Part three of my portfolio series is about the best business in America, Property and Casualty Insurance.
music selection: “Sheena Is A Punk Rocker” — Ramones
High yield and fixed income make up the first two parts of my portfolio construction and are necessary to generate sufficient cash flow in early retirement to keep me from needing to go back to a job. The remaining parts of the portfolio concept are about growing the stockpile to provide a brighter future and to outpace inflation.
One way to reliably beat the broad market averages is to buy quality insurance companies at fair valuations. You want companies in the P&C space rather than in life insurance as life is a commodity business where there is no competitive moat. With P&C you often find companies with a long history of strong underwriting. Your key metric is something called the “combined ratio.” This is a measure of how profitable the underlying insurance business is. You want to “play golf” and go for low scores as anything under 100 is profitable. You also want to filter out cyclical effects by using a ten year average combined ratio. From time to time, I will highlight such companies in these pages.
I have most of my insurance holdings in my IRA. The taxable accounts have to provide immediate income but the advantaged account is all about the future and low (by my standards) yields are not worrisome there. Once I find companies with good underwriting history, I evaluate based on price. Anything under 1.2 times book value is fairly valued. If you look long and hard however, you can often find strong underwriting priced for less than liquidation value. Back up the truck!
The beauty of insurance with profitable underwriting is the “float.” Because cash is collected up front and claims are paid out ‘later’, the insurer can invest the cash for return in the meantime. Thus, profitable underwriting provides a form of negative interest margin. Even with very conservative bond centric investing, a company can rapidly grow book value by investing float. Some insurance companies are more aggressive and can build truly massive empires on the strength of strong investing.
I make two exceptions to the rule for strong underwriting and these are Third Point Re (TPRE) and Greenlight Re (GLRE). These are two relatively new insurance companies that are still building the scale necessary to have successful underwriting. They are getting close. The enormous opportunity is that each is run by a hedge fund legend, Dan Loeb and David Einhorn respectively, that could potentially duplicate Warren Buffet’s long term success with Berkshire Hathaway (BRK-B). The position sizes are small. I’m giving each ten years to prove their worth. I’ll keep the raptors posted on progress. The next quarterly reports (and combined ratio results) are due in early August.
Devour your prey raptors!