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Money for Nuthin

(Guest Commentary by Rick Konrad – December 11, 2008)

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 guest commentary.  Rick is one of our two regular guest commentators (besides Bill Rempel) and usually writes for us every third Wednesday of the month.  Rick has kindly penned an early commentary for us this month as I spend the next couple of days unwinding the first quarter of my UCLA Anderson MBA education (yes, that means finals).  We highly appreciate your investment insights and general wisdom, Rick!

I can't emphasize this enough.  In these trying times, it is important to keep in mind why we are investing in the stock market in the first place – and most importantly, what has worked in the past and should continue to constitute investing success in the future.  For subscribers who are not professional investors and who are close to retirement, that means proper asset allocation depending on your future needs and risk tolerance.  Individual investors can only “get a leg up” over professional investors by using bear market declines to their advantage (the old adage “Buy in times of fear and sell in times of greed” applies here).  The ones that lose in the long run are those who based their investment decisions on emotions or a scant reading of the Wall Street Journal.  Our guest commentator, Rick Konrad, is no stranger to this, as he has served both institutional and retail investors in his 25 years of professional investing experience.

In this commentary, Rick will discuss the recent phenomena in the US Treasury market and the deterioration of our state budgets.  Rick has also refined his screen that he had provided last month, and added a new one based on the P/BV ratio with some checks for earnings quality and improving working capital management.  Rick's fellow portfolio manager, Mr. John Moran, CFA, has also kindly provided us with his insights on Alleghany Corp (you can find a biography of Mr. Moran here).  Without further ado, following is a biography of Rick:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Surfing the Tsunami” 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.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  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.

Now that aint workin thats the way you do it
You play the guitar on the mtv
That aint workin thats the way you do it
Money for nothin and your chicks for free
Money for nothin and chicks for free

Dire Straits-1985

Risk aversion may have started to disappear in some parts of the capital markets but certainly not everywhere. Yesterday, the 90-day US Treasury bill was reported to have traded in an auction at a negative yield.  Now sit back and think about what this means. You bought the instrument at the price indicated and, if you held it to maturity, you got back less money than you paid for it.  Essentially, someone paid the government for the right to loan money to it. As Dire Straits put it twenty years ago, “money for nothing.”

If you do believe that the world is coming to some sort of end and you want to be ultra-risk-averse, there are plenty of ways to get federal government guarantees with above zero yields…think CDs for example.

But more important than this, in fixed income, this is the time to buy spread product in the corporate sector or the tax-free municipal sector or in the mortgage sector. Negative T-bill yields are an anomaly if not lunacy.

At the state level, the fiscal situation appears much more troubled. On December 3rd,  the Port Authority of New York and New Jersey attracted no bids from investment banks interested in underwriting a $300 million taxable note offering in another sign that the seizure in credit markets persists. As the National Conference of State Legislatures describes it:

“State finances were taking a turn for the worse long before the National Bureau of Economic Research (NBER) officially announced a recession, which NBER says began in December 2007. As early as fiscal year (FY) 2008, nearly half the states faced budget gaps. That number rose to two-thirds by the time states were crafting their FY 2009 budgets. But despite closing a cumulative gap of nearly $40 billion during budget development, the states were not done addressing FY 2009 budget problems. Another sizable gap has opened and an even bigger one looms for FY 2010. The state budget situation is grim and getting worse with each new revenue revision.”

To check out the state of the budget in your own state, please try this interactive map.

In my mind, US Treasury paper from short to long end is in a serious bubble and may be the most expensive asset class that there is. Clearly, there has been a buying panic in treasuries of all maturities. The10 year is under 3%, the 30 year is close to 3% and the shortest bills are at zero and by some reports, negative. Municipal paper is yielding a lot more than treasuries with like maturities.

Corporate paper is acting very peculiarly. I can find very good credits (single A) of ten year maturities with yields to maturity ranging from 3.45% all the way to about 7.80%. Interestingly, the interest coverage ratios based on trailing twelve month numbers are similar the credits at either end of the scale, 11-12 times EBITDA coverage. Cash flow available for debt service/ interest paid is a more comprehensive measure that considers tax and lease payments prior to any interest being paid. Here, both credits have very similar interest coverage too, at 7.5 times to 8 times.

