April 2016 Press On Research Issue
Below is an excerpt from the unfinished 40 page April 2016 Press On Research issue to release exclusive to subscribers tomorrow April 19th. If you'd like to subscribe to Press On Research go to the links above or below.
Investing In The Greatest Investment Secret In The World Again
To Earn Up To 71%
April 2016 Press On Research Issue
By Jason Rivera
Press On Research Volume 2 Issue 1
If you ever think of insurance companies like I do – yes I know this is odd 🙂 - one of the first things that may come to mind is catastrophes.
Everything I’ve ever read about the business of insurance has talked about catastrophes both natural and manmade. And how insurance companies lessen the risks of these disasters.
Disaster is the business of insurance. But insurance companies insure against risk to protect clients. And reinsures against them to protect themselves from financial disaster.
Until humans can control hurricanes, tornadoes, fires, death, theft, floods, health issues, and other disasters the business of insurance will be a great one to invest in.
And I love investing in businesses that should remain great for generations.
This is one of the many reasons I love insurance companies. And today this is the industry we’re heading back to again.
As an investor I try to stay away from risk as much as possible but the entire insurance industry is based on the probabilities of risk. When something bad will happen not if it will happen.
There’s no way to avoid risk in insurance. This is because the business of insurance is all about shifting risk to other parties so you’re not crushed when disaster strikes.
When investing in insurance companies you have to make sure the company reserves its premiums well and conservatively. That you can trust management to keep doing this. And that management is more focused on underwriting profits than growing revenue.
These are the most important things when evaluating insurance companies. Because if a company doesn’t do these things well it will go out of business at some point.
Today’s pick does all these well.
It’s a (MARKET CAP REMOVED) million life and property and casualty insurer that pays a 1% dividend. Is undervalued by 28.8% to 71%. Has produced an underwriting profit in six of the last nine years. And has produced cumulative redundancies every year of the last nine.
I’ll explain all this below but it’s all great. And this isn’t all that’s great about the company.
Its float supports 3.49 times its operating assets or 349% of its operating assets. And its float is also better than cost-free because of the company’s ability to consistently produce underwriting profits.
This acts as a better than cost-free loan the company can use to invest and grow the business.
Another advantage we have over other investors is that we’re willing and love to invest in insurance companies. Most others hate this business.
Investing In Insurance Part 2
Most people won’t research insurance companies. I wouldn’t early in my investing journey. And many professional analysts stay away too.
This is because insurance companies are hard to understand at first. Have new and confusing terminology to learn. And normal profit metrics don’t matter for them.
But if you learn how to evaluate them not only will you learn they’re easy to evaluate once you know what you’re doing. But you can use the same repeatable process on every insurance company.
And Buffett has continued to buy into insurance – his favorite industry – constantly over the decades. This is one reason he’s so successful.
In reality insurance companies are easy to understand.
Insurance companies take premiums as payment for insuring things like businesses, equipment, health, life, etc. Premiums are the insurance version of revenue.
The insurance company doesn’t have to pay you a dime of the money it earns over the years until there’s some kind of damage or theft of whatever’s insured.
When this happens they pay the agreed upon insurance rate out to the policyholder minus a deductible from you when you make a claim.
While the company continues to earn money – premiums again - it invests some of it so it can pay back your policy in the future. And also make a profit in excess of the amount earned, invested, and paid out.
If the company writes its policies and invests well over time it will earn underwriting profits. This is the main profitability metric to care about when evaluating insurance companies. And grow the assets it can use to write policies and invest more money.
When done well this can turn into a virtuous circle for insurance companies and shareholders producing great profits and returns for both.
When done poorly this can also turn into a negative cycle for those involved.
If it doesn’t do things well the company will go out of business when a major disaster strikes.
Think of insurance companies like investment management companies. But instead of only earning management fees insurance companies earn underwriting profits on top of investment earnings.
These effects can double profits over time… If management is great at what they do.
The insurance business while easy to understand is one of the hardest businesses to be great at.
Other than being a low-cost operator like GEICO owned by Berkshire Hathaway. There are no competitive advantages in this industry. And it also experiences wild swings of huge profitability than massive losses on a regular basis.
But if the company writes policies and invests money well over a long period they can grow to great sizes at almost no extra costs. The only new costs may be to hire more staff.
Insurance companies also hold the greatest secret in the investment world… Float. This is how Buffett built his fortune. And how we’ll start to build ours.
But before we get to this we need to know why float is so important.
Brief Berkshire Hathaway History
Buffett began buying Berkshire Hathaway stock in 1962 when it was still a textile manufacturer. And when he still ran his investment partnership.
He bought Berkshire stock because it was cheap compared to the assets it had. Even though the company was losing money.
