Tuesday, May 29, 2012

CNA: One-of-the-Parts (of Loews)

Loews (L) has been, for years, a popular sum-of-the-parts play by value investors and it seems that's it's always trading at a discount.  I suppose that's normal for a conglomerate.

I am a big fan of L and have a lot of confidence in the Tisch family but one thing has always been nagging me about L, and that is:  What is up with CNA?  I'm sure I'm not the only one wondering about this.  So I decided to take a closer look.

Now L is a disciplined value investor and stays away from silliness, thinks long term and does all the right things.   They sound a lot like Buffett in many ways.  They concentrate their bets, are very shareholder friendly and all that.

But I just never really got CNA.  I'm sure they bought CNA well in 1974, but the performance there has been less than stellar. Yes, you have to think long term and not worry about short-term problems there. (I was a little surprised that they took such a hit back in 2008, but those were mostly marks against them and BPS has bounced back quickly so maybe it wasn't as bad as it looked at the time; but still, you don't want to see that sort of book volatility!).

So anyway, thinking long term is exactly what we have to do so that's what I did.  Since I can't see long term into the future, I decided to take a long term look at CNA going back. 

And this is what I found:

CNA Book Value Per Share versus S&P 500 (w/dvd)

This is the book value per share (BPS) of CNA versus the S&P 500 index since 1987.

Here is how they compare:

                                      CNA BPS                 S&P 500 (incl dvd)
5 year average                +4.4%                      -0.2%
10 year average              +1.8%                     +2.9%
Since 1987                     +4.5%                      +9.5%

CNA book value per share over the past five years has beaten the S&P 500 index and that is certainly encouraging, especially given what happened in 2008 (they gained back the big loss in 2008 and then some).  (CNA BPS change includes dividends) 

But if you look at CNA over the past ten years and since 1987, it's been pretty dreadful.

A quick calculation shows that if CNA did just as well as the S&P 500 index since 1987, the book value of L today would be $82.40/share instead of $47.49/share (through year-end 2011).  The sum-of-the-parts of the listed holdings plus cash and investments at the holding company would be $80/share instead of $42.59/share (from 2011 annual report).

But of course, we can't just look back and say that; every portfolio is going to have a dog.  We can't say, well, if we owned this instead of that, we would've been better off.  So that's certainly not fair.

But still, from such a prominent value investor, we'd expect better than this for such a large part of the portfolio.

Here is the comparison between CNA (book value growth w/dividends) and the S&P 500 index return (w/dividends) over rolling five year periods.  This is the measure used by Buffett in a recent annual report showing how BRK should retain earnings if they can keep outperforming the index.


CNA versus S&P 500 Index by Five-year Periods


It's kind of stunning how thoroughly CNA has been outdone by the S&P 500 in both up-markets and down-markets. Reading the annual reports, you'd think that it was all about the poor insurance market, but the data shows constant underperformance since 1992 which should have included some good years in the insurance market, economy etc... But you see no trace of that here.


CNA is a Key Value Driver
L has owned most of CNA since 1974 and it's been a large part of the portfolio since then.  Below are some figures that show how big of a factor CNA has been in the value of L over time.

CNA as Percentage of Loews by Market Cap
           %CNA              CNA                 Loews                    CNA %
           owned by L       market cap       market cap             of L mkt cap
1994    84%                 $4.0 bn             $4.8 bn                   70%
2000    87%                 $7.1 bn             $10.2 bn                 61%
2011    90%                 $7.2 bn             $14.9 bn                 43%

CNA as Percentage of Loews by Book Value

             L equity          CNA equity     L share of CNA      CNA equity % L equity
1994        $5.4 bn             $4.5 bn           $3.8 bn                  70%
2000      $11.1 bn             $9.6 bn           $8.4 bn                  76%
2011      $18.8 bn           $11.6 bn         $10.4 bn                  62%               

You can see that CNA is big part of L, but it is getting smaller as other parts grow.  CNA has spun off Lorillard, sold part of DO etc... 

