Delirious Deleveraging

Michael Lewis, in his 2011 book “Boomerang” on the consequences of the financial crisis, said that “leverage buys you a glimpse of a prosperity you haven’t earned”. Well, if that is true, we are all in trouble based upon the findings from the fascinating Geneva report “Deleveraging? What Deleveraging?” from Luigi Buttiglione, Philip Lane, Lucrezia Reichlin and Vincent Reinhart, published yesterday.

The report paints a stark picture, as the following statements illustrate:

“Contrary to widely held beliefs, the world has not yet begun to delever and the global debt-to-GDP is still growing, breaking new highs. At the same time, in a poisonous combination, world growth and inflation are also lower than previously expected, also – though not only – as a legacy of the past crisis. Deleveraging and slower nominal growth are in many cases interacting in a vicious loop, with the latter making the deleveraging process harder and the former exacerbating the economic slowdown. Moreover, the global capacity to take on debt has been reduced through the combination of slower expansion in real output and lower inflation.”

The report has a number of attention grabbing graphs on debt levels as a % of GDP like the one below on the US and others on Europe, China and global debt levels, as below.

click to enlargeUS Debt as % of GDP

click to enlargeDebt as % of GDP

The report is particularly pessimistic about China’s medium term prospects after its rapid 72% rise in debt levels since the crisis. On the US and the UK, for the countries who “managed the trade-off between deleveraging policies and output costs better so far, by avoiding a credit crunch while achieving a meaningful reduction of debt exposure of the private sector and the financial system” the legacy of “a substantial re-leveraging of the public sector, including the central banks” leaves a considerable challenge for the future.

Quick check on AIG

My last post on AIG concluded that a target of $60-$70 per share over the medium term did not seem unreasonable. However, given the difficulty in predicting a number of moving items in their results and the competitive insurance market, AIG didn’t excite me enough to get involved. Based upon a quick review of the results over H1 2014, that remains my view.

Q2 results were flattered by a gain of over $2 billion on the aircraft leasing sale. Overall the operating results were steady for H1, as the graph below shows, trending towards an approximate $10 billion operating income for 2014. Core earnings from P&C and life & retirement have been steady at approximately $2.5 billion each for the year to date.

click to enlargeAIG OpIncome 2011 to 2014H1

Analysts have an average EPS estimate of $4.62 for 2014, roughly the same as 2013, and $5.00 for 2015 which supports a target share price in the low to mid sixties. The AIG “discount” continues with the stock trading around 80% of book (excluding Accumulated Other Comprehensive Income), as per the graph below.

click to enlargeAIG Book Multiples 2009 to Sept2014

Some may argue that this discount is harsh given how far AIG has come. I’m not yet convinced that AIG desires to come off the naughty step and get a more normal valuation.

An ice age or a golden one?

The debate on whether the US stock market is overvalued, as measured by the cyclically adjusted price to earnings ratio (CAPE) as developed by Robert Shiller, or whether CAPE is not relevant due to weaknesses in comparing past cycles with today’s mixed up macro-economic world, continues to rage. I have posted several times on this, most recently here and here. In an article in this week’s Economist, Buttonwood outlines some of the bull and bear arguments on the prospects for US corporate growth and concludes that “America is an exception but not as big an exception as markets suggest”.

Bulls argue that, although the CAPE for the S&P500 is currently historically high at 26.5, earnings growth remains strong as the US economy picks up speed and that at a forward PE around 16 the S&P500 is not at excessive levels indicative of a bubble. The latest statistics compiled by the excellent Yardeni Research from sources such as the Bureau of Economic Analysis show that earnings, whether S&P reported or operating earnings or NIPA after tax profits from current production or based upon tax returns, continue to trend along a 7% growth projection. Jim Paulsen, chief investment strategist at Wells Capital Management, believes that “this recovery will last several more years” and “earnings will grow”. Even the prospect of increased US interest rates does not perturb some bulls who assert that rates will remain low relative to history for some time and that S&P500 firms still have plenty of cash with an aggregate cash-pile of over $1 trillion. The king of the bulls, Jeremy Siegel recently said that “If you look at history, the bull markets do not end when the Fed starts raising interest rates. Bull markets could go on for another 9 months to 2 years“.

Bears point to high corporate profits to GDP and argue that they are as a direct result of low real wages and are therefore unsustainable when normal macro conditions return. Others point to the surge in share buybacks, estimated at nearly $2 trillion by S&P500 firms since 2009, as a significant factor behind EPS growth. Société Générale estimate a 20% fall in Q2 buybacks and (the always to be listened to) Andrew Lapthorne warns that as debt gets dearer firms will find it hard to maintain this key support to stock prices as in the “absence of the largest buyers of US equity going forward is likely to have significant consequence on stock prices”. The (current) king of the bears, Albert Edwards, also at SocGen, provided good copy in a recent report “Is that a hissing I can hear?” saying that “companies themselves have been the only substantive buyers of equity, but the most recent data suggests that this party is over and as profits also stall out, the equity market is now running on fumes“. Edwards believes that an economic Ice Age is possible due to global deflationary pressures. Another contender for king of the bears is fund manager John Hussman and he recently commented: “make no mistake, this is an equity bubble, and a highly advanced one“.

