Patience on earnings

With the S&P500 up 100 points since last week’s low of 1882, the worry about global growth and earnings has been given a breather in the last few days trading. Last weeks low was about 12% below the May high (today’s close is at -8.6%). Last week, the vampire squid themselves lowered their S&P500 EPS forecast for 2015 and 2016 to $109 and $120 respectively, or approximately 18.2 and 16.6 times today’s close with the snappy by-line that “flats the new up”.

The forward PE, according this FACTSET report, as at last Thursday’s close (1924) was at 15.1, down from 16.8 in early May (as per this post).

click to enlargeForward 12 month PE S&P500 October2015

Year on year revenue growth for the S&P500 is still hard to find with Q3 expected to mark the third quarter in a row of declines, with energy and materials being a particular drag. Interestingly, telecom is a bright spot with at over 5% revenue growth and 10% earnings growth (both excluding AT&T).

Yardeni’s October report also shows the downward estimates of earnings and profit margins, as per below.

click to enlargeS&P500 EPS Profit Margin 2015 estimates

As usual, opinion is split on where the market goes next. SocGen contend that “US profits growth has never been this weak outside of a recession“. David Bianco of Deutsche Bank believes “earnings season is going to be very sobering“. While on the other side Citi strategist Tobias Levkovich opined that there is “a 96 percent probability the markets are up a year from now“.

Q3 earnings and company’s forecasts are critical to determining the future direction of the S&P500, alongside macro trends, the Fed and the politics behind the debt ceiling. Whilst we wait, this volatility presents an opportune time to look over your portfolio and run the ruler over some ideas.

Low risk premia and leverage

The buzz from the annual insurance speed dating festival in Monte Carlo last week seems to have been subdued. Amid all the gossip about the M&A bubble, insurers and reinsurers tried to talk up a slowing of the rate of price decreases. Matt Weber of Swiss Re said “We’ve seen a slowing down of price decreases, although prices are not yet stable. We believe the trend will continue and we’ll see a stabilisation very soon”. However, analysts are not so sure. Moody’s stated that “despite strong signs that a more rational marketplace is emerging in terms of pricing, the expansion of alternative capital markets continues to threaten the traditional reinsurance business models”.  Fitch commented that “a number of fundamental factors that influence pricing remain negative” and that “some reinsurers view defending market share by writing business below the technical price floor as being an acceptable risk”. KBW comment that on-going pricing pressures will “eventually compressing underwriting margins below acceptable returns”.

It is no surprise then that much of the official comments from firms focused on new markets and innovation. Moody’s states that “innovation is a defence against ongoing disintermediation, which is likely to become more pronounced in areas in which reinsurers are not able to maintain proprietary expertise”. Munich Re cited developing new forms of reinsurance cover and partnering with hi-tech industries to create covers for emerging risks in high growth industries. Aon Benfield highlighted three areas of potential growth – products based upon advanced data and analytics (for example in wider indemnification for financial institutions or pharmaceuticals), emerging risks such as cyber, and covering risks currently covered by public pools (like flood or mortgage credit). Others think the whole business model will change fundamentally. Stephan Ruoff of Tokio Millennium Re said “the traditional insurance and reinsurance value chain is breaking up and transforming”. Robert DeRose of AM Best commented that reinsurers “will have a greater transformer capital markets operation”.

Back in April 2013, I posed the question of whether financial innovation always ends in reduced risk premia (here). The risk adjusted ROE today from a well spread portfolio of property catastrophe business is reportingly somewhere between 6% and 12% today (depending upon who you ask and on how they calculate risk adjusted capital). Although I’d be inclined to believe more in the lower range, the results are likely near or below the cost of capital for most reinsurers. That leads you to the magic of diversification and the over hyped “non-correlated” feature of certain insurance risks to other asset classes. There’s little point in reiterating my views on those arguments as per previous posts here, here and here.

In the last post cited above, I commented that “the use by insurers of their economic capital models for reinsurance/retrocession purchases is a trend that is only going to increase as we enter into the risk based solvency world under Solvency II”. Dennis Sugrue of S&P said “we take some comfort from the strength of European reinsurers’ capital modelling capabilities”, which can’t but enhance the reputation of regulatory approved models under Solvency II. Some ILS funds, such as Twelve Capital, have set up subordinated debt funds in anticipation of the demand for regulatory capital (and provide a good comparison of sub-debt and reinsurance here).

One interesting piece of news from Monte Carlo was the establishment of a fund by Guy Carpenter and a new firm founded by ex-PwC partners called Vario Partners. Vario states on their website they were “established to increase the options to insurers looking to optimise capital in a post-Solvency II environment” and are proposing private bonds with collateral structured as quota share type arrangements with loss trigger points at 1-in-100 or 1-in-200 probabilities. I am guessing that the objective of the capital relief focussed structures, which presumably will use Vario proprietary modelling capabilities, is to allow investors a return by offering insurers an ability to leverage capital. As their website saysthe highest RoE is one where the insurer’s shareholders’ equity is geared the most, and therefore [capital] at it’s thinnest”. The sponsors claim that the potential for these bonds could be six times that of the cat bond market. The prospects of allowing capital markets easy access to the large quota share market could add to the woes of the current reinsurance business model.

Low risk premia and leverage. Now that’s a good mix and, by all accounts, the future.

Why Liquidity Rules

Businesses with strong cash-flow are rightfully held in high esteem as investments. Google and Apple are good examples. Betting/gambling firms and insurers (in non-stressed loss periods) are other examples of businesses, if properly run, that can operate with high positive cash-flow.

The banking sector is at a completely different end of the spectrum as liquidity transformation is essentially the business. Everybody knows of Lehman Brothers bankruptcy, which was instigated in late 2008 by an immediate need to find $3 billion of cash to meet its obligations. The winding-up of the Lehman Brothers holding company in the US is estimated to return approximately 26 cents on the dollar according to this FT article.  It was therefore a surprise to read in the FT article and in another recent article on the expected surplus of £6 to £7 billion from the winding up of Lehman Brothers operation in London after all of the ordinary creditors have been repaid in full. This outcome is particularly surprising as I understood that the US operation of Lehman did a cash sweep across the group, including London, just prior to entering bankruptcy.

In his book (as referenced in this post), Martin Wolf highlights the changing perceptions of value since the crisis by using ABX indices from Markit which represent a standardized basket of home equity asset backed securities. The graph below shows the value for one such index, the ABX.HE.1, to the end of 2011. These indices are infamous as they were commonly used to value securities since the crisis when confidence collapsed and can be used to demonstrate the perils of mark to market/model accounting (or more accurately referred to as mark to myth values!).

click to enlargeMarket Value Asset Backed Subprime Index

I have included the more recent values of similar ABX indices in the bubbles as at last year from Wolf’s book. This graph accentuates the oft used quote from Keynes that “the market can remain irrational longer than you can remain solvent”.

Wolf argues that the 3% liquidity ratio proposed under Basel III or indeed the 5% proposed in the UK are totally inadequate and he suggests a liquidity ratio closer to 10%. On capital ratios, Wolf argues for capital ratios of 20% and above with a strong emphasis on tier 1 type equity or bail-inable debt that automatically converts. This contrasts against the 6% and 2.5% of tier 1 and 2 capital proposed respectively under Basel III (plus a countercyclical and G-SIFI buffer of up to 5%). Wolf also highlights the bankers ability to game the risk weighted asset rules and suggests that simple capital ratios based upon all assets are simpler and cleaner.

Wolf supports his arguments with research by Bank of England staffers like David Miles1 and Andrew Haldane2 and references a 2013 book3 from Admati and Hellwing on the banking sector. Critics of higher liquidity and capital ratios point to the damage that high ratios could do to business lending, despite the relatively low level of business lending that made up the inflated financing sector prior to the crisis. It also ignores, well, the enormous cost of the bailing out failed banks for many tax payers!