But CNA's holdings still account for 43% of L's market cap and 62% of value based on book value.


CNA Has Done Well in Past Five Years
So it seems like CNA has done well over the past five years, despite their large loss in 2008.  So why is CNA stock so cheap? Shouldn't it get at least book value per share for their outperformance?

To see what's going on, I looked at some other insurance companies.  For comparables, I just took the list  in their proxy statement and didn't include companies that didn't seem like it was in the same business (Ace Ltd is reinsurance, Allstate is mostly retail (auto and home-owners), Lincoln National is life etc...).


Book Value Growth (incl dvd) Since 2001

(CB = Chubb, TRV = Travellers, AFG = American Financial Group, HIG = Hartford Financial)

This is how other insurance companies have done over the past ten years compared to CNA.  CNA is the dark, fat line at the bottom of the chart.  You notice that CNA has done demonstrably worse than the other insurance companies and even underperformed the S&P 500 index (as we already saw earlier).




Book Value Growth (incl dvd) of Various Insurance Companies

So yes, CNA has outperformed the S&P 500 index over the past five years, but when compared to other insurance companies, it doesn't look so good.  It looks good compared to HIG, but that is not such a great comp. CNA underperformed even HIG over ten years.

Reading through the CNA annual reports over the years, I am struck at how often the management talks about the tough competitive environment and horrible pricing and things like that.   They also talk about awful economic environment and disasters that cost them money but these are things that other insurance companies had to deal with too.

Also, management often talks about how they have a great balance sheet,  great relationships with agents, are controlling costs and getting more efficient, focusing on more profitable business lines and things like that, but it's sort of been the same story since at least 1994 (read all of the letter to shareholders and you'll see what I mean (there are some LTS missing since they are not in some of the 10k's).

CNA is Cheap
CNA is certainly cheap at 0.65x book or some such.  But if you look at the chart below, CNA is sort of always trading below book value, and the subpar performance of the business is probably the reason for that.

CNA BPS versus Stock Price

During one of the L earnings conference calls, I think last year, someone asked Tisch what has the most potential upside in the coming year or two; what business has the most potential for value gains at Loews?  (kind of a similar question was asked at the Leucadia annual meeting and Steinberg didn't want to answer the question due to Reg FD).

Tisch responded by saying that CNA stock is really cheap so if that gets revalued, that would be an upside boost to L.  He also said that CNA will get hurt in a rising interest rate environment as they have to own bonds against their insurance reserves, but Tisch said that a stronger economy and improving business conditions in insurance would be a positive offset to that.

So let's see.  What is it going to take to get CNA back up to book value?

Since 1987, CNA has averaged 0.94x book.

Let's take a look at some other insurance companies:

Price-to-Book Value Ratio Comparisons

So we see that CNA has pretty much always traded much cheaper than the other insurance companies (excepting HIG; they are both in the doghouse now).

Obviously, the better performing insurance companies trade at a high p/b multiple.

Expected Returns
So we looked at historical returns of the various insurance companies (book value growth including dividends is the same as comprehensive income for this purpose.  Net income is not so great as realized gains go through the income statement but not unrealized gains, even when unrealized gains increase the value of a company.  Unrealized gains are booked in AOCI (accumulated other comprehensive income) and does change book value of a company.)

So we know that CNA is cheap, but it's cheap also because it hasn't done too well versus peers.

What is the proper value of CNA, then?

For this I was going to do a scatter plot, but realized that five companies isn't going to make a great chart, so I did something simpler.

Expected Returns based on Historical Book Value Growth (plus dvd) and P/B Ratios

In the table above, the average return is just the average growth in book values including dividends (my "comprehensive income"), the p/b ratio is exactly that, and the average expected return is simply the average return divided by the average p/b ratio.  If a company earns an ROE of 20% and you pay 2x book value for it, your expected return is 10%.

