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!! 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.

When does one plus one equal more than two?

S&P released a thoughtful piece on Monday called “Hedge Fund Reinsurers: Are The Potential Rewards Worth The Added Risk?” I couldn’t find a direct link to the article but Artemis has a good summary here. They start by asking whether combining a reinsurer strategy with a hedge fund strategy can create higher risk adjusted returns than the two approaches could achieve separately. They conclude with the following:

“The potential crossover between hedge funds and reinsurers offers compelling possibilities. However, a commensurate focus on additional risks would have to supplement the singular focus on higher investment returns. Considering both is necessary in determining whether one plus one is truly greater than two. This depends on whether combining hedge funds and reinsurers can create additional diversification benefits that don’t occur in these two types of organisations independently, thus creating a more capital efficient vehicle. We believe it’s possible. However, in our view, closing the gap between reinsurer and hedge fund risk cultures and implementing prudent risk controls is necessary to realize these benefits.”

I have posted on this topic before. One of the hedge fund reinsurer strategies is to combine low volatility P&C business (primarily as a source of cheap “float”)with the alpha seeking asset business. My problem with this strategy is that every reinsurer is looking out for low volatility/stable return (re)insurance business (its the holy grail after all!), even more so in today’s highly efficient and competitive market. So what can clever chino wearing quants living on a tropical island offer that every other established reinsurer can’t? I suspect that the answer is to price the business with a higher discount rate based upon their higher expected return. S&P point out that this may create increased risks elsewhere such as liquidity risk in stress scenarios. Another strategy is to combine volatile property catastrophe risk with higher asset risk, essentially combining two tail risk strategies. This pushes the business model more towards the highly leveraged model as per that used by the monoline insurer, the ultimate “picking up pennies in front of a stream-roller” play.

To get an idea of the theory behind the various strategies, the graph below illustrates the diversification of each using the calculation in the Solvency II standard formula, with different concentrations for market, counterparty, life, health and non-life risks (selected for illustration purposes only).

click to enlargeHedge Fund Reinsurer Diversification

The graph shows that a hedge fund reinsurer with a low volatility liability strategy shows the least amount of diversification compared to a composite, non-life or a property cat reinsurer due to the dominance of market risk. Interesting, the high risk strategy of combining a hedge fund strategy on assets with property cat on the liability side shows diversification at a similar level (i.e. 78%) to that of a non-life reinsurer where non-life risk dominates.

Hedge fund reinsurers would no doubt argue that, through their alpha creating ability, the 25% correlation between market and non-life risk is too high for them. Reducing that correlation to 0% for the hedge fund reinsurers gives the diversification above, as per “Diversification 1” above. Some may even argue that the 25% correlation in the standard formula is too low for traditional players, as this post on Munich Re’s results excluding catastrophic losses illustrates, so I have shown the diversification for an illustrative composite, non-life or a property cat reinsurer with a 75% correlation between market and non-life risks, as per “Diversification 2” above.

In my opinion, one plus one is always two and under-priced risk cannot be justified by combining risk strategies. Risk is risk and combining two risks doesn’t change the fundamentals of each. One strategy that hasn’t re-emerged as yet is what I call the hedging reinsurer whereby liabilities are specifically hedged by asset strategies. Initially, the property cat reinsurers tried to use weather derivatives to hedge their risk but an illiquid market for weather derivatives and the considerable amount of basis risk resulted in difficulties with the strategy. The strategy is commonly used on the life side of the business with investment type business, particularly business with guarantees and options. Also the appetite for longevity risk by those reinsurers with significant mortality exposure that can significantly hedge the longevity risk is a major developing market trend. I do not see why the strategy could not be used more on the non-life side for economic related exposures such as mortgage indemnity or other credit type exposures.

In the immediate term, the best strategy that I see is the arbitrage one that those who have survived a few underwriting cycles are following, as per this post. On that point, I noticed that BRIT, in their results today, stated they have “taken advantage of current market conditions in reinsurance to significantly strengthen group wide catastrophe cover. These additional protections include a property aggregate catastrophe cover and some additional variable quota share protection”. When risk is cheap, arbitrating it makes the most sense to me as a strategy, not doubling up on risks.

A visit to the dentist

Last week, Raghuram Rajan, the current governor of the Indian Central Bank and the author of the excellent book Fault Lines, warned about asset prices and macro-economic policies in the developed world. Rajan said that things may work out if “we can find a way to unwind everything steadily” but added “it is a big hope and prayer” and that the reality of history is one of sudden movements and volatility. Also this week, hedge fund manager David Einhorn said that his fund was having “difficult time finding new investments this quarter” and that “as the market continues to rise in the face of conflicting economic data, global unrest, and looming overdue Fed exit from quantitative easing we remain cautiously positioned”.

As regular readers will know, I am also wary about valuations in the current market which seem to be largely driven by the lack of return as a direct result of macro-economic policy (see Buttonwood post). I am comforted by the fact that, as a part-time investor, I am not bound by the pressures that professional money managers have in the beauty parade that is the relative annual performance competition. So that affords me and other part-time investors (our own family offices in a way!!) the luxury of watching developments from the sidelines. Trying to find the holy grail of an undervalued stock in today’s market is unrealistic and fanciful in my opinion, given the resources of a lone investor at one’s disposal. So I tend to let my attention drift to whatever comes my way with the intention of broadening my mind and maybe broadening my list of stocks to keep an eye on.

That brings me to my visit to the dentist last week. My visit was primarily to get a new crown on a neglected tooth. I had rescheduled the appointment a number of times and as a result had not really thought about the procedure beforehand. Compared to a similar procedure a number of years ago, the process was totally different. First off, my mouth was scanned by a camera and a 3D image of my teeth was produced. I was then asked to wait in the reception for 20 minutes and upon my return the ceramic crown was ready having been produced in a milling machine onsite. The crown fit perfectly and was easily fitted. My dentist conducted the procedure using a new one-day crown system produced by a German firm called Sirona Dental Systems. The system includes a computer that takes digital images of the damaged tooth, software to design the crown and a milling machine. There have been some concerns about the use of such crowns for front teeth due to colouring issues or the suitability of such crowns for people who grind their teeth heavily. Within my mouth, I have a live comparative test of a laboratory fabricated crown and a new one day procedure produced one. It will be interesting to see how the new crown gets on!

I had previously heard about new technology that could impact the dental sector. A specially designed camera, fitted to a smart phone, can scan your mouth and then send a 3D image to a central database whereupon a panel of dental experts could diagnose the issue and then submit the recommended procedure to a marketplace of dentists to provide a quote on a solution. Naturally, my dentist was skeptical on diagnosing problems with a smartphone scan! Given my first experience with a scan, I think such ideas may have potential to disrupt a protected professional sector. As a further illustration of how technology is impacting medicine, this article on a new app that can turn a smartphone into a highly portable and low cost eye scanner to diagnose eye health issues in remote areas is interesting.

So I had a look at Sirona, ticker SIRO, who coincidentally reported quarterly results last week. SIRO’s year end is September and, based upon an estimate for Q4, revenue has grown on average by 9% for the last 3 years with operating income by 15%. The stock price has doubled over that time. The graph below shows the share price since 2007 and the 12 month trailing PE ratio and the next 12 months (current quarter and estimated next 3 quarters) PE estimate.

click to enlargeSIRO Share Price & Earnings Multiples

SIRO’s revenue is split into 4 main segments: dental CAD/CAM systems (such as the one I experienced), imaging systems, treatments centers, and instruments. The first two segments are the larger making up approximately 35% of revenue each and are the higher growth and margin segments. Each are described below:

  • Dental CAD/CAM systems address the market for dental restorations, which includes several types of restorations, such as inlays, onlays, veneers, crowns, bridges, copings and bridge frameworks made from ceramic, metal or composite blocks. SIRO estimates it has an approx 15% market share in US and Germany.
  • Imaging systems comprise a broad range of systems for diagnostic imaging in the dental practice. SIRO has developed a comprehensive range of imaging systems for 2D or 3D, panoramic and intra-oral applications that allow the dentist to accommodate the patient in a more efficient manner.
  • Treatment centers comprise a broad range of products from basic dentist chairs to sophisticated chair-based units with integrated diagnostic, hygiene and ergonomic functionalities, as well as specialist centers used in preventative treatment and for training purposes.
  • SIRO offers a wide range of instruments, including handheld and power-operated handpieces for cavity preparation, endodontics, periodontology and prophylaxis, which are regularly updated and improved.

The graph below shows the historical segment & geographical revenue split and the historical operating margin.

click to enlargeSIRO Revenue Split & Op Margins

The growth in operating results is impressive, as is their balance sheet and cashflow. The issue is one of valuation with SIRO trading around 26 times this year’s earnings and about 20 times next year’s projected earnings. However, despite SIRO having some major competitors, they are growing their highest margin segments impressively and, in the vein of Peter Lynch’s philosophy of investing in what you know, I shall be putting SIRO on my watch list to keep an eye on them whilst I do some more research (the most obvious of which is seeing how my crown gets on!!) and wait for a better entry point.

Speaking of valuations, my dental experience did get me thinking about the much hyped 3D printing sector. The number of applications for 3D printing continues to grow from construction, to aerospace, to medical/dental, to fashion, to biotech, to a whole host of industrial design applications. Wohlers Associates project a CAGR of 30% for the sector over the next few years (I’d love to know on what basis these guys come up with their projections). I had a brief look over two of the most hyped firms in the sector – Stratasys Ltd (SSYS) and 3D Systems (DDD). Historical comparisons are difficult as both companies have been aggressive acquirers. SSYS has had more favourable results of late compared to DDD due to SSYS acquisition of MakerBot and to DDD’s recent stumble due to heavy investments in growth. A quick snapshot of some metrics since 2011 are in the graphs below.

click to enlargeSSYS & DDD Share price revenues and earnings multiples

With SSYS and DDD trading at 36 and 40 times next year’s projected earnings respectively, these firms are not for the faint hearted. Hyper growth stories in new sectors are normally areas outside my comfort zone due to the inherent uncertainties. In this case my experience at the dentist may mean I will do some more digging in the future of this new technology, time permitting. For the sake of curiosity if nothing else.