TWGP: Tower Group, Inc.
April 10, 2010
– Comments (18) |
RELATED TICKERS: TWGP
I've made it no secret that I tend to pick outperforms/underperforms on CAPS after just a quick look at the financial statements. One can quickly determine if a company is obviously undervalued or not after just a quick look. As the market has come up and the obvious bargains have become fewer and fewer, I've now taken it upon myself to further research my opportunities, understanding how the companies make money and how they can grow business.
I've taken an interest in the financial sector, one that I avoided for the most part in the past. I've specifically begun to learn a lot more about banking and more recently, insurance. I've decided to highlight a recent CAPS pick that I added once before but closed out early just to bank accuracy. It's hard to keep a pick open long if you don't understand its business. Upon taking a further look, I discovered that I rather like this company.
What company am I talking about? Tower Group, Inc. (TWGP), as you've no doubt noticed from the title.
In my screens lately, I've been looking for low PB, low PE, and high RoE. Together, low PB and high RoE make quite a good combination. Given the same level of earnings, companies that trade at a discount to book value will tend to have lower return on equity than a company trades at a premium to its book value. It's hard to earn a ridiculous return on equity if there's a lot of equity to begin with. If a company has low PB and high RoE, that means you're getting a bargain company that earns money at a rather nice rate. Low PE is probably a given if you have the low PB and high RoE combination working, but I like to look for it anyway.
Anyways, here goes...
Business:
TWGP offers property and casualty insurance to small and medium sized businesses. It generally does business in segments untouched by the big boys, since these areas tend to require special underwriting expertise that requires time and skill. The big boys seem to have a more one-size-fits-all approach, which is profitable in general but cannot be used properly to serve certain smaller segments. TWGP seems to target these types of opportunities.
Why is all that important? Property and casualty insurance is somewhat of a commodity. You pay money for coverage. Pricing power is intense in this industry and margins aren't always great. Operating in a business segment that is largely avoided by the big boys is a huge plus. I believe a good analogy would be large mutual funds being unable to own small caps because the impact to the bottom line just isn't there. I believe small caps contain the best values, but someone with billions to invest would be better served investing in mid and large caps, since a high rate of return on so little money amounts to a paltry rate of return.
Numbers:
I first became interested due to these numbers:
PB: 0.94
PE: 7.98
RoE: 15.78%
The numbers aren't amazing, but I like the PE numbers the best. In an economy where businesses' earnings have been shelled since 2007, check out the earnings growth for the past 5 years:
2005: $1.03
2006: $1.82
2007: $1.93
2008: $2.47
2009: $2.76
Based on the earnings growth, I would say that the company does indeed know what it's doing and has grown business at a nice clip without any major hitches. TWGP is only projected to earn $2.83 in 2010, but that's still an increase without a dip in a very long time.
Combined ratio:
Most who know about Berkshire Hathaway know that Buffett skillfully invests the float from the various insurance businesses quite masterfully. Not every company has Buffett to deploy capital and make such strategic moves, so I'm more interested in an insurance company's combined ratio. Combined ratio is the loss ratio (premiums - losses) plus the underwriting expense ratio (cost of attaining new policies). A ratio under 100% indicates profitability.
Gross combined ratio has averaged 83.32% over the past 5 years and net combined ratio has averaged 86.02% over the past 5 years, with the combined ratio never exceeding 90% in any of the years.
Acquisitions:
There have been several acquisitions in the past year and many others in the past. I obviously prefer organic growth, but I would say that TWGP has done well acquiring businesses based on its track record. TWGP seems to want to maintain its edge in the more profitable niche segments while achieving economy of scale.
Dividend Policy:
The company current pays a $0.07 quarterly dividend, which amounts to a 1.3% yield based on the close price of $22.03 on Friday 4/9/10. This dividend started at $0.025 in 2004 and has been steady and slowly increasing. The payout ratio is quite tiny, so I expect the dividend to continue growing in the future.
Risk Factors:
There are many risks in general in the insurance industry. Terrorism or a major catastrophe could cause earnings to fall off a cliff and even go very negative at any given moment. That seems less likely with TWGP, but it the risk is still there.
Three times in the past 10 years, TWGP has participated in major dilution. I believe this has been to acquire similar businesses, because EPS growth has not slowed despite the dilution. Management is quite solid, but there's a chance of a major acquisition in the future that doesn't quite pan out.
For the most part, I haven't seen any major risk factors that aren't common to all other insurers as well.
Conclusion:
I like what I see. EPS growth has been fantastic, even increasing the past 2 years while other businesses have seen their earnings fall off a cliff. As TWGP grows, I expect EPS growth to slow at some point and for combined ratios to eventually climb as margins eventually fall. This is inevitable, since the property and casualty segment is very competitive and the margins from its niche segment cannot last forever. While it may be far away, the company will eventually will eventually grow large enough to have to sacrifice its margins a bit to grow its business.
I believe that a company still growing its earnings without hurting margins should be valued at much higher than a PE of 8. Considering that this company is still growing, I believe this company is easily worth $35-$40 and will exceed those levels sometime in the future. It may take some time to get there, but I believe TWGP will continue to increase earnings and dividends and that the market will eventually price this company higher.
Disclosure: Long TWGP.
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