November 4, 2009
The Easy Money is Gone

On March 2, 2009, when the SNL Insurance Index was down more than 50% from its high, I wrote that the market's distress was "pretty good news for investors who have been cautious because, as always, distress creates opportunities." I mentioned that I'd bought the securities of 10 insurance businesses including the common stock of IPC Holdings Ltd. and the bonds of White Mountains Insurance Group Ltd. and Montpelier Re Holdings Ltd.

Over the next three-and-a-half months the SNL Insurance Index rose 37.3%. In my July 20 blog I noted that "value is harder to find" but that it nonetheless still existed. I cited three examples: Zenith National Insurance Corp. (at 80% of tangible book), Investors Title Co. (at 72% of book), and IPC (an attractive arbitrage — it was being taken over by Validus Holdings Ltd.)

The SNL Insurance Index is now up 16.51% since my last blog and, not surprisingly, insurance stocks are far from cheap. I've sold Zenith and IPC, both of which rose sharply, and I'm not enamored of insurance stocks in general. Insurance bonds hold even less value for an enterprising investor. An example: On March 2, I made the case for the Montpelier Re 6.125% senior notes due Aug. 15, 2013. The company was in good financial condition: it wasn't easy to envision a reasonable scenario in which bondholders were likely to be impaired. Nonetheless, the bonds were trading around 74 — a 14% yield to maturity. Montpelier's stock, at 80% of book value, was not pricey either, but why take risk with a common stock when extremely high returns are available from safe bonds?

Since March, distress has left the market. It has been replaced by a certain complacency. Security prices generally reflect greater reason today, which is a reason not to buy. The Montpelier bonds, for example, are now around 99. (That means they've compounded at a 41% annual rate since my recommendation eight months ago. Montpelier's stock is up 33% over the same period.) At 99, the Montpelier bonds now yield 6.4% to maturity. There's little upside left. Montpelier's stock is trading at 80% of book value — not expensive, but I don't feel compelled to own it.

In fact, I don't feel compelled to buy much of anything right now. This past year was one of those infrequent periods where good insurance businesses with clean balance sheets and decent managements traded at significant discounts to tangible book value.

I've used the big rally this year to pare positions that became fully valued, or at least reasonably valued. But I still own some bonds issued by Montpelier, White Mountains, and Marsh & McLennan Cos. Inc. (all bought at much lower prices).

I've also got small stock positions in Investors Title and Erie Indemnity Co.

I have two disproportionately large equity positions, and both have risen sharply over the last year, but I still feel comfortable with them. Baldwin & Lyons Inc., at 88.8% of book value is no longer dirt cheap, but it's an excellent underwriter controlled by the Shapiro family — good people in whom I have faith. From my viewpoint, there are few, if any, stock companies that have a stronger balance sheet.

You've probably never heard of my largest position, Unico American Corp., and even if you have, it isn't easy to buy its stock. Average daily volume is 2,162 shares, and the market cap is $53 million. Half the company is owned by insiders. Despite a big rally in the stock, Unico is still quantitatively cheap — 70% of book value. The company has little operating leverage at the moment; written premiums are roughly half the company's book value. As for the balance sheet, well, it's probably too conservative: 83% of investments are in Treasurys, 10% in certificates of deposit, and 7% in bonds. Unico recently repurchased about 2% of its shares. I'd like to see it buy back much more.