So the table above just shows the expected return based on average returns and valuations.  We see that the higher the comprehensive income return on equity, the higher the valuation.  It seems that even though CNA has been cheap averaging 0.7x book in the past five years, that is still not cheap when considering that it only earned an average of 4.4%/year.  So the expected return assuming a 4.4%/year return and paying 0.7x book is still 6%, much lower than the 12% you can earn on CB paying 1.2x book if CB continues to earn the average 14-15% comprehensive return on equity.

If CNA continues to earn 4.4%/year and we need to get expected return to 10% or more like the other insurance companies (except HIG), then CNA would have to trade at 0.44x book value.  This means that CNA may, even at 0.65x book, be 50% overvalued.

For reference on current valuations, here are the P/B ratios based on book value as of March-end 2012 and current stock prices:


                            Current     Current                 Expected return based on:                
             BPS        Price         P/B                        5 yr avg return     10 yr avg return
CNA    $44.48     $28.94      0.65x                        6.8%                   2.8%
CB       $57.37     $72.70      1.27x                       11.4%                  11.8%
TRV    $63.81     $62.92      0.99x                       14.0%                  14.3%
AFG    $45.65     $39.15      0.86x                       13.9%                  15.3%
HIG     $43.25     $17.40      0.40x                        -7.8%                  11.0%


This is the same table with current price and P/B ratios.  Assuming CNA can do as well as it has in the past five years, paying 0.65x book for it will yield an expected return of 6.8%.   So we see that unless there is substantial improvement in the operations of CNA (which is questionable due to the long history of promising comments from management with little improvement in 20+ years), it's hard to see how CNA can get valued much higher.

Paying a premium for CB and even TRV and AFT would yield higher expected returns.

There is a problem in using historical book value growth (or comprehensive returns on equity) as interest rates are very low now and many insurance companies still report investment income in their fixed income portfolios of 4-5% range.  This is because even though interest rates have declined substantially, it will take time for the old bonds with high yields to roll off and be replaced by lower yielding bonds.

But this applies to all insurers, not just to CNA.  So going forward, returns may be lower (unless conditions normalize). Even then, CNA will go lower from a lower base and could even make them unprofitable if rates stay here and the insurance operations keep going as it has been.


Underwriting History
OK, so let's just take a quick look at CNA's underwriting history.  There wasn't an easy way to get historical combined ratios and "float" figures (I didn't want to add up all the different things), so I just used a quick proxy for this.


Operating Profits Excluding Investment Income


So for a proxy of underwriting gains, I just used income excluding investment income (and some others).  I took net earned premiums and other revenues and then deducted "claims, benefits and expenses".  So that may not be the exact combined ratio or underwriting profit, but these figures were easy to pull out of the reports.

So we see that excluding investment income and realized gains on investments, CNA is pretty deeply unprofitable.  That's OK, many insurance companies run at underwriting losses over time.

The columns on the right is "Total Investments" and the column next to that is the operating losses excluding investment income as a percentage of Total investments.  Total investments include float and CNA's own shareholders' equity so is not quite cost of float.

But it does tell you how much the investment portfolio has to earn for CNA to be profitable.  The two basic income streams here is insurance operating profits and investment income.

So you see here that if interest rates continue to go down and investment income goes down, CNA can look a lot worse. 


Limited Partnerships
The other thing that may offer some upside to CNA is their investments in limited partnerships.  They do have $2.2 billion or so invested in them.  They are invested in 79 partnerships that breaks down into 81% hedge funds, 14% private debt and equity and others including real estate.

The hedge funds seek "gains from differentials between securities, distressed investments, sector rotation or various arbitrage disciplines".  46% of the hedge funds are in equity related strategies, 32% in multi-strategy, 19% in distressed and 3% in fixed income.

People have asked on conference calls who CNA has given money to and they won't disclose that.

Anyway, here is some data from their 10K's:


They have $2.2 billion in limited partnerships as of the end of 2011.  I don't think you can calculate the rate of return on these funds as we don't know the cash inflow/redemptions from these funds.  All we know for sure is the investment income that comes from the partnerships, and that is listed in the table above.  That comes to an average of 7.5% since 2001, but that probably understates the actual return.  In 2011, there was $560 million in undistributed earnings included in the $2.2 billion figure above.  I suppose you can calculate the change in undistributed earnings, but that isn't disclosed going that far back.

