of capital for LRE may actually be lower than 10%.  They recent sold a ten year fixed rate note at 5.70%.  8% or 9% may be an appropriate cost of capital in today's low interest rate environment for LRE instead of ten percent.  This would tend to increase the PV in your analysis, as using an appropriate terminal date would lower the calculated PV.

 

The big unknown is the appropriate terminal date after which their returns would cease to be excess.

 

I think that terminal date should be more than six years out because Brindle's record is 20 years plus, including his time at Lloyds.  He is still in his forties, and he has built up a great team at LRE that would be expected to carry on well without him.  But 20 years may be too long because "there is many a slip, 'twixt cup and lip."  Lets assume conservatively that Brindle's tenure as CEO is 12 more years (unless there is a take out before then at a much higher P/E than now) and that his team will continue to have the same high returns for four more years after his departure, after which the returns will drop to the hurdle rate.  That would put the terminal date 16 years out if you wanted to do another calculation using a different formula for PV.

 

Thank you for your analysis that is much food for thought.  :)

 

twacowfca,

I think your assumptions regarding Mr. Brindle’s tenure of just 12 more years are very conservative! He is just 49! And clearly is extremely passionate about his work!

Anyway, even taking into account your assumptions, my thesis does not change much. If you explicit Professor Penman’s formula (“Accounting for Value”, page 68, Columbia Business School Publishing) that I used before, what you get is the following:

 

Present value of equity = B0 + [(ROE1 – r) * B0] / (1 + r) + [(ROE2 – r) * B1] / (1 + r)² +[(ROE3 – r) * B2] / (1 + r)³ + etc.

 

Until you get to the 16th year (12 of Mr. Brindle’s tenure + 4 more years after his departure). According to your assumptions, I used $8.46 as B0, a ROE of 19.5% and a cost of capital of 9%. Then, even assuming terminal value equal to zero, we still get a PV of equity of $36.85.

 

My idea is not really to get to a “number”… what I would like to discuss is the inability of the market to value properly a machine that can compound capital at high rates of return for a very long time. I think the greatest inefficiencies in the market are there. And that’s why I don’t really like to jump from an undervalued security to another: because short term mispricings (and for “short term” I mean 3-5 years) are much less remarkable than long term mispricings (and for “long term” I mean 15-20 years).

 

giofranchi

 

 

Thank you very much, Giofranchi. 

 

I have shied away from PV analyses because assumptions about how long excess returns will continue are usually over optimistic.  However, this dialog has helped me get comfortable using 12 + 4 = 16 years as a reasonable and conservative period for returns about equal to Brindle's long term record to continue (unless there is a take out before then at a much higher multiple than their recent multiple has been).

 

This supports my gut feeling that this company is a treasure that shouldn't be sold at the current valuation, merely because it has had a great ride.

 

Well, I didn't even know of Lancashire, until I read your posts...  :-[

But now I have read about it a lot and you helped me clarify many doubts: and I agree with you that this company is a treasure!

So, you certainly are the one to be thanked!  ;)

 

giofranchi

[twacowfca]

Giofranchi,

 

There are two basic methods for valuing a company, as I'm sure you know, that has intrinsic value that exceeds its book value.  The method you used is to discount the value of the more or less uncertain future cash flows available for the owners.  This method is much more apropos for Lancashire than for many companies because they don't have to reinvest in their business to maintain their competitive position.  Their earnings aren't taxed, and are almost entirely distributed to the owners as share buybacks when that is efficient or through dividends.  This avoids the bane of most companies, diminishing returns with increasing size.  Brindle's long term record provides a proxy for Lancashire as if they had produced their high returns for more than two decades in various insurance markets.  They are switch hitters and are not locked into a particular market if it no longer has an acceptable margin.  In short, a DCF valuation is a good way to look at them.

 

The other basic method for valuation is what a private buyer might pay for them at various points in time.  The valuation for most insurance companies is depressed currently, but there have been a few of the better insurance companies that have been taken out at more than two times book recently.  Interestingly, pieces of capacity of one of the best Lloyd's syndicates recently went at auction for £1.58 over each £1.00 of capacity.  Capacity isn't  NAV, but this does show that good insurance businesses command a premium.

 

At the peak of the market in the late 1990s the syndicates managed by Charman of which  Brindle  was the chief underwriter were purchased by a large insurer for three times NAV.  All things considered, two times NAV might be in the top of the range of what a private buyer might pay currently for a company of Lancashire's quality, but in a stronger market, the top of that range could be three times NAV.  However, in a strong market for P&C companies, it's possible that the public market value could also be high.

[giofranchi]

Giofranchi,

 

There are two basic methods for valuing a company, as I'm sure you know, that has intrinsic value that exceeds its book value.  The method you used is to discount the value of the more or less uncertain future cash flows available for the owners.  This method is much more apropos for Lancashire than for many companies because they don't have to reinvest in their business to maintain their competitive position.  Their earnings aren't taxed, and are almost entirely distributed to the owners as share buybacks when that is efficient or through dividends.  This avoids the bane of most companies, diminishing returns with increasing size.  Brindle's long term record provides a proxy for Lancashire as if they had produced their high returns for more than two decades in various insurance markets.  They are switch hitters and are not locked into a particular market if it no longer has an acceptable margin.  In short, a DCF valuation is a good way to look at them.

 

The other basic method for valuation is what a private buyer might pay for them at various points in time.  The valuation for most insurance companies is depressed currently, but there have been a few of the better insurance companies that have been taken out at more than two times book recently.  Interestingly, pieces of capacity of one of the best Lloyd's syndicates recently went at auction for £1.58 over each £1.00 of capacity.  Capacity isn't  NAV, but this does show that good insurance businesses command a premium.

