Friday, 6 March 2015

QBE: Still cheap after 20% ytd rise

QBE shares are up 20% YTD after strong second half performance and firm 2015 guidance. As I wrote earlier in July and October 2014; QBE was going through transition which gave investors an opportunity to buy shares at decade low price. I continue to believe stock has more legs to reach it's intrinsic value; question is when? Is it worth waiting? To answer these questions, lets look at potential upside for the stock from current price of $13.43. My calculation for intrinsic value is as follows:
  • Net earned premium: 13B
  • Normalised Combined ratio: 0.92
  • Underwriting profit: 1.04B
  • Investment Assets: 30B
  • Normalised investment yield: 4% (conservative assumption)
  • Investment Income: 1.2B
  • Pretax Earning: 2.24B about 2.8B in AUD (AUD @ 0.8)
With modest 10x multiple, intrinsic valuation will be 28B; about $20 per share. Current market cap is 18.2B @$13.43. QBE still has good 50% upside from current level. Other way of valuing insurance company is through float, I wrote earlier in July - QBE float is $16-17. 

Looking at both the valuation method, valuation range is between $17-$20. I believe it will take 2-3 years for stock to reach these level. Meanwhile, patient investor can keep pocketing 2.5% dividend yield. Just to put the potential upside in perspective with historical valuation. At its peak before GFC, QBE was trading at $34. During that time investment yield was 5-6% and earned premium was lower than it's today.

I'll leave investors with quote from Warren Buffet "You don't make money dancing in and out of the market, you make money waiting". I strongly believe QBE is one of those investment. 

P.S: For US investor, you can buy QBE ADR. Ticker: QBIEY

Saturday, 18 October 2014

Stock Market Capitulation - Why and How to Profit from it ?

Last 2 weeks has been quite tough on investors with stock market capitulating; whipping out this year gains, in fact S&P 500 was briefly negative for the year. I was expecting this kind of correction all this year but it never happened until start of October. It was interesting to note this time the reason for the decline was not due to one factor but multiple factors that interestingly happened at same time. Let's take a look at the all the factors that contributed to market decline, put them in perspective, and discuss how investor can take advantage of decline.

Reason for Market Decline

1) Strong US dollar - The market correction started with strong US dollar on a back of rate increase over next year. This has caused disturbance in global markets because with ultra low interest rates in US; institutions are borrowing in USD and investing overseas for higher yield. With stronger USD, they have to reverse their positions causing decline in overseas markets and currencies - AUD under $0.90c, ASX down 10%, EUR under $1.30, Emerging market currencies down as well. Not to mention, commodities which are down significantly as well - oil below $85, copper under $3!

2) Market was slowly adjusting to stronger USD when bad economic news from Europe started reflecting that deflation and recession in Europe is a real possibility. This got exasperated with news of economic contraction in Germany - exports down 5% - Russian teeth biting them ouch! 25% of Germany natural gas consumption comes from Russia.

3) Domino effect of recession in Europe, Slowness in Global economy esp China could slow US economy therefore market got concerned. This got exasperated with poor retail numbers. Hence, we saw 10 yr treasury down from 2.5% to under 2%

4) Oil below $85 is major concern, This reflects slow global growth. However, I think Oil is also down due to stronger USD and over-supply as we enter into price war with Saudi pumping more oil in the market and wants lower oil price so that it can whip out high cost producer. Saudi is a low-cost producer with average crude cost price of $16.5 a barrel whereas US Baken shale producer has average crude cost about $60-70 a barrel. So keep an eye on that as well!! Also S&P500 has about 12% weightage to energy sector so it can have domino effect on index return with change in oil price. Energy sector is down about 10-12% in this correction

5) Concern over Corporate Earnings - Mainly due to global economic growth concerns, decline in earning due to stronger USD as most of the large caps company has earning from overseas. This is a good example why market trade on sentiments but not on logic  - Market tend to forget that most of large multi-national companies tend to hedge their currency exposure; however this is not reflected in income statement or EPS.

6) Rise in 10 yr bond yields of Greece, Italy and Spain (GIS). Greece bond yield are about 9% again (last saw them at these level in 2011). This reflects that investor are quite concern about Europe. I'm keeping track of these since 2011, a good gauge of potential financial crisis in Europe. I get quite concerned when bond yield in GIS goes up because this effect US banks stocks and I've major exposure to them. Note: JPM down almost 9%, BAC down 10-12% even after good earnings report

7) Fed taper officially ends this month. Though market were aware of this but exasperated with other concerns
In addition to these concerns were geo-political concern such as protest in Hong Kong and fighting in Ukraine. It's an old saying - "Wall St doesn't like uncertainty" and we had all these event happening simultaneously within 2 weeks; therefore violent move to downside was quite expected. 

