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.

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.