In any case, I think as a whole, these strategies would probably earn 10%/year over time.  So with $2.2 billion invested, that's $220 million or so in earnings.   Against $12 billion or so in equity, this would add almost 2.0% to pretax return on equity.  If these funds can earn 15% over time, that can add 3% or so to pretax return on equity.

But keep in mind that the above returns are already included in all of the historic return calculations of CNA.  To make it additive to what is already in the history, they would have to do that much better.

Having looked at a bunch of listed hedge funds and private equity companies and their performance, I wonder if they can earn high returns going forward.

I wouldn't want to lean on this to make the CNA idea work.   If the funds can do well, that would be a nice bonus if the rest of CNA can improve.  But these limited partnerships in themselves isn't a reason to get excited about CNA.

What is Loews Thinking?
So what the heck is Loews thinking with this thing?  It has performed horribly over the years. If you ask them, they will say that they own 90% so noone is more disappointed in CNA than them and noone would like to see them improve more than them.  They will say that they think about it all the time and work very hard in trying to turn it around.

As for selling CNA even at this nominally cheap price (but possibly very expensive depending on point of view), I can see Tisch saying that they can sell it, but cash is earning nothing right now and with CNA, they can at least be owning something that earns 4% at a 40% discount and in this environment that doesn't sound like a good sale.

Fair enough. 

(well, how about then repurchasing L stock with the proceeds?)


Thought Experiment
But I wonder if they can't sell CNA, take a loss and use it to offset a gain on a sale of DO and then buy back a ton of stock?

As of the end of March, 2012, the BPS of L was $48.96.  The sum of the listed entities plus net cash and investments of L was $45/share (this is based on the sum-of-the-parts in the 2011 annual report with the figures updated to March-end.  This excludes L's unlisted subsidiaries etc.)

So I will assume L sells all of it's CNA and DO.  The loss on the CNA sale will offset the gain on sale of DO.

In a conference call, I remember someone asking about the cost basis of L's subsidiaries and I think Tisch said that it is complicated and they haven't worked out the exact cost basis for each sub.

But here, I will just use a simple measure which may be totally off, but that's OK.  This is just a thought experiment and we're allowed some guesswork.

For DO and CNA, I will just use book value as the 'cost'.  Since these entities are consolidated, the book value shows the accounting value of the businesses.  If a business is sold above book, a gain is realized and if it is sold below book, then a loss is realized.  I don't really know much about tax and accounting in these situations but let's just assume that is a reasonable ballpark assumption.

Then if we now sell DO, L would get proceeds of $4.3 billion and a gain of $2 billion (because DO is trading at 1.9x book value). 

If we sell CNA now at current prices, L would get proceeds of $6.9 billion and a loss of $3.9 billion (because CNA is trading at 0.65x book value).

So the transaction above would cause a net realized loss of $1.9 billion pretax and cash proceeds of $11.2 billion.

Let's say further that this $11.2 billion was used to repurchase L stock.  I know, you're not going to buy $11 billion of L stock in one shot. 

Anyway, book value of L at March-end 2012 was $19.4 billion.  With a pretax loss of $1.9 billion, let's call that $1.2 billion net after tax, that brings L shareholders' equity to $18.2 billion.

So assuming $11.2 billion is used to buy back stock, the shareholders' equity would drop to $7.0 billion (loss and cash out for share repurchase), and number of shares will go down to 117 million shares ($11.2 billion can buy 280 million L shares at $40/share).

Shareholders' equity of  $7.0 billion and shares outstanding of 117 million shares would bring BPS to around $60/share.

That compares to the current book value per share of $49/share and sum-of-the-parts (excluding unlisted entities) of $45/share.

A big advantage would be that with a much smaller capital base of $7 billion or so, the universe of potential investments can be much larger.  After this hypothetical transaction, L would still have $3 billion of net cash and investments on the balance sheet.