I thought S&P500 will end at 1800 by friday (17th Oct) but we had a strong reversal at 1820 mainly due to good economic numbers from US - industrial prod up 1% and jobless claims down 20k to 260k followed by strong corporate earning; in fact earnings are been revised upwards. This is a cliche where stock market correction due to global macro concerns is supported by strong corporate earning. Also on Friday, Central bankers in Europe has announced major bond buying program starting immediately, and China central bank has announced 200B yuan ($33B) stimulus package to shore up banking system. This has helped to taper concern over Europe and China as printing money potentially abate deflation concern in Europe and stimulus package will be help stimulate Chinese economy. It will also support market going forward as well.

As a long-term value investor, I cherish these corrections because stocks gets cheaper; providing an opportunity to buy more as they go down. Though I keep track of macro events, I don't make decision based on macro events and data. I continue to focus on researching and valuing good businesses, buying them at reasonable and cheap price. This is nice opportunity for long-term investor to buy companies that they like or add to existing positions. I think volatility in the market will continue for a while; giving long-term investor an opportunity to put cash to work. This is exactly what i'm doing!! You could be assured of nice long-term gains.

I would also highlight buying in the declining market is less risk for long-term investor as opposed to common belief that buying in declining market is more risky. Let me explain why: 
  • Firstly, market declines because of some macro concerns or bad news. After certain point these concerns and bad news are built and reflected in the market so even if there are more bad news, market would not decline exponentially; whereas any good news would cause reversal in market direction
  • Secondly, investor get better return on money when share price goes down For eg: QBE at $12 has a potential earning yield of 16%, at $10.6 it has potential earning yield of 18%.
Buying share when market in turmoil is a difficult process, therefore I would highlight two points. Firstly, with all these macro concerns and headwinds, investors should have long-term horizon to investing with focus on business performance of individual companies because in long run it's the earning growth that will drive the share price of a company higher. Secondly, have a strong belief in old saying: "Wall St will eventually climb the wall of worries"

Saturday, 11 October 2014

QBE: Underwriting discipline will ride the ship

***Didn't get time to write this blog earlier but here are my thoughts on QBE after 1H14 earning release

QBE came out with 1H14 with profit headline number marked with following developments:
  • 116M reserve strengthing in Latin America division; majority pertaining to Argentina workers compensation portfolio with increase in litigated workers compensation claim following changes to legislative changes in 2012 and 2013
  •  a non-cash charge of 118M for lowering discount rate used in calculating central reserve estimates
  • Gross Written Premium down 10% to 8.49B with over capacity and competition kept premium rates low and QBE continue to forgo business where adequate premium is not paid for underwriting risk
  • Insurance margin down to 7%. Adjusted margin (adjusting to non-recurring items) inline with expectation of 10%
  • Cash profit down 29% to $416M
  • Increase in investment income - up slightly y-o-y
QBE also taking some positive initiative and have announced capital plan to strength its balance sheet. This will have minimal effect on long term profitability and our valuation. Firstly, it is divesting non-core agency business in North America and Australia as these businesses will drive better revenue growth under external distribution ownership whilst QBE continues to underwrite premiums generated by them. Secondly, it will launch partial IPO for Australian LMI (Lender Mortgage Insurance) business in 2015, this will allow QBE to convert considerable amount intangible capital to tangible capital, whilst retaining considerable exposure to profitable and well positioned mortgage insurer. Thirdly, will raise 750M through equity placement to buyback 500M convertible subordinate debt. This will strength the balance sheet by reducing debt-to-equity ratio down from 38% to 25-30%, whilst having minimal effect on our valuation as I have already used diluted shares in my calculation.

The capital management initiative will give QBE higher APRA regulatory capital up from 1.5x to 1.8x to withstand any downside scenario, balance sheet flexibility by reducing debt-to-equity to 30%.

