In this review I primarily want to talk about HCC Insurance Holdings (HCC) and the offer from Fairfax Financial Holdings (Fairfax) to take over Blackberry. The last time I really wrote about insurance company HCC was just over a year ago. The topic of discussion were the results and their strength in underwriting. They manage to structurally make an underwriting profit. Not every insurer can manage that. Most of them have to compensate an underwriting loss with a return on their investments, while HCC can add their return on investments to their underwriting profit. A great position to be in.
But management hasn’t finished their job with earning money for the company. They also have to determine what they will do with it. There are a few alternatives.
- You could reinvest it in the business, for example via acquisitions.
- Hoarding cash is a second alternative. But it in this interest environment you won’t earn a lot on it on the short-term. In the long term, however, you can have money to invest ready right at the time you need it the most.
- A third alternative is paying a dividend. Warren Buffett wrote a lot about the disadvantages of dividends in his last annual letter (2012) and gave therewith the reason why Berkshire Hathaway doesn’t pay dividends (yet). Just to make sure we are on the same page, dividends aren’t bad. It’s just that companies might have a better use to the money. But it certainly makes sense to give the money back if the company doesn’t.
- The fourth alternative is often taken together with the third. Management often talks about ‘returning money to shareholders via dividends and stock buybacks’. In my opinion are companies not returning money to shareholders via stock buybacks. I would rather look at stock buybacks as investing in business. It just happens to be the business that you already own. Own partly of course, but your stake in the business gets bigger!
But! Buying stock back isn’t alway the most sensible thing to do with the excess money. Buffett wrote in his last letter: “Value is destroyed when purchases are made above intrinsic value”. As I said before, management teams find the third and fourth alternative similar, but I rather had they would approach stock buybacks the same way as they would approach the first alternative of (re)investing in the business. There they would look at the return of the money invested as they also should do if they decide to buy stock back.
Back to HCC. Until recently HCC used a combination of the above alternatives for the money earned. Though they haven’t found any acquisitions they like so far, they are looking into it and they are spending money, by hiring underwriting teams, to expand in new markets. HCC is also paying a dividend, although a not very large one. And finally, they were buying back stock at quite a rate. Their stock buybacks became a topic at the last couple of earnings calls which started with the question in the third quarter 2012 earnings call as seen below.
When John Molbeck said that my first reaction was: saying you’re a Warren Buffett-type (two t’s btw) doesn’t make you so. For me this was a reason to keep this quote in mind and wait for the thing Buffett would also do with stock buybacks, namely stopping them if the price of the company exceeds the intrinsic value of the company (he would probably stop them even earlier and would start only if the company sells for a meaningful discount to intrinsic value).
Then, about a half year later, we had the first quarter 2013 earnings call with the following statement:
This was a clear statement about their thinking process during a stock buyback. The market price is below the intrinsic value, so we buy. Clear, but when and will they stop buying? Well, as you can read in the statement below from the second quarter 2013 earnings call, they are stopping.
The market price is approaching the intrinsic value and they are stopping buying. It looks like the management’s approach of stock buybacks is a bit like Warren Buffett’s. For me, this is a confirmation about the quality of the management. Unfortunately, it also means that the stock price is approaching it’s intrinsic value. So, don’t be surprised if I sell HCC in the coming months.
In part 2, which I probably publish next week, will I discuss the take-over offer from Fairfax and will I provide a brief update on the investment results so far. This is provided that the offer for Blackberry still stands.