One commentator who I also respect is the author behind the excellent blog Philosophical Economics. A post last month on CAPE highlighted the obvious but often forgotten fact thatthe market’s valuation arises as an inadvertent byproduct of the equilibriation of supply and demand: the process through which the quantity of equity being supplied by sellers achieves an equilibrium with the quantity of equity being demanded by buyers”. As such, the current macro-economic situation makes any reference to an average or a “normal period” questionable. The post is well worth a read and concludes that the author expects the market to be volatile but continue its upward trajectory, albeit at a slower pace, until signs that the real economy is in trouble.

For me, the easy position is to remain negative as I see valuations and behaviour that frightens me (hello AAPL?). I see volatility but not necessarily a major correction. Unless political events get messy, I think the conclusion in a previous Buttonwood piece still holds true: “investors are reluctant bulls; there seems no alternative”. Sticking only to high conviction names and careful risk management through buying insurance where possible remain my core principles. That and trying to keep my greed in check…..

Lancashire is looking unloved

With exposure adjusted rates in the specialty insurance and reinsurance sector continually under pressure and founder/former CEO, Richard Brindle, making an unseemly quick exit with a generous pay-out, Lancashire’s stock has been decidedly unloved with the price trading well below the key £7 threshold highlighted in my last post on the subject in February. Although we remain in the middle of the US hurricane season (and indeed the Napa earthquake is a reminder that its always earthquake season), I thought it was a good time to have a quick look over Lancashire’s figures again, particularly as the share price broke below the £6 threshold earlier this month, a level not seen since early 2011. The stock has clearly now lost its premium valuation compared to others in the London market as the graph below shows.

click to enlargeLondon Market Specialty Insurers Tangible Book Value Multiples August 2014

Results for H1-2014, which include full numbers from the November 2013 acquisition of Cathedral, show a continuing trend on the impact of rate reductions on loss ratios, as per the graph below.

click to enlargeLancashire Historical Combined Loss 2006 to H12014

The impact of the Cathedral deal on reserve levels are highlighted below. The graph illustrates the consistent relative level of IBNR to case reserves compared to the recent past which suggests a limited potential for any cushion for loss ratios from prior year reserve releases.

click to enlargeLancashire Historical Net Loss Reserves

The management at Lancashire have clearly stated their strategy of maintaining their discipline whilst taking advantage of arbitrage opportunities “that allow us to maintain our core insurance and reinsurance portfolios, whilst significantly reducing net exposures and enhancing risk adjusted returns”. In my last post, I looked at post Cathedral gross and net PMLs as a percentage of earned premiums against historical PMLs. More applicable figures as per July for each year, against calendar year gross and net earned premiums (with an estimate for 2014), are presented below. They clearly show that the net exposures have reduced from the 2012 peak. It is important to note however that the Gulf of Mexico net 1 in 100 figures are high at 35%, particularly compared to many of its peers.

click to enlargeLancashire PMLs July 2010 to July 2014

There is of course always the allure of the special dividend. Lancashire has indicated that in the absence of attractive business opportunities they will look at returning most, if not all, of their 2014 earnings to shareholders. Assuming the remainder of 2014 is relatively catastrophe free; Lancashire is on track to make $1-$1.10 of EPS for the full year. If they do return, say, $1 to shareholders that represents a return of just below 10% on today’s share price of £6.18. Not bad in today’s environment! There may be a short term trade there in October after the hurricane season to take advantage of a share pick-up in advance of any special dividend.

Others in the sector are also holding out the prospect of special dividends to reward patient shareholders. The fact that other firms, some with more diverse businesses and less risky risk profiles, offer potential upside through special dividends may also explain why Lancashire has lost its premium tangible book multiple, as per the first graph in this post.

Notwithstanding that previously Lancashire was a favorite of mine due to its nimble and focused approach, I cannot get past the fact that the sector as a whole is mired in an inadequate risk adjusted premia environment (the impact of which I highlighted in a previous post). In the absence of any sector wide catalyst to change the current market dynamic, my opinion is that it is expedient to pass on Lancashire here, even at this multi-year low.

The game of chicken that is unfolding across this sector is best viewed from the side-lines in my view.

Trinity Biotech looks interesting here

The bull market is raging ahead with the S&P500 and the Dow both less than 1% away from key levels and Apple breaking $100 yesterday. Given my cautious stance on the market, as articulated in multiple posts for over a year now, it is therefore uncharacteristic of me to be talking about establishing a new position. After having watched Trinity Biotech, ticker TRIB, for nearly a year now (I previously posted on the firm last year here), I have been doing some more research and modelling on the firm.

Last September, when the stock was trading around $19, I concluded that despite an attractive pipeline of new products following a number of acquisitions by TRIB, the stock was overvalued given the execution risks involved. Since that time, the stock climbed steadily to over $27 after Q3 and Q4 results last year before falling to trade around $23 since March before dropping to around $21 for the past few weeks. The graph below shows the quarterly EPS for the past 14 quarters.

click to enlargeTRIB Quarterly EPS 2011 to Q2 2014

The past two quarters have been hit by subdued revenues, due to timing delays on Premier reagent income and lower lyme sales, and higher expenses from consolidating manufacturing costs and trial expenses on the Meritas Troponin cardiac test. In addition to the EPS misses, the recent drop may be as a result of cooling off on the tax inversion restructuring craze by US firms. There is always the possibility that it’s a result of some as yet unknown development (the impact of the Ebola outbreak on HIV test product sales in Africa is an example)!! Notwithstanding such a development, I spent some time going through TRIB’s releases and calls. The graph below represents my best efforts at a forecast.

click to enlargeTRIB Revenue Split & EPS Projections August 2014

My revenue and EPS estimates for 2014 are slightly below estimates. My revenue and EPS estimates for 2015 are 10% and 15% below consensus respectively. Using my EPA estimates with the consensus estimates for TRIB’s competitors from yahoo-finance, the graph below shows the relative valuations of TRIB and selected competitors.

click to enlargeTRIB PE Multiples August 2014

This analysis shows a stock with good growth potential but one which is trading at 22 times forward earnings. Add in that TRIB have spent their cash-pile and have intangibles of $138 million making up 58% of assets (with a history of having to write-off intangibles, see previous post). Not exactly a cause to jump up and down. Indeed there are many similar growth stocks trading at lower multiples (such as SIRO as per a previous post). So, what’s the reason for my change in heart on TRIB?

Well, it’s really all about the aforementioned Meritas Troponin cardiac tests, the high sensitivity quantitative point-of-care immunoassay platform TRIB purchased in the Fiomi deal (Note – the financial projections above exclude any assumed benefit from these products). The worldwide market for point-of-care cardiac testing currently stands at about $650 million (with a larger potential for other related add-on tests) and is heavily U.S. centric. The market is dominated by three firms – Alere, Roche and Abbott – and will be a tough one to break into. However, new guidelines in the US mean that the existing products are no longer fit for purpose. A letter, dated the 25th of June 2014, from the FDA stated that “laboratories and clinicians using these troponin test results are not generally aware that the performance data listed in the device labeling is obsolete.” The letter further states the following:

“To address these concerns while improving patient care, FDA has started working with troponin assay manufacturers to modernize the performance evaluation and regulatory review of these critical tests. Our main interest is to ensure that laboratories and clinicians are informed of the true performance of troponin assays to help in result interpretation and laboratory verification of performance parameters. This is particularly important for newer, more sensitive troponin tests which may render values that can be difficult to interpret if sufficient information is not available in the device labelling. These recommendations solidified troponin’s importance in MI diagnosis and triage; at the same time, they formalized an adjustment in the clinical cutoffs and changed the way troponin results were interpreted and used.”

TRIB have obtained a European CE certificate for one of their Troponin tests and hope to gain another shortly (end of August was mentioned). However, Europe generally follows the US and the real approval required is from the FDA in the US. Studies conducted for the CE certificate show very positive results albeit with approximately 20% of the sample size required in the US, on US patients. The size of the studies required in the US has been the reason behind recent delays although TRIB hope to complete the studies and submit the results to the FDA by year end. FDA approval could then take up to 6 months so mid-year 2015 is a reasonable target date. However, these studies are dependent upon getting enough targeted patients into the study and that can be uncertain.

So, TRIB have a market opportunity for a new product line which they say has been proven in trails (albeit smaller than the FDA mandated sample sizes) to exceed the new guidelines. The opportunity is significant and will pit TRIB against some big names competitors (although Alere seems to be in a bit of a mess right now). Analysts estimate the option value of the cardiac products at between $8 to $10 per share depending upon the underlying assumptions of probability of the FDA approval and subsequent market penetration for Meritas.

I like the potential risk dynamic here as I see TRIB’s core business improve its performance over the coming quarters. News flow on the Troponin trials will likely drive share volatility but if future profits on the stock over the coming quarters from improving operating results could be used to buy options to play the embedded call in TRIB share price on the Troponin products, I can see a win:win situation arising. That does require taking a risk today however with the share price around $21. Although it is against the grain of where I believe the overall market is headed, I therefore established a small position in the stock earlier this week. Maybe I am just getting bored of the sidelines and being reckless!! Time will tell whether I am timing this really badly or not.