My conclusion: Inefficiencies abound in the corporate credit marketplace. Some careful analysis and some reflection as to the competitive position of the underlying business will pay off in my opinion.

Let's turn to stocks. As Henry has already described, in many ways this will be a bleak holiday season. The tumultuous capital markets, the exceedingly high volatility, the unemployment, and the continued bailout news have most of my clients worn, not to mention yours truly. But as a value investor, I do regard cheap prices as a kind of holiday gift. Last month, I put together a screen which highlights non-financial companies having free cash flow greater than earnings, and showing improvement in return on assets with a minimum ROA of 12%

I have updated this screen and refined it further to ensure that cash flow available for debt service is a minimum of five times the interest paid. The screen is quite conservative with the median coverage of interest at about 30 times! The analytics appears through the courtesy of my friends at Cash Flow

I will be profiling some of the companies on this list at Value Discipline.

At times of capital markets distress, investors frequently turn to old metrics such as price to book value as having some reliability. I find that book value can be a very dangerous measure because it frequently contains many intangible assets that are more indicative of a history of having paid too much for an acquisition. It is also important to note that companies that have a history of buying back stock at prices above book value will drive down that metric's valuation. Consequently, excellent companies that have generated excess cash and treated shareholders well by returning capital through buybacks will be missed by P/BV screens.

With those warning labels in place, I have created a screen of non-financial companies with P/BV of less than 1.0 time. I have included an earnings quality filter to show only companies that have shown improvement in accruals to revenues (accruals should be falling as a percentage of revs on a year-over-year basis) As well, I wanted to filter for companies that were showing improvement in their working capital management i.e. operating working capital as a percentage of revenues was declining year over year. Finally, I also wanted to seek companies that showed improvement in their return on assets.

Despite these highly restrictive filters, the NYSE and NASDAQ contained 123 companies that made it through this screen.

Please check out Book Value Bargains???

Finally, an old favorite idea in financial services, but in my opinion, essentially a mini-Berkshire, Alleghany Corp. This write-up was prepared by my fellow portfolio manager, John Moran, CFA:

Alleghany Corporation (NYSE:Y)


Alleghany is based in New York City and has a rich and colorful history dating to the late 1920's. Originally a railroad holding company, the firm sold the last of its former industrial businesses over the past decade is now an insurance holding company. While the composition of the company's investments and operating subsidiaries have changed over the years, the firm's investing philosophy has not – that is to say it remains a conservative, long-term oriented “value” investor with a core expertise in property and casualty insurance. The company's stated objective is to “create stockholder value through the ownership and management of a small group of operating businesses and investments, anchored by a core position in property and casualty insurance.” Similar to Berkshire Hathaway, Y is managed by a small staff at the holding company that is charged primarily with capital allocation/investment decisions. The company's operating subsidiaries are quasi-autonomous enterprises that are left to function on their own, with daily management delegated to competent and motivated managers. In Y's own words:

Conservatism dominates Alleghany's management philosophy. Alleghany's philosophy shuns investment fads and fashions in favor of acquiring relatively few interests in basic financial and industrial enterprises that offer the potential to deliver long-term value to the investor.

Weston Hicks has served as President and CEO for the last four years and has been with Alleghany since 2002. Before joining the company, Mr. Hicks spent one year as the CFO of The Chubb Corporation. For more than a decade earlier in his career, he was a top-ranked research analyst in the P&C insurance sector at Sanford Bernstein and JP Morgan. John Burns has been the Chairman of the company since 2006, having previously enjoyed an extremely successful career as Alleghany's former CEO. His continued involvement on both strategic and investment issues is clearly beneficial. Burns took over the Chairman position from Allan Kirby.

The Kirby family remains the largest investor in the company with control of approximately 34% of the total shares outstanding. Moreover, the company has attracted the “right” kinds of investors and enjoys strong sponsorship by well-regarded asset management firms including Franklin Mutual and Royce, which are the two largest institutional owners of the company with just over 16% ownership. Perhaps because of this ownership structure, Alleghany continues to operate very much like a private company. In fact, management does not provide earnings conference calls, will not accept media requests, and rarely presents at industry or brokerage conferences. As such, there is no analyst coverage from Wall Street and the company is a bit of an orphan security.

