Saturday, December 30, 2006

ACE Limited ($60.6) and Expectations Investing

A little due diligence can go a long way in beating the professionals at their own game, given that a lack of context in Street published research seems as pervasive today as five years ago. One strategy we believe can go a long way to avoiding some irreparable harm (or outsized gains) to your portfolio is to spend more time trying to understand the "expectations" investment game a bit better (not just earnings estimates) for each specific Financial Institution subsector. In particular, the confluence of factors, including rising margins, expanding ROEs, and increasing sector and subsector valuations have resulted in substantial price gains for the property/casualty industry over the three and four year periods. We think the risk/reward today is substantial, given that two of these critical factors will be working against the industry going forward. The third factor, valuation support from lower average interest rates would now seem to have less positive momentum (and substantial more downside) given how far we have come.

We think it is interesting to look for clues that show contrasting sentiment between "analysts" and "owner/shareholders", by focusing on meaningful discrepancies between estimated price targets and buy/sell/hold ratings. A sample review of one property/casualty insurance stock provides a test case. There is a total absence of conviction in the ratings of Institutional teams providing detailed coverage of multibillion dollar insurer ACE Limited (ACE). Currently, the stock has 9 strong buys, 5 buys, 9 holds and 1 strong sell. Based on this bullish rating, you would think performance expectations would be substantially greater than the average 9% potential rise (target price $66, no time frame). The analysts providing coverage have their feet as close to the ground as possible, suggesting something is awry in the closed loop research process that predominates on Wall Street. Bias for ones own coverage can't fully explain the lack of proper assessment of risk and opportunity. In fact, a 9% expected return looks pretty meager for a stock that has averaged 25% to 30% average annual returns from the lows of 2003, and ought not be associated with buy or strong buy ratings. Our sense is that the "point in time" earnings estimates and price targets don't do an adequate job of providing context for ratings. While going out on the limb and calling for a "major industry cyclical decline" can be a career spoiler for analysts, an "if/then" style of scenario modelling can provide a comprehensive analytical framework for understanding sector (missed) opportunities

For ACE, consensus earnings estimates for 2006, 2007 2008 are essentially flat (in the $7 range). However, we sense little in the way of conviction in the estimates beyond the next few quarters, given how much margin expansion has been a fucntion of reserve releases. Operating ROE's are expected to drop modestly from the high teens level, though they will still be "above" average. One of the reasons that analysts can't square the circle is that they are constitutionally incapable of hypothesizing lower earnings for outer years despite the fact that they certainly know there is, at best, a one in five chance that peak industry margins and ROEs can be sustained even in 2007 without an even more notable decline in the quality of earnings.

We now believe there is greater than a 50% chance of a major cyclical decline in earnings within winking distance and single digit ROEs by late 2008/2009. And while things may be "different" this cycle, the differences are not likely to be sufficent to allow the sector to garner even average sector returns through 2009. As the bottom ranked group (time horizon two to three years) among the whole financial sector, we think one ought to sell before someone does it for you.

No comments: