The Return of Irrational Exuberance Part 2 - The thrill is gone, suggests David Schiff
Although Brokaw's bullishness on insurance stocks was correct, it's not clear that things worked out well for him, as we shall see later. Insurance stocks - and most stocks - rose sharply from their lows, but the securities business languished. Wall Street was a depressed, chastened environment in the 1930s and 1940s, and fear prevailed. The total number of shares traded on the NYSE in 1935 was 381.6mn, about one-third of 1929's volume (and 0.1 percent of 2003's volume). Stocks came to be viewed as inherently speculative even though, in absolute terms, their cheap prices made them good long-term investments. The DJIA's average dividend yield was higher than the yield on Moody's Aaa bonds every year from 1935 to 1958. During the 1940s, for example, the dividend yield on the DJIA averaged 5.32 percent versus a 2.7 percent yield for Aaa bonds.
Railroads, public utilities, and industrial companies were the blue chips of the day. Insurance stocks were obscure, and most traded over the counter. In Security Analysis, published in 1934, Benjamin Graham wrote that "the investment counselor should do his best to discourage the purchase of stocks of banking and insurance institutions by the ordinary small investor". (In the 1962 edition of his book, Graham espoused a different view. He wrote that "industries which do not show large profit declines in periods of recession" have the "qualities of stability and predictability which make them ideal for formal appraisal". These industries included utilities, insurance companies, pharmaceuticals, and tobacco.)
The effects the capital markets have on the insurance business haven't changed much over the years. "It is also true," wrote Graham in 1934, "that rampant speculation (called 'investment') in bank and insurance company stocks leads to the ill-advised launching of new enterprises, to the unwise expansion of old ones, and to a general relaxation of established standards of conservatism and even of probity".
Insurance cycles aren't the result of physical laws; they're the result of human behaviour. Insurance leaders have been jabbering away about underwriting discipline for at least 130 years, and many were doing so again at the 15th Annual Executive Conference for the Property- Casualty Industry, held a few weeks ago.
(We cannot recall any instance-even during hard markets-when insurance CEOs said that insurance companies were charging rates that were too high.)
By 1944, when Shelby Cullom Davis was appointed as New York's commissioner of insurance, insurance companies had grown so risk averse that they eschewed common stocks, which were cheap, loading up on long-term bonds, instead. (They were especially fond of long-term Treasurys, even though they yielded a mere 2.5 percent.) As John Rothchild writes in The Davis Dynasty, Davis was an "anti- bond maverick." He considered bonds to be "certificates of confiscation" and railed against their purchase, urging life- insurance companies to invest some of their funds in common stocks instead. His ideas were considered heresy, and ignored. But the ensuing years would show that buying long-term bonds in 1946 was a worse investment than buying stocks in 1929. (In early 1981, Treasury yields peaked above 15 percent.)
In 1946 and 1947, Benjamin Graham gave a series of lectures at the New York Institute of Finance. He discussed a variety of subjects, including insurance and insurance stocks. Using North River Insurance Company as an example, he pointed out that "from the standpoint of good results for the stockholders, [it seems] to have much too much capital per dollar of business done in 1945". At that time North River had $25mn of equity and wrote $9mn in premiums. In 1927 it had written more premiums with half as much capital.
Graham threw out a concept:
Now, I might suggest that somebody should raise the question, "What can the stockholders do to get a decent return on their investment on the North River Insurance Company?" Let us assume it was a matter for the stockholders to decide, which would be a very extraordinary suggestion for anyone to make-elementary as it sounds in theory.
Here is a possible answer: Suppose you reestablished the relationship between capital and premiums that existed in 1927, when things were quite satisfactory, by simply returning to the stockholders the excess capital in relation to the business done.
If you did that, you would be able to get the earnings of about 6 percent on your capital and to pay the 4 percent dividend on your capital, which I suggested might be a definition of a reasonable return to the stockholder.
That could happen because, when you take out $15 a share from the present $31-and you have left only $16 to earn money on for the stockholder-you are reducing your earnings only by the net investment income on the $15 withdrawn, which is on the order of, say, 40 cents at the most. Thus you would earn about 85¢ on the remaining investment of $16, and you would get reasonably close to the 6 percent which you need.