He continued to pour millions of dollars into Berkshire to keep up with foreign and non-union competition. But none of this worked.
In time Buffett realized he was never going to make a profit again in the textile industry. So whatever excess funds Berkshire produced he started buying other companies.
The first insurance company Berkshire Hathaway bought was National Indemnity Company in 1967.
Since then Berkshire’s float grew from $39 million in 1970 to $84 billion in 2014.
Float compounds like interest does if you use and invest it well. But not only does float compound, if you use it well it also compounds the value of the company that owns the float.
Since buying National Indemnity in 1967 Berkshire’s stock price has risen from $20.50 a share to today’s price of $210,130. Or a total gain of 10,250%.
This is the power of insurance companies when operated well. And today’s recommendation is an insurance company that operates the right way too.
But before we get to that I need to explain how float makes this possible.
The Biggest Investment Secret Revealed Part 2
‘Float is money that doesn’t belong to us, but that we temporarily hold.” Warren Buffett
Float is things like prepaid expenses. Billings in excess of expected earnings. Deferred taxes. Accounts payable. Unearned premiums. And other liabilities that don’t require interest payments.
But they are the farthest thing from “normal” liabilities.
With normal liabilities you have to pay an agreed upon amount within a certain period or your customers and suppliers will stop paying you.
Float are things you won’t have to pay back for a while the company uses in the mean time to grow the business.
Instead of paying this money out now like normal liabilities. Companies can use these “liabilities” to fund current operations.
Float is positive leverage instead of negative leverage like debt and interest payments.
Think of float as the opposite of paying interest on a loan. Instead of paying the bank for the cash you’ve borrowed. The bank pays you interest to use the money you loaned. And you can use this money to invest.
A nice example is long-term debt versus unpaid premiums. Both liabilities listed on the balance sheet. But each is far different from a real world perspective.
With long-term debt you get money in exchange for agreeing to pay back to loan at an agreed upon rate for an agreed upon period. If you don’t you can go into bankruptcy and/or go out of business.
With unpaid premiums you get paid a monthly amount from a customer – say for house insurance – and only have to pay back any amount when a disaster occurs.
If your clients don’t make big claims for a long time – or ever over the life of an individual policy – the company keeps using this “liability” to continue investing and growing the business.
Now let’s keep going with this example…
If you own a home with a mortgage you have home insurance in the United States. The ranges of this vary but let’s say you own a home and pay $300 a month towards home insurance costs.
This $300 a month - $3,600 a year or $36,000 after 10 years – goes to the insurance company every month. Year after year even if you never claim any insurance.
The insurance company holds this money on the balance sheet as a liability because the assumption – probability – is you’ll make an insurance claim at some point.
In the mean time the insurance company invests this money to grow assets. This way it makes sure it has enough money to pay claims when it has to.
Now imagine this multiplied by thousands, tens of thousands, hundreds of thousands, or even millions of customers.
If the insurance company produces underwriting profits on top of the float it gets and invests this money well over a long period this money compounds exponentially.
This is how Buffett and Munger grew Berkshire to the giant it is today.
Using better than cost-free float to fund operations can improve margins by up to a few percentage points each. And this happens when a company produces consistent underwriting profits.
The best way to explain why float is so important is with the following quote:
“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of free – other peoples money – in highly productive assets so that return on owners capital becomes exceptional.” Professor Sanjay Bakshi adding to something Warren Buffett said about great businesses.
I said in a past issue: “When a company’s float/operating assets ratio is above 100% it means the company is operating with “free” or cost-free money.”
But this isn’t true with insurance companies.
For an insurance company to operate on a cost-free basis it has to produce underwriting profits for a sustained period.
I look for underwriting profits of at least five years straight to consider its float cost-free.
And the company I’m going to tell you about today has earned an underwriting profit in six of the last nine years.
Cost-free float and the power of positive leverage it generates is explained more in my posts in a still ongoing series about float:
- Charlie Munger On Deferred Tax Liabilities And Intrinsic Value – On Float Part 1
- What Is Float? On Float Part 2
- Buffett’s Alpha Notes – The Power Of Float – On Float Part 3
When you come across companies that generate all the above on a consistent basis you should expect exceptional returns in the future.
This is because when a company operates its entire business on a cost-free basis it means several things. 1) It’s a great business. 2.) It’s an efficient business. And 3.) That float magnifies margins which will compound value in the company for shareholders over time.
So what is the wonderful company that checks all my – and Buffett’s – marks for a great insurance company? But also fits into the criteria of Press On Research focusing on small companies?
I go on from here to reveal and detail the company in full in this 40 page issue. I also compare it to a past Press On Research pick and some of its competitors
To find out what this great company is subscribe to Press On Research.
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