Wednesday, December 27, 2006

PHLY; A Gem In the Rough?

While calling a top in property/casualty insurance sector is proving to be a difficult task (my call this half of 2006) primarily because of liquidity-related demand for financial stocks, refuting the evidence supporting the long case for PHLY is rather easy. No significant company-specific or industry evidence is presented to bolster an already weak and tired case. According to the editors at Forbes in their "7 gems for 2007", PHLY makes the cut, though, like freshman basketball tryouts, you just have to show up. One must assume, that the stock screeners looked at the 5 year average annual advance in revenues (38%), and earnings (30%), as well as a 5-year uninterrupted advance in the stock price that resulted in a five bagger for investors. One must also assume that the quantitaive model (Quantex rating 100) must have spit this one out after a gangbuster Q3 with massive reserve releases which no one is his right mind would give "any" credit for at this stage of the insurance cycle (huh!!). One can also be fairly confident that assessing risk is not Forbes forte, since no mention of it appears. Resting the bullish case on the a reasonable valuation (14 x), while reiterating management's belief that the consensus can be beat seems about as poor an argument for buying a stock I've seen in a "respectable" journal. Given the top line growth (almost 25% in Q3) and absence of reserve growth (just about flat) from the Dec 2005 quarter through Sep 2006, and steep valuation (forget about p/e; its at over 3 times book) there is little room for error. The probability of sustaining 25% ROEs for the next six quarters is closer to zero than it is to 50%. The probability of growing premiums 25% annually and doing so in a flattish industry environment (premiums) without substantial risk approximates zero. The chance of sustaining the 3 x book valuation in the event the ROE starts to slip even modestly is quite high. We think you ought to sell before somebody else does it for you.


David said...

But would you dare sell it short?

David Merkel

FIG Investor and Trader Intelligence said...

Not only would I sell it short, but massively so, if I were a fundamentalist hedge fund manager with a 2 to 3 year horizon. With a 9 to 15 month horizon, I would go long (another financial non p/c insurance stock, say CFC) and short PHLY. It's always a question of picking your spots. Technically, financials are on the ascendancy (mostly interest rate-related) and nobody wants to go against the trend as long as rate/valuation environment remains sound. But even under the most optimistic fundamental scenarios for p/c insurance companies, it is one of the most expensive stocks in the riskiest subsector of financials based on realistic risk-adjusted ROEs through 2010 (reflected in the stock price by 2009)