With all this uncertainty, why I'm still interested in QBE and see it as an opportunity with double digit return over few years? Because amidst uncertainty; I'm also looking at following facts which make QBE intrinsically quite valuable and compelling investment:
  • Core Insurance business/underwriting is still profitable. COR under 100
  • Management continue to be discipline in underwriting. It is forgoing business where adequate premium is not paid for underwriting risk
  • Trading at considerable discount to cost-free float of $16-17$ per share. Comparative insurers with similar underwriting profile, trades above or at par to the value of float
  • Good future earning potential 
    • Investment income will increase in coming years as QBE plan to change its investment style by diversifying assets away from conservative fixed income assets to risk averse assets - upto 15% of total assets. Currently QBE investment assets are mainly in cash, short term fixed income bonds (duration 6 months) and money market funds. Also with increase in interest rate, the investment return could increase from 2.7% to 4-5% in coming years
    • Cost reduction program will be fully accretive to FY 2015 earning - about 250M 
    • Earnings are reported in USD so fall in AUD should be accretive to earning in 2014-2015
  • Compelling valuation:
    • Net earned premium: 13B (incld decrease in premium due  offloading of LMI business)
    • Normalised Combined ratio: 0.92
    • Underwriting profit: 1.04B
    • Investment Assets: 30B
    • Normalised investment yield: 4% (conservative assumption)
    • Investment Income: 1.2B
    • Pretax Earning: 2.24B about 2.5B in AUD (AUD @ 0.9)
    With market cap of 15B; at current price of $11.07 potential earning yield is about 15-17%!!!
  • Most of the bad news is built in the stock price and investor is paying no premium for growth in the business
Uncertainty is a friend of long term investor. This is certainly true in QBE case - profitable insurer with history of profitable underwriting, committed management, trading at decade low valuation with discount to cost-free float. I believe its a right time for long term investor to swing at this pitch.

Disclousre: I own QBE shares

Monday, 28 July 2014

QBE - Is it still a buy?

QBE has again issued a profit warning prior to announcing its mid year result in August. This time its Latin America business in Argentina having issues with revision to reserve strengthening by 170M plus changes to discount rate adversely impacting the result by 120M (non-cash) excld Argentina. This has brought down Combine Ratio (COR) from 93% to 96-97% and insurance profit down from 10% to 8%.

Amidst these continued downward profit revision since mid 2013, one must keep the holistic view of the company as a premier insurance underwriter in the industry. Not many insurer can match the QBE underwriting standards with consistent COR in 90's. The business is still profitable. Good news is that North American business which had problem last year is improving and management is happy with the progress. QBE also has cost reduction initiative in place which will reduce cost overtime, taking effect from 2015.

Whilst valuing insurer on the basis of earning could be difficult given revision to reserve estimates, inclusion and exclusion of non-cash and non-recurring items could change profitability year-over-year;  however, book value and float remains stable. Herein lies an opportunity, with $16-17 of float, QBE is trading at 40% discount to its cost-free float, which relatively and historically is quite cheap. Comparative profitable insurer on average trades above float or atleast at the value of float. Other good news is the investment yield is rising up from 2.5% to 2.7%. QBE is also leveraged to increase in interest rate in US.

In nutshell, QBE will fix these issues. In 2 year, QBE will have higher investment income, continue to have profitable underwriting, and increase it's value of float. I expect QBE to trade atleast at the value of the float which is about $16-$17.

Tuesday, 17 June 2014

Is GE a buy?

I believe GE is undervalued and misunderstood by market as it transition it's earning base from GE Capital to Industrial segment. This has been a multi-year transition process which is concluding to end by 2014-15. However, market is still skeptic about the transition, providing long term investor an opportunity to buy shares at significant discount to its intrinsic value.

My analysis shows that GE is worth atleast $360-370b. With current market cap of 267b, its has 35-40% upside with no growth assumption build in my analysis. The analysis is based on sum-of-parts analysis and capital return to shareholders over next 4-5 years as explained below:


As per annual letter, GE will return 90-100b of capital back to shareholder in next 4 years, adjust that to current market cap, investor is paying 170b for GE.

GE Capital book value is about 82b with cash earning of about 9b in 2013, ROTE 16%. Given management is scaling down GE Capital, I believe BV will come down around 70b. 1.3x BV or 10x cash earning, GE capital is about 90B.

170B less 90B = 80B, investor is paying 80B for industrial business earning about 12-13b pre-tax in 2013;that's 6-7x multiple which is pretty cheap. I'm willing to give market multiple of 15x for industrial with no growth projection.

Now let's work backward to calculate intrinsic value of GE:

Cash to shareholder: 100b
GE Capital: 90b
GE industrial: 12b  * 15 =  180

Add all of them, GE is worth 370B, trading about 270B. Investor has 37-40% upside with no growth assumption built in the valuation. With minimal 5-7% increase in industrial earning growth, valuation will be north of 390-400b.

GE is one of the cheapest DOW component trailing market advances significantly. I see earning growth in industrial combine with dividend increase and share buyback as catalyst to share price increase over next 3 years. Patient investor get 3.2% yield for waiting.

P.S: I am long GE in a concentrated portfolio