October 10, 2008Buyback This! (Principal, Pru, Hartford)
I've been turned off by insurance stocks for quite some time. My reasons were mundane: too much speculation, companies being run by average guys who thought they were geniuses, and prices weren't cheap.
That last reason — the most important — bears some elaboration. Insurance, especially property-casualty, isn't a bad business. Run prudently, an insurance company can make respectable returns over the long haul — in the neighborhood of 9% to 11% compounded. Insurance is not a 15% ROE type of business, however, nor is it a rapidly expanding business. But a lot of clever people have tried to turn it into that. They do this by growing premiums a little faster, or using borrowed money, or being more aggressive on their investments. Or, more likely, they do all three.
That's an easy strategy to execute. Any company can turn on the spigot of premium growth by cutting prices a little. And any damned fool can issue long-term debt, GICs and trust preferreds. And it's not hard to go out longer on your fixed-income investments and take on extra credit risk while you're at it.
Over the years in Schiff's Insurance Observer, I've chronicled companies that stretched for yield and embraced extra risk. Often, they ran into trouble. Not all, of course. But all insurance companies are supposed to be prudent and conservative. In my book, anyway.
If you believe that a decent insurance company can earn 9% to 11% over time, then it stands to reason that if you buy most insurance stocks at a price greater than book value your return will be lower than 9% to 11%.
I don't know about you, but when I buy a stock, I usually want to make considerably more than 10% compounded over time. It has been my experience that a reasonable way of doing this is by buying the stocks (or, on rare occasions, bonds) of good, conservative insurance businesses at prices below book value.
In recent years, however, you couldn't find decent insurance companies at that price. It has also been my experience that that phenomena doesn't last forever. Patience is usually rewarded. Every now and then, something happens — a soft market, a financial scare, a big failure, an internet-stock bubble — and loads of insurance stocks trade below book value.
Right now is one of those times. Yesterday, the SNL Insurance Index fell 10.15%. It is down 54.36% over the past year. You can now have your pick of brand name insurance companies below book. And not just a little below. Hartford Financial Services, for example, is at 45% of book; MetLife is at 59%; and IPC Holdings is at 62%. For the record, I just bought IPC. I do not expect to buy Hartford or MetLife.
While the big discounts to book are tempting, I'm not interested in most insurance stocks, for several reasons.
* The most recent book-value figures are from June 30, and companies' portfolios have declined markedly since then.
* I don't know what the hell many companies are up to. I just know that they have riskier balance sheets than I'm comfortable with.
* Insurance companies are inherently leveraged. That's not great in a financial crisis.
In the last cycle of cheap insurance stocks eight years ago, I was able to buy the stocks of staid, solvent insurance companies with clean, simple balance sheets at prices well below book. It's not so easy to do that right now. Many of the good companies have been taken over, and some have spent years debasing their balance sheets by repurchasing stock at prices significantly higher than book value.
Take the mutuals, for example. In the late 1990s, many of the largest mutual life insurance companies decided that they needed to convert to stock companies. "How can we participate in the consolidation, much less globalization [of the insurance industry] if we're restricted to the capital in a mutual organization," said David Drury, then-CEO of Principal Mutual. The mutuals' preferred method of conversion was something called the "mutual insurance holding company," or MIHC, which, as proposed, would have screwed policyholders out of tens of billions of dollars.
Several individuals opposed the mutuals' plans: myself, attorney Jason Adkins, Joe Belth of The Insurance Forum, and New York State Assemblyman Pete Grannis. Amazingly, this ragtag group of oddballs pretty much prevailed over the giant mutuals in the end. (To read all about this sordid episode in insurance history, go to www.insuranceobserver.com/topics/thebigfix.php.)
At a 1998 public hearing for Principal's MIHC conversion, an amazing exchange took place. During his testimony, Drury repeatedly discussed issuing stock and making acquisitions for stock and cash. However, when I questioned him under oath and asked how much Principal was worth, he professed ignorance. "I don't have an opinion as to what … the market would assign as a current value to the company," he said.
When I suggested a figure, Principal's lawyer immediately objected, stating, "Mr. Drury has already said that he doesn't have the expertise to make such an assumption."
"If he doesn't have the expertise," I said, "why would he want to acquire companies?"
Drury responded by saying he had expertise on his staff and that "we hire expertise from investment bankers."
Since that time, Principal's action has proven that not only did Drury not know a damned thing about the value of insurance companies but neither did his successors or their business cronies on the company's board.
When Principal demutualized in 2001, it issued stock below book value, at a net price of $17.54. Immediately after issuing 100 million shares, Principal began buying back stock at much higher prices — and never stopped. From the IPO through June 30, the company spent $4.7 billion to repurchase shares at an average price of $36.94. Book value is now $25.56.
Yesterday, Principal's stock closed at $15.79, an all-time low. And the company's market cap is now $4.09 billion, 20% less than what it spent to repurchase stock.
Principal is hardly the only company to go wild on buybacks. Since 2002, Prudential Financial has spent $11.3 billion to buy back stock at an average price of $63.35. Book value is $50.36. Its shares closed yesterday at $33.27.
Of course you needn't be a former mutual insurance company to be reckless. Hartford, for example, spent $871 million in the second quarter to buy back shares at an average price of $74.63. Last year, it spent $1.2 billion to buy back stock at an average price of $98.77 per share. At the time of these buybacks, book value was in the neighborhood of $60 per share.
On Oct. 6, Hartford, which planned to report a big loss and needed capital, agreed to sell Allianz $750 million of preferred shares convertible into common at $31, and $1.75 billion of 10% junior subordinated debentures. In addition, Allianz received seven-year warrants to purchase Hartford common stock for $25.32 per share.
Hartford's repurchases have cost the company about $1.45 billion. But because repurchases are capital transactions, that loss won't show up on the income statement. But it's a real loss nonetheless.
Last year, the CEOs of Principal, Prudential and Hartford made $7.4 million, $18.6 million and $22.1 million, respectively. For that kind of money, you'd think that they'd have waited until their company's shares were below book value before buying it back.