Value Play: W.R. Berkley (NYSE: WRB)

If you read my writings on value investing, you will quickly discover that I am a huge fan of Warren Buffett and his investment vehicle, Berkshire Hathaway, an insurance company that has generated tremendous wealth over its 48-year history.

Insurance companies get paid up front and only are required to pay out claims later, if ever. The time between receiving insurance premiums and paying out claims is called the “float.” This float is, in essence, an interest-free loan that can be used to make investments. What other business can do that? Insurance can be a great business if you know how to judge and price risk accurately. It doesn’t surprise me that some of the greatest value investors like Shelby Davis made their fortune investing in insurance companies.

Insurance companies make money two different ways with their interest-free loans:

1. Underwriting Insurance Policies – Take in more money in premiums than pay out in claims and administrative costs. A “combined ratio” of claims and administrative costs below 1.0 means that total insurance costs are below insurance premiums received and the underwriting is profitable.
2. Investment Returns – Invest the premiums received in fixed-income and equity securities that generate income and capital gains.

As a small and mid-cap advisory focused on companies with a market cap below $10 billion, I cannot recommend Berkshire Hathaway, which sports a huge market cap of $285 billion. Fortunately, there are small and mid-cap insurance companies operating like “mini-Berkshires” that still offer tremendous investment opportunities. One such company is my Value Front Runner this month: W.R. Berkley, a property casualty insurer with Buffett-like characteristics that is run by its founder.

W.R. Berkley was founded in 1967 by William R. Berkley, a Harvard Business School graduate who decided it would be easier to compete in the backward insurance business than in the hyper-competitive investment management business. Today, 47 years later, W.R. Berkley is a Fortune 500 company and one of the largest commercial lines writers in the United States. The company operates in three business segments of the property casualty insurance business:

W.R. Berkley’s Three Business Segments

Business Segment	2013 Revenue	2012 Pre-Tax Income	Profit Margin	% of Total Revenue
Insurance-Domestic	$4.3 billion	$648.7 million	15.1%	73.1%
Insurance-International	$770 million	$56.9 million	7.4%	13.1%
Reinsurance-Global	$810 million	$110.4 million	13.6%	13.8%

Source: 10K Filing

Berkley focuses on “excess and surplus” lines of insurance, which is specialized insurance based on complex and sophisticated risks that regulators allow much more pricing flexibility than standard “admitted” lines of insurance like life, health, and auto. Specialized insurance is typically much more profitable for the insurer than standard insurance. Berkley’s underwriting is profitable, with its combined ratio ending 2013 comfortably below 100% at 95.1% (an improvement from 97.2% in 2012). As CEO Berkley stated in the fourth-quarter financial report:

We are beginning to make headway on our expense ratio, and anticipate additional improvement in both our overall underwriting results and our combined ratio in 2014.

Prior to 2013, the company reported five business segments as follows:

Business Segment	2013 Revenue	2012 Pre-Tax Income	Profit Margin	% of Total Revenue
Specialty	$1.8 billion	$262 million	14.6%	33.7%
Regional	$1.2 billion	$122 million	10.2%	22.5%
Alternative Markets	$931 million	$194 million	20.8%	17.4%
Reinsurance	$543 million	$93 million	17.1%	10.2%
International	$866 million	$62 million	7.2%	16.2%

Source: 2012 Annual Report

To service specialized lines of insurance, the company is comprised of 49 de-centralized operating units that are close to the customer and have the independence to respond quickly to local business conditions. Each operating unit is held accountable for its own P&L statement and almost half of these units have been created since 2006. This operating structure reminds me of Berkshire Hathaway, which also provides its subsidiaries with substantial independence and flexibility for better financial results.

In a 2008 interview, CEO Berkley said the following:

I like to tell people we’re a very unique combination of a family business that’s a public company that’s run like a large company with some of the strengths of a small, autonomous unit. It’s just a very unique combination that looks so simple. But it’s the day-to-day implementation of that combination, that humanist approach that fits common sense goals, that makes it a very special place.

Just as Berkshire Hathaway measures its performance by increases in book value per share, so does W.R. Berkley. Compare the first page of Berkshire’s annual shareholder letter with page 4 of Berkley’s 2012 annual report. They look identical, other than Berkshire’s slightly-higher long-term annualized return. Nevertheless, Berkley has trounced the S&P 500’s return since 1974 by 7.6% annualized and Berkley’s annual book-value gains have beaten Berkshire’s book- value gains every year between 2000 and 2012! Furthermore, Berkley’s share-price return has trounced Berkshire’s return over the past 15-year, 10-year, and 3-year periods:

W.R. Berkley Has Outperformed Berkshire Hathaway

Time Period	WRB	BRK-A	W.R. Berkley Advantage
15-Year Total Return	772.3%	143.3%	+629.0%
10-Year Total Return	147.6%	84.8%	+62.8%
3-Year Total Return	45.4%	36.4%	+9.0%

Source: Bloomberg

One of the big differences between Berkshire and Berkley is that the vast majority of Berkley’s investment assets (85%) are in low-return fixed-income securities, whereas Berkshire invests heavily in stocks and operating businesses. This fact makes Berkley’s outperformance even more amazing. Granted, bonds have enjoyed a historic bull market over the past 30 years that will not be repeated, so it’s heartening to hear Berkley’s CEO voice in the 2012 annual report (page 10) that he understands the changing interest-rate environment and has started to diversify the company’s investment portfolio into alternative asset classes (page 7):

We have consciously managed our duration in anticipation of increased inflation and the effects on the portfolio. Thus, we have shortened the duration of our portfolio and sought out investments that offer us more attractive returns, while giving up short-term marketability. Our cash position has also increased as has our common stock portfolio.

For the five years prior to the 2008 financial crisis (2003-2007), Berkley routinely generated returns on equity (ROE) of 20%-plus, but since 2008 low interest rates and subdued business activity have caused the company’s ROE to average only in the 9-12% range. Nevertheless, Berkley has continued to generate strong earnings-per-share gains and dividend increases thanks to an aggressive share repurchase program that has reduced shares outstanding by 30% since 2006 (142 million versus 202 million).

And share repurchases are set to continue into the future. In the fourth quarter of 2013, the company bought back 2.95 million shares (page 28) at an average price around $43 per share and on February 19^th upped its buyback authorization to 10 million more shares, representing 8% of the remaining shares outstanding. Besides share buybacks, the company is also aggressively increasing its dividend, the last 11% increase occurring in May 2013 which marked the company’s eighth dividend increase since 2005. W.R. Berkley is clearly a shareholder-friendly company dedicated to returning cash to shareholders.

Berkley aligns management compensation with investment performance. See an April 2013 filing for details. Insider ownership is 21%. Of this amount, founder CEO Berkley owns 18.9% of the company (page 21) and has never sold a single share in more than 40 years (other than cashless option exercises or to cover taxes on restricted stock grants). Berