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Rick Konrad on Financial Services Companies

(Guest Commentary by Rick Konrad – March 22, 2007)

Dear Subscribers and Readers,

For those who had wanted to learn more about picking stocks, evaluating companies, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a mid-week discussion.  Rick is one of our two regular guest commentators (besides Bill Rempel) and publishes a guest commentary on our site during the third Thursday of every month.  

In this commentary, Rick will be offering his thoughts on various financial services companies and why they may currently be a good buy – along with some of his personal experiences with buying some of these companies in the past.  Rick also devotes a section to the European banking industry. As usual, you can learn much more about companies from Rick's commentary than any of my personal commentaries!  Without further ado, following is a biography of Rick:

Rick is author of the excellent investment blog “Value Discipline” and is a regular guest commentator of MarketThoughts (please see “An Annuity That is Actually a Good Buy?” for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog and should you have any questions or thoughts for Rick after reading his commentary, you can also email him at the following address.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers. 

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.

Have you ever noticed how many successful investors seem to be involved in financial services companies? Warren Buffett immediately comes to mind. Why the appeal? What makes these companies special? It comes down to leverage, controlling a relatively large asset on which a relatively small return on assets is earned. But do this successfully on a small equity base, and magic ensues! Here is a whirlwind tour.

I like financial services companies. Frequently, I have utilized property casualty companies in portfolios. Long tail liability companies such as reinsurance operations such as Berkshire Hathaway provide many years for reserves to compound and build wealth. Short tail liability companies such as auto insurance companies with a significant cost advantage to their competitors can build considerable franchise value. GEICO of course comes to mind. Progressive is another wonderful business that has utilized clever and innovative underwriting as well as fanatic cost controls to grow its profitability. Specialty underwriting companies such as WR Berkley, RLI, and Markel utilize great underwriting expertise in difficult to insure cases with appropriate pricing for the risks undertaken to grow their profitability. Markel augments its underwriting profitability with its outstanding investment prowess. One of the marvelous aspects of studying insurance companies is the fact that there are so few worthwhile and disciplined underwriters to bother with; over my investment career I have identified perhaps ten companies out of the hundreds that I have examined and thousands that exist. Though an insurance cycle clearly exists, the companies that I mention rarely experience the downside of the cycle...they simply refuse to write business for an underwriting loss. The ability to say no, the ability to control the underwriting pen, the ability to service claims quickly before ambulance chasers have a chance to influence the client, and the ability to invest the “float” are the hallmarks that I look for. When the insurance cycle “hardens” and prices firm because too little risk capital is willing to underwrite risk, these companies can enjoy huge profitability because their balance sheets have ample capital.

Life companies investing for me has been special situation investing too. I find considerably less differentiation amongst the large life companies and generally, I have found few life companies that were decent capital allocators. Term life insurance tends to be written for a loss or at best a tiny profit. Whole life and its variants can effect some clever actuarial science and terrific profitability. Annuity business is a pure spread business in a very competitive rate-conscious environment.  But the investment department for most life companies rarely stands out in my view. Aggressive investment management in life companies rarely provides long term success...think of the junk bond disasters of the late 80's and early 90's. In the early 80's, at a time when successful investors were increasing duration and maturities to the max, most of the life industry was shortening term...exactly the wrong response to the fabulously (at least for the investor) high rates that existed at that time. The life insurance businesses of Leucadia National, AIG, and AFLAC are exceptions to my general rule for strong investment abilities, international growth or innovative product.

I have a warm place in my heart for title insurance companies. Unlike other insurance, title insures the past. Essentially, this is a library of data that is sold and resold incessantly upon refinancing or resale. The securitization of mortgages created a need for fungibility of mortgages that had a nationally identifiable title insurer as the “endorser” of the quality of the title to underlying property. Housing cycles may come and go but the title insurers ride the cycle by utilizing a blend of full time and part time employees. Other real estate related data are also sold such as flood plain information. My favorites over time have been Fidelity and First American. Fidelity has been a standout as an allocator of capital over the years.

Having spent some time as a consultant and a research director for a brokerage firm that was successfully focused on community banks, I observed many consolidation transactions among small U.S. banks. The climate for bank consolidation in the U.S. at least among small banks has slowed considerably in the last year. Adverse interest rate movements have squeezed net margins and hence earnings growth. Yet, valuations seem to reflect strong takeover potential, at least in my opinion. There are some spectacularly strong community banks in the market that have excellent credit qualities, many of these are microcap capitalizations with limited trading that I would not dare mention in a blog or newsletter. But there is great franchise value in a self-funded deposit taking institution that can lend well. Unfortunately, the deposit premia that most of these companies currently enjoy provides little room for disappointment. There are fortunes to be made in small banks. The consolidation trends over time are well-established and reliable. Unfortunately, most of the small banks reflect that fact. No margin of safety, ergo no investment in my view. Larger cap US banks at this point in my view represent far better value. Over the years I have had very mixed views of the capital allocation abilities of most of the larger cap US banks and often decidedly negative views of their managements. Wells Fargo and Bank of America have been my favorites over many years. Citi, despite its flailing and faltering strategy has been successfully avoided for some years but is starting to look like a decent risk/reward for the first time in five years.

What intrigues me now? I am fascinated with European banking. ABN AMRO has confirmed that it is in exploratory discussions with Barclays concerning a potential merger combination. ABN AMRO is a thoroughly diversified, if not over-diversified enterprise that has the leading market position in the Netherlands as well as major presence in both the US (LaSalle Bank of Chicago) and Brazil with earnings contributions from each of these countries representing roughly 20% each. Should Barclays actually bid for ABN, I suspect that a battle will develop amongst a number of European banks for ABN.

ABN AMRO became a target as a result of investor activism, a trend that is developing strongly in Europe. Despite some six years of serial restructurings, the Dutch bank remains a hodgepodge of both highly performing and poorly performing businesses. For example, the Dutch banking business returned about 1.19% on risk based assets last year whereas other European banking businesses returned only 0.09%. LaSalle on the other hand returned superb profitability of about 150 basis points.

Barclays has been a very well run bank in my view. Some extraordinary returns are earned in Barclays Global Investors which constitutes roughly 10% of the earnings. This is a warrant on the growth of ETF's. BGI was established in 2000 and has grown assets under management by about 90% per annum and generated returns on equity for this division of over 200%! Barclays gets another 25% of its earnings from its capital markets operations. Many investors agonize over Barclaycard, the credit card division of the bank which has seen some credit problems. This represents a very minor 5% of earnings. Other UK banking represents about 40% of total earnings. The balance of Barclays is well management and international banking.

Other European banks because of their greater internationalization have better cost synergy opportunities than Barclays. For example. Spain's Banco Santander has a significant Latin American presence that overlaps ABN's Brazilian operations. Similarly, the Royal Bank of Scotland and HSBC have US operations that could provide cost synergies to complement ABN's US presence. France's BNP has significant presence in Asia that could complement ABN's activities in the area.

Overall, I find the valuations of most of the European banks that I have mentioned to be more attractive than their US counterparts. The international diversification strategies of these banks into emerging economies is largely unappreciated by North American investors. Finally, the pressures to perform created by the growing presence of activist shareholders should keep managements focused on shareholder returns.

Disclaimer: I, my family, and clients have a current position in Berkshire Hathaway, RLI, Markel, Fidelity, Wells Fargo, Bankamerica, Fidelity National, and Barclays.

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