OK, so this may not happen any time soon, and $60/share is not *that* exciting for such a drastic transaction.   Who's going to buy CNA?  DO?  Who's going to sell L?  But that is the potential value embedded in L (or one way to look at it).

I have juggled a bunch of numbers here on this thought experiment; I may have screwed something up but I think it gives a rough picture of what could be...

Synthetic Restructuring
We know that we can jump up and down all we want and say L should sell CNA, even at a loss and they won't do it (well, actually we don't know that they won't.  They just won't say what they are planning!). This is not to say that they are wrong. There are all sorts of other factors that must be considered, and I'm sure the Tisch's are thinking of all the best options for them and I can't imagine them making anything other than a rational decision (even though sometimes we on the outside can't see everything so can't understand things).

But here's an idea. If you don't like CNA, but think CB, TRV or even BRK is better, you can synthetically swap out the business: Just go long L and then sell short the amount of CNA that L owns, and then go long your preferred insurance company.   L has done very well over the years despite the performance anchor of CNA.  Imagine what would happen with a strong insurance company!

Of course, this is not without risk. There can be a sharp rally in CNA for whatever reason (deal, massive restructuring, sudden hardening of the insurance market etc...) and the L share price may not reflect dollar-for-dollar the increase in the CNA value.

Of course CNA can go up and your choice of insurance company can go down; that's what it seems like always happens on these kinds of ideas.

But the fact is, you can restructure CNA by yourself.

Conclusion
I do like L, and I really respect the Tisch family.  I have no doubt they will do very well going forward.  As for the discount to asset value, this has been the case for many years so I wouldn't get too excited about that gap closing any time soon.

If you own L, you have to believe that L will continue to grow intrinsic value per share over time.  I don't doubt that they will.

On the other hand, part of the reason why I looked so closely at CNA here is because it is so cheap.  I was thinking that maybe CNA on it's own would be a good investment or maybe even better than L.  Any turn in the insurance market, improving market and economic conditions may really boost CNA results and get it trading closer to book value.  

That's what I was thinking initially, but a look at the long term history of CNA has made me wonder about that.  It's true that they are doing a little bit better in the past five years or so (despite the jawdropping decline in book in 2008) but improvements at CNA have been promised before.

So I'm not as excited about the potential of CNA as I thought I would be after taking this deeper look.

I hope I am wrong, though, and hope CNA does turn around.  If interest rates stay low and investment returns start coming down as higher yielding bonds roll off, things can get quite ugly at CNA.  It's hard to imagine that they would be able to make up that lost income with underwriting gains given their underwriting history (not so good).

Of course, this concern about CNA can also be a factor in the discount to asset value for L as a whole.

I hope they figure something out.





4 comments:

  1. This comment has been removed by a blog administrator.

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  2. Good blog !!

    Silly question (probably because of my mood today morning !! ) : Can you summarise this to a single line ? something like a twitter post ? would it be "lets welcome market volatility " ?? or ??

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  3. Tom Armistead, another blogger, who together with you is among the few financial bloggers I read for original content and insight, had an article about CNA, where he had good arguments that CNA is on a the path to a turnaround thanks to new management. I find his analysis compelling and together with the discount of L makes this one of those rare moments of " Heads, I win; Tails, I don't lose that much".
    http://seekingalpha.com/article/397251-cna-a-p-c-insurance-turnaround-story

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  4. Sometimes people post comments, I get the email notice but it doesn't show up here. I guess it's a blogger bug.

    Someone asked what's wrong with CNA and why the L folks can't seem to get this one right even though the current CEO might be the one to get it right.

    Anyway, I too am confused about this one. I guess the answer is that they are trying their best and Tisch is probably is as confused and frustrated as anyone else. Even with CNA being a big part of L for the past few decades, L returns have been pretty good, though. If it wasn't, maybe they would have to take more drastic measures (like sell it), if that's even possible at a reasonable price.

    I have no real insight into this. We shall have to see what happens.

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