Insurance Subsidiaries:

With the recent sale of Darwin to Allied World Assurance, the company operates through four main insurance subs: (1) RSUI Group, which is the largest and most important and underwrites specialty insurance in property, umbrella/excess, general liability, D&O, and professional liability; (2) Capital Transamerica Corporation (CATA), a specialty P&C and commercial surety insurer; (3) Employers Direct Corporation (EDC), which writes workers compensation on a direct basis in the Western US (primarily California); and (4) AIHL Re, a Vermont-domiciled captive reinsurance company. In addition, the company owns a 32.9% minority stake in Homesite, a national, full-service, mono-line provider of homeowners insurance.

Investment Thesis:

Y has an incredibly clean Balance Sheet and considerable excess capital. The investment portfolio is not littered with Alt-A and Sub-prime toxic structured finance products that have turned up in the portfolios of other investment/insurance operations. In fact, the company's MBS and ABS exposures at September 30, 2008 was just under $700m, more than $650m of which was FNMA, FHLMC, GNMA, or prime and 100% of which was AAA-rated. The companies CEO and board are extremely conservative, with an impressive long-term track record of tangible equity generation and solid underwriting. The public equity portfolio was worth $853.2m at September 30, 2008 – with the largest holdings in Burlington Northern, Global Industries, Nabors, Chicago Bridge & Iron, Chevron, and ConocoPhillips. Equities account for 20.2% of the company's investment portfolio and represent exposure to oil, gas, energy, and infrastructure with a very low original cost basis.

Mr. Hicks has done very well as CEO so far and appears to be transforming Y into a mini Berkshire. At the moment, he has dry powder in an environment that is becoming increasingly distressed – a perfect position for the company in our view. With $4.3b in cash and investments and $2.7 in equity, we estimate Y has more than $530m in excess capital. The company currently has $748.4m in cash and marketable securities at the holding company level, consisting of $520m at the parent company and $228.4 at the insurance holding company level. Moreover, the company received $300m in cash from the sale of Darwin after the third quarter closed, providing ample liquidity to take advantage of current market dislocations.

Our valuation on Y is extremely simple. At current market prices, the company trades below stated book value (97.4% as of this writing). Importantly, stated book value doesn't account for the gain on the sale of Darwin or 315 acres of real estate owned in the Sacramento, CA carried at below-market-value prices. RSUI's (~80% of underwriting profit) best peers, MKL and RLI, command multiples of 1.3x and 1.7x book value, respectively. Another good comp, Commerce Group, was acquired earlier this year for 1.7x book value. These businesses have sold for as much as 2.0x book value or higher. Applying a more conservative 1.3x multiple to Y's current stated common book value supports a value of $370+/share. Adding the $530m in excess capital (~$63/share) the company currently carries on its balance sheet suggests Y is worth ~$433. Simply stated, at current market prices we believe we are offered 50+% upside with a “free call option” on Wes Hicks/John Burns proven capital allocation skills.

In terms of book value growth, we believe after-tax earnings from the insurance operations of $20 to $22 per share should be achievable in an average year. The equity portfolio could return ~8+% a year on average, creating another $8+/share in book value a year. Even if the rest of the portfolio returned only 2% a year on average, it would create another ~$8+/share in book value a year. Add it up and the result is $35+ in tangible book value accretion per year, about 12% growth from current levels. Assuming the same 1.3x book value multiple as above, the incremental per share accretion to BV would be worth ~$45 per share annually. While the company will not generate 12% book value accretion each and every year (insurance is a lumpy business after all), we believe this should be the case over time. Historically, the company has grown book value by approximately 15% per year since 1967, 5% better than the S&P 500 although shy of Buffett's record at Berkshire Hathaway. Again, in the company's own words:

Alleghany's principal financial objective is to grow book value per share at double-digit rates without employing excessive amounts of financial leverage or taking undue amounts of operating risk. By consistently growing book value per share, we believe that we can better compound the value of the company and create attractive long-term returns for our shareholders. This approach stands in contrast to that of many other companies that assume significant risk in the hope of outsized returns in any one year. Although such an approach can at times produce spectacular gains, it can also produce large losses, sometimes more than offsetting these gains.

Music to our ears!

Have a happy and healthy holiday and may you find joy, peace and prosperity in the New Year!


Disclaimer: I, my family, or clients currently own a long position in Alleghany Corp.

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