Sunday, December 10, 2006

PHLY short of the decade

As one of the most expensive property/casualty insurance stocks in the universe, investors can play this short of Philadelphia Consolidated Holdings myriad ways. If one is to buy into this idea as a pure short, you'll have to believe that the market expects near record margins and ROE's are likely through 2008 (at least 20% ROEs). If you agree with my contention that the p/c insurance cycle is at the tipping point and margins are likely to slip quite substantially by 2008/2009, than get on board (I think ROEs will fall to low double digits by late 2008). It could be fun on the way down. How steep this correction will be obviously depends on how the macro scenario unfolds, since lower interest rates are propping up valuations of all financial stocks. (There are some longer term ramifications to pricing because of this, but that is another discussion.) My sense is that the magnitude and duration of the correction could be rather severe and long, given the almost ten fold increase since 2000 of PHLY stock. A look at industry history shows few parallels in terms of uninterrupted stock advances and there is virtually no risk in taking some type of short position: be it long/short between financial subsectors, pure short, or even long short (large cap/mid cap p/c stocks). At three times book, it would only take one earnings miss to get the ball rolling, while potential for material misses rises as we go into 2007. One can envision the stock almost being cut in half in a worst case scenario (i.e ROE falling to low single digits) with the price/book falling to to 1.5X and interst rates backing up (now a less likely scenario in 2007). But the industry history is littered with rapidly growing companies with revenues advancing 20% plus, without growing reserves (flat since 12/31).

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