 

At the peak of the market in the late 1990s the syndicates managed by Charman of which  Brindle  was the chief underwriter were purchased by a large insurer for three times NAV.  All things considered, two times NAV might be in the top of the range of what a private buyer might pay currently for a company of Lancashire's quality, but in a stronger market, the top of that range could be three times NAV.  However, in a strong market for P&C companies, it's possible that the public market value could also be high.

 

twacowfca,

I agree with you. The fact is that I don’t know how much a private buyer could count on Mr. Brindle’s skills to go on compounding capital, after the acquisition is completed. I just don’t see people like Mr. Buffett, Mr. Watsa, or Mr. Brindle to work for someone else… And insurance, as far as I know, is all about management. Also in your assumptions, after Mr. Brindle’s departure, the years of outperformance shrink to just 4, right? A private buyer, of course, must take this into proper account. What I mean is that, if I were a private buyer interested in purchasing the whole company, I wouldn’t want to pay for a “Brindle’s premium”. So, which is more valuable: an insurance company that you own the entirety of and is managed by an average CEO, or an insurance company that you are only partial owner of but is managed by Mr. Brindle? For any business in which management isn’t so important, I agree that entire ownership is a plus. But what about insurance? I wouldn’t be so sure. That’s why I preferred a PV analysis, using assumptions given by a person like yourself, who is clearly very knowledgeable about Lancashire.

Anyway, I have proceeded cautiously: I bought just 1/3 of the amount I intend to invest in LRE. And I hope I will be able to average down aggressively in the future.

 

giofranchi

[twacowfca]

Giofranchi,

 

There are two basic methods for valuing a company, as I'm sure you know, that has intrinsic value that exceeds its book value.  The method you used is to discount the value of the more or less uncertain future cash flows available for the owners.  This method is much more apropos for Lancashire than for many companies because they don't have to reinvest in their business to maintain their competitive position.  Their earnings aren't taxed, and are almost entirely distributed to the owners as share buybacks when that is efficient or through dividends.  This avoids the bane of most companies, diminishing returns with increasing size.  Brindle's long term record provides a proxy for Lancashire as if they had produced their high returns for more than two decades in various insurance markets.  They are switch hitters and are not locked into a particular market if it no longer has an acceptable margin.  In short, a DCF valuation is a good way to look at them.

 

The other basic method for valuation is what a private buyer might pay for them at various points in time.  The valuation for most insurance companies is depressed currently, but there have been a few of the better insurance companies that have been taken out at more than two times book recently.  Interestingly, pieces of capacity of one of the best Lloyd's syndicates recently went at auction for £1.58 over each £1.00 of capacity.  Capacity isn't  NAV, but this does show that good insurance businesses command a premium.

 

At the peak of the market in the late 1990s the syndicates managed by Charman of which  Brindle  was the chief underwriter were purchased by a large insurer for three times NAV.  All things considered, two times NAV might be in the top of the range of what a private buyer might pay currently for a company of Lancashire's quality, but in a stronger market, the top of that range could be three times NAV.  However, in a strong market for P&C companies, it's possible that the public market value could also be high.

 

twacowfca,

I agree with you. The fact is that I don’t know how much a private buyer could count on Mr. Brindle’s skills to go on compounding capital, after the acquisition is completed. I just don’t see people like Mr. Buffett, Mr. Watsa, or Mr. Brindle to work for someone else… And insurance, as far as I know, is all about management. Also in your assumptions, after Mr. Brindle’s departure, the years of outperformance shrink to just 4, right? A private buyer, of course, must take this into proper account. What I mean is that, if I were a private buyer interested in purchasing the whole company, I wouldn’t want to pay for a “Brindle’s premium”. So, which is more valuable: an insurance company that you own the entirety of and is managed by an average CEO, or an insurance company that you are only partial owner of but is managed by Mr. Brindle? For any business in which management isn’t so important, I agree that entire ownership is a plus. But what about insurance? I wouldn’t be so sure. That’s why I preferred a PV analysis, using assumptions given by a person like yourself, who is clearly very knowledgeable about Lancashire.

Anyway, I have proceeded cautiously: I bought just 1/3 of the amount I intend to invest in LRE. And I hope I will be able to average down aggressively in the future.

 

giofranchi

 

Agreed.  I put a very high premium on Brindle's overseeing the business.  He's gone through all the difficulties of building a great business.  He apparently has most of his wealth in LRE through deep in the money warrants, options, restricted stock, and he receives a regular salary.  He's fifteen or twenty years away from a normal retirement age.  He's highly respected in the London - Bermuda international market.  It's hard to imagine accepting a takeout offer unless it's for a huge premium.

 

There are rare times though when a large insurance company will offer a large premium for a best of class smaller company.  The large company may want to lever the expertise of the smaller company or perhaps write more business in the sweet spots that are beyond the capacity of the small co.  Brindle became the risk manager for AIG's London operations after Charmin sold his Lloyds syndicates before he was tapped to be the CEO for LRE.  Brindle headed up the committee to rewrite the insurance contracts for the London companies and put liability limits on them after 9/11.  Therefore, he knows a lot more about where the sweetest spots in many lines of business are than almost anyone else. 

 

However, Richard enjoys running his own small company much more than having to spend most of his time on the politics of managing a large company.  I don't think a takeout is likely in the next few years, unless someone makes an offer he can't refuse.  Therefore, a DCF model should be the first choice for valuation.  :)

 

 

[racemize]

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?