Friday, October 7, 2011

Alleghany Corp (Y)

To continue the boring pattern of featuring companies with great track records being offered by Mr. Market at a discount, here is Alleghany Corp (Y), an insurance company/conglomerate.  This currently looks like an insurance company but acts more like a conglomerate.

This is one of those companies where the annual reports are very well written and is worth your time to read every year.  These are no-nonsense people, anti-fad, anti-trend etc...  Very, very conservative and primarily seeks to preserve capital rather than swing for the fences.

Here is a graph from their 2010 annual report:

Book value per share (BPS) at year-end 2010 was $331.81, +10.3% on the year.  Over the past five years, BPS grew +8.9%/year versus +2.3%/year for the S&P 500 index, and the ten year return was +8.7%/year versus +1.6%/year for the index.

That's a pretty good return, again, in a flat market and what is considered a pretty horrible insurance market (soft prices, many large, unprecendented disasters).   It is stunning how well they have done given what has happened in the past decade.  BPS has barely budged in the face of a collapsing stock market in 2000-2002 (when the stock market went down 50%), the various insurance disasters and the financial crisis since then.  I have been reading their annual reports for a few years and they are very conservative and hate to lose money; they would rather sit on cash and earn nothing than do something stupid.  These are the kind of people you want to invest with.

Y, unlike most other insurance companies, but like MKL and BRK invests much more in equities.  Their equity portfolio return in 2010 was +17.1% versus +15.1% for the S&P 500 index and +6.2%/year and +2.3%/year respectively for the past five years.  They are very good equity market investors.

This is a really old company and it is fun to go to their website and go through the history of the company; it started in 1929 in real estate development and ownership of many railroad companies and it has morphed over the years.

Alleghany Timeline

For those interested in annual reports, read those too.  They are fantastic (but I know that 9 out of 10 people you tell to read annual reports won't read them, but that's OK.  It is a hassle if you don't like that sort of thing), and are worth reading even if you have no interest in investing in Y.  (I own some but not a large position).


Anyway, maybe I will dig into this idea a bit more in another post, but for now let's just look at a quick valuation of this thing.  As with other insurance companies, Y does market their positions to market so book value is a pretty good indication of what this business is worth.

As of the end of the second quarter of 2011, BPS was $340.97/share, up +4.8% year to date.  However, the S&P 500 index has declined -12.5% since the end of June and Y owns $1.6 billion or so in equities.  So assuming the stocks went down a like amount, BPS adjusting for this would come to $319/share or so.  Y is now trading at $285/share, 89% of this value, or at an 11% discount.

Given the history of Y's returns combined with their conservatism, this seems very attractive.  Y also has excess liquidity that they can deploy in acquisitions if an opportunity arises.  They have been very, very picky, so they are underinvested.  If all hell breaks loose, they have the cash to take advantage of that. 

Why a 10% discount is so attractive
By the way, I was going to make this another post altogether, but one reason why I think these companies trading at book or below book value is so attractive is because they have a history of significantly outperforming the major averages and you can get them without a premium, or even in some cases a discount.

Think about mutual funds for a second.  Mutual funds typical underperform the market AND charge you a fee of 1.00%-1.50% of assets whether they do well or not.

Think about that for a moment.  They underperform and then they charge you for it.  What is this 1.00-1.50% expense worth?  If you capitalize it at 10%, that's worth 10-15% of assets.  That means that when you buy a mutual fund (at net asset value per share), you are actually paying a 10-15% *premium* to net asset values.

It gets worse.  If you want to capitalize that cost at 5% (since interest rates are low), that 1.00%-1.50% expense is worth 20%-30% of book value.  That means, again, that if you buy a mutual fund at the closing price, you are actually paying a 20%-30% *premium* to net assets for something that is most likely going to UNDERPERFORM the index! 

This makes no sense at all. 

Even if you buy an index fund for a 0.40% expense ratio, that is still costing you a 4% or 8% premium.

And these days, you get a lot of these wonderful businesses at book value or less.  Totally, mindbogglingly insane.

Closed-End Fund Discounts
This leads to the other issue of closed end funds and their discounts.  Closed end funds, in most cases *should* trade at a discount for the above reason.  The expense ratio will automatically set back any investor, and I am not aware of any closed end fund that outperforms their benchmarks for any significant period of time. 

At least with closed end funds, you have the chance to invest at a discount, though (although I wouldn't recommend most closed end funds except in certain situations where there is no alternative investment vehicle).  With mutual funds, you have no choice. You have to buy and sell the shares at net asset value per share, so you are forced to pay the above, capitalized premium!

Industry Concentration
I have mentioned great businesses for cheap, but keep in mind that many of these are in the same industry.  BRK, L, MKL and Y are all insurance companies or have big exposure to insurance.  Even though concentrated portfolios is a good idea, I don't know that anyone would want to have too much of their assets exposed to the insurance business.   That would not be prudent, even though the names I mention do underwrite conservatively (except L, the owner of CNA, which seems more like a conventional insurer than the others)

It's just something to keep in mind.

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