Alleghany (Y)

[Enterprising Investor]

Alleghany Invests by the Book (5/14/16)

The insurer’s book value has grown 8%-plus annually for the past 11 years, and shares have followed.

By Andrew Bary

Under the leadership of Weston Hicks, Alleghany has built an impressive company focused on property-and-casualty insurance and investments, which resembles a small-scale Berkshire Hathaway . Book value has grown at a consistent 8.2% annual rate over his 11 years at the helm, about a percentage point better than the performance of the Standard & Poor’s 500 index.

That record hasn’t gotten a lot of reward on Wall Street, however. While the stock (ticker: Y) is up 10% this year, to $526, it trades for only a small premium to its March 31 book value of $503 a share.

By comparison, Markel (MKL), a better-known P&C insurer with an investment focus, trades for $960, or nearly 1.6 times book. That’s a steep premium even given Markel’s better growth. But it suggests that there’s plenty of room for Alleghany shares to appreciate. What’s the upside? If book value continues to grow at an 8% clip and Alleghany gets valued at 1.1 to 1.2 times book, the stock would trade around $625 in a year, a nearly 20% gain. On a sum-of-the-parts basis, Alleghany is worth at least $600 a share, Barron’s estimates.

The New York–based company has a market value of about $8 billion. It earned nearly $32 a share from operations last year and $9.32 in the first quarter, up from $8.19 in the year-earlier quarter.

Hicks isn’t an attention seeker. The company doesn’t hold earnings conference calls, and has scant analyst coverage. As a result, Alleghany has a low profile in the investment community.

The company’s stated goal is to generate 7% to 10% annual growth in book value over the long term. But that’s a challenging objective in an “environment of low interest rates, negligible inflation, maybe deflation,” CEO Hicks conceded in an appearance at a BofA-Merrill Lynch insurance conference earlier this year. Nor does it help that competitive conditions in the P&C market are difficult. The industry is sitting on too much capital, and insurance buyers increasingly can turn to alternative structures like catastrophe bonds for their needs. All of this puts pressure on pricing.

“Weston Hicks has done an excellent job of protecting and growing book value over more than 10 years,” says Larry Pitkowsky, a portfolio manager at GoodHaven Capital Management, an Alleghany holder. “Alleghany has been opportunistic on the acquisition front, cautious on the investment side, and it has allocated capital well. The company has opportunistically bought back stock when it traded below book value”—4% of shares outstanding in the past five quarters.

Barron’s wrote favorably on Alleghany 4½ years ago (“Alleghany Finds Its Elephant,” Nov. 26, 2011), when the stock traded around $275.

ALLEGHANY’S TWO MAIN businesses are TransRe, a global reinsurer, and RSUI, a property-and-casualty insurer that focuses on higher-risk, specialized situations that big insurers like Chubb (CB) and Travelers (TRV) typically avoid. Alleghany bought RSUI in 2003 for $626 million. It purchased TransRe for $3.5 billion in cash and stock in 2012, outbidding Berkshire Hathaway (BRK.A). Both deals have been winners. The insurers have generated significant profits, which Alleghany has reinvested in their operations and used to repurchase stock and invest in a group of noninsurance business. Alleghany doesn’t pay a dividend.

Four years ago, Hicks recruited former Berkshire Hathaway insurance executive Joe Brandon to head the Alleghany insurance operations, and the results have been excellent. TransRe, Alleghany’s largest insurance division, has generated an underwriting profit margin of 10% since 2012, considerably better than the industry average. TransRe has exposure to aviation, marine, and mortgage insurance, as well as property risks.

RSUI has produced a very attractive underwriting profit margin of 18% since 2003. Hicks attributes that to a culture in which underwriters are paid based on the long-term profitability of the business they generate. This contrasts with other insurers where sales volume factors into compensation. RSUI is willing to accept less business when pricing is soft, and that was the case in the first quarter, when premiums declined 8.9%.

Alleghany’s favorable results have come despite a conservative risk posture. It would take the smallest hit to equity from a large catastrophe with a 1% chance of occurring among a group of P&C insurers, according to a recent study by insurance specialist Dowling Partners. Alleghany would lose 6.5% of equity, half the average of the group that included XL Group and Everest Re Group.

Alleghany carries several risks, including poor underwriting decisions, a drop in the stock market and higher rates, which would depress its $14 billion bond portfolio.

Alleghany’s $3 billion equity portfolio is tilted toward high-quality stocks, including Visa (V), Walt Disney (DIS), Alphabet (GOOGL), and CVS Health (CVS).

Like Berkshire and Markel, Alleghany has plowed insurance profits into a group of noninsurance businesses. It has about $600 million allocated to a division called Alleghany Capital. Its investments include Stranded Oil Resources, which seeks to extract oil from old fields; Kentucky Trailer, which makes customized truck trailers; and Jazwares, a toy company. Profits at Alleghany Capital so far are modest.

LIKE BUFFETT, Hicks pens an honest and insightful shareholder letter. Earlier this year, he wrote that Alleghany is positioned conservatively, given high asset prices and challenging conditions in many insurance markets: “For the long-term stockholder, we aim to produce attractive real returns with a very low chance of permanent capital loss.”

One issue is whether Alleghany would consider a merger with an offshore insurer in order to reduce its tax bite, which was about 26% last year. “We’re always open to strategic moves that make sense from a business point of view,” Hicks said last week, noting that he opposes anything dictated primarily by taxes.

Since joining Alleghany in a senior role in 2002, Hicks, now 59, has taken a company with $1.4 billion in capital and no major operating businesses to one now with two sizable insurers, other businesses, and $7.8 billion of equity capital. “I feel fortunate to have this job,” he told Barron’s. “I want to finish this movie.”

Based on the results so far, the movie may have a happy ending.

http://www.barrons.com/articles/alleghany-invests-by-the-book-1463197522

Pre-publication closing price: $528.07