For me, it strengthens the important of liquidity profiles in investing. It also reinforces a growing suspicion that the response to the crisis is trying to fix a financial system that is fundamentally broken.



  1. Optimal Bank Capital by David Miles, Jing Yang and Gilberto Marcheggiano
  2. The Dog and the Frisbee by Andrew Haldane
  3. The Bankers New Cloths by Anat Admati and Martin Hellwing


Path of profits

The increase in corporate profits has been one of the factors behind the market run-up (as per posts such as here and here from last year). McKinsey have a new report out called “Playing to win: The new global competition for corporate profits” that predicts a decrease of the current rate of 10% of global GDP back to the 1980 level of below 8% by 2025.

Factors that McKinsey cite for the decline are that the impact of global labour arbitrage and falling interest rates have reached their limits. McKinsey also predict that competitive forces from 2 sources will drive down profits, as per the following extract:

“On one side is an enormous wave of companies based in emerging markets. The most prominent have been operating as industrial giants for decades, but over the past ten to 15 years, they have reached massive scale in their home markets. Now they are expanding globally, just as their predecessors from Japan and South Korea did before them. On the other side, high-tech firms are introducing new business models and striking into new sectors. And the tech (and tech-enabled) firms giants themselves are not the only threat. Powerful digital platforms such as Alibaba and Amazon serve as launching pads for thousands of small and medium-sized enterprises, giving them the reach and resources to challenge larger companies.”

Interesting graphs from the report included those below. One shows the factors contributing to the rise in US corporate profits, as below.

click to enlargeMGI Historical US Corporate Profit Components 1980 to 2013

Another graph shows the variability and median return on invested capital (ROIC) from US firms from 1964 to 2013, as below.

click to enlargeMGI Historical ROIC US Corporates 1964 to 2013

Another shows the reduction in labour inputs by country, as below.

click to enlargeMGI Labor Share of Total Income 1980 to 2012

Another shows the growth in corporate sales by region from 1980 to 2013, as below.

click to enlargeMGI Global Corporate Sales By Region

Another shows the ownership and the ROIC profile of the new competitors, as below.

click to enlargeMGI The New Competitors ownership split & ROIC by region

And finally the graph below shows McKinseys’ projections for EBITDA, EBIT, operating profit, and net income to 2025.

click to enlargeMGI Global Corporate Profits 1980 2013 2025

Hot Take-outs

In many episodes of fervent investment activity within a particular hot spot, like the current insurance M&A party, there is a point where you think “really?”. The deal by Mitsui Sumitomo to take over Amlin at 2.4 times tangible book is one such moment. A takeover of Amlin was predicted by analysts, as per this post, so that’s no surprise but the price is.

With the usual caveat on the need to be careful when comparing multiples for US, Bermuda, London and European insurers given the different accounting standards, the graph below from a December post, shows the historical tangible book value levels and the improving multiples being applied by the market to London firms such as Amlin.

click to enlargeHistorical Tangible Book Multiples for Reinsurers & Specialty Insurers

Comparable multiples from recent deals, as per the graph below, show the high multiple of the Mitsui/Amlin deal. Amlin has a 10 year average ROE around 20% but a more realistic measure is the recent 5 year average of 11%. In today’s market, the short to medium term ROE expectation is likely to be in the high single digits. Even at 10%, the 2.4 multiple looks aggressive.

click to enlargeM&A Tangible Book Multiples September 2015

There is little doubt that the insurance M&A party will continue and that the multiples may be racy. In the London market, the remaining independent players are getting valued as such, as per the graph below tracking valuations at points in time.

click to enlargeLondon Specialty Insurers Tangible Book Values

When the hangover comes, a 2.4 multiple will look even sillier than its does now at this point in the pricing cycle. In the meantime, its party like 1999 time!