Graham's idea made sense: give the excess capital - which was earning about 2.7 percent - back to the shareholders. Of course the executives running the insurance companies were not about to part with their capital willingly, and Graham knew this. He remarked that his idea "will not recommend itself to insurance company managements".
By 1947, Frank Brokaw's small firm was in poor shape. Brokers make their money from executing trades, and very little trading was being done. NYSE daily share volume was only 60 percent of what it had been in 1935. Total volume for all of 1947 was 253.6mn shares. On May 1, 1947 Shelby Cullom Davis, who had left the insurance department, bought a controlling interest in F. L. Brokaw & Co., which owned a seat on the NYSE, and changed the firm's name to Shelby Cullom Davis & Co. An advertisement in The Weekly Underwriter noted the formation of the new company and listed three employees: Shelby Cullom Davis, K. W. Davis (his wife Kathryn, who bankrolled him), and Brokaw, who was listed as "Manager Insurance Stock Department." (Brokaw committed suicide several months later.)
Over the next 47 years Davis would become the greatest insurance investor of all time. Frugality was part of his essence, and he didn't like to pay much for his investments. He bought stocks of insurance companies - especially life- insurance companies - at dirt cheap prices and realized tremendous capital appreciation over time as those stocks' prices increased to reflect their true value, and to reflect the growth of the underlying businesses. Davis, who was a perpetual bull, owned hundreds of insurance stocks and always invested on margin. When he died in 1994, his initial $100,000 of capital had grown to almost $1bn. Most of his estate went to charity. (For more on Davis, see Schiff's, June 1994.)
On September 18, 1952, Davis gave a speech to the Insurance Accountants Association, "Finance Looks at Insurance." He predicted a wave of mergers and acquisitions of smaller independent insurance companies, similar to what had happened with smaller banks. More importantly, he called the audience's attention to a great buying opportunity: insurance stocks were selling at discounts of 40 percent to 50 percent of net asset value or liquidating value. So cheap were insurance stocks, Davis observed, that not only did the market accord a 50 percent haircut to the value for insurance companies' tangible assets, it accorded no value for intangibles such as agency plant or goodwill.
Right place, right time
Davis had the good fortune to be in the right place at the right time, and he had the foresight to do the right thing. Regarding his contempt for "certificates of confiscation," investors may do well to ask whether the return on "high-yield" bonds (currently about 7 percent), is worth the risk. For that matter, they may also question whether the return on high-quality bonds is worth the risk.
Insurance companies prospered during the post-war years and their balance sheets grew flush. Over time the fear of investing in stocks subsided, and insurance companies' balance sheets were enriched by the rising market. In August 1967, when Ed Netter, a 34-year-old analyst at Carter, Berlind & Weill, wrote a report entitled "The Financial Services Holding Company," insurance stocks were in another one of their cyclical bargain periods, however.
Netter's report, probably the most influential piece of insurance-stock research ever published, outlined "The New Economics." A fire & casualty company making a 6.5 percent return on equity could, by "operating as a diversified and leveraged holding company," earn a 9 percent after-tax return on equity, he wrote. The idea was so sensible. A little asset shuffling and - poof! - higher returns.
The concept worked because, as Netter calculated, many prominent insurance companies had a "capital redundancy" (aka "surplus surplus"). Netter's thesis was the logical extension of Benjamin Graham's writing and speeches, as well as thoughts put forth by Brokaw and Davis. Graham had noted that insurance companies had more capital than they needed to run their businesses and had suggested that they return that capital to their shareholders. Brokaw and Davis had, years earlier, said that many insurance companies were trading at prices well below their liquidating values.
Netter's "new economics" added a twist to the old economics. He stated, for example, that Great American's book value was $98 per share, its stock price was $57.50, and its capital redundancy was $55 per share. Reading Netter's report it was quite clear - at least in theory - that one could take over Great American for $57.50 and immediately recoup $55 from its excess capital. Thus, for a net investment of $2.50 per share one could own a large insurance company that had a $43-per- share book value.
Other major insurers with similar mathematics included Continental Insurance, The Hartford, The Home, INA, and Reliance. Many would be acquired by conglomerates or holding companies within several years of Netter's report. Two early ones to go were Great American and Reliance, bought by National General and Leasco Data Processing Equipment Corp., respectively.
(Netter's employer, Cogan, Berlind, Weill & Levitt, served as consultant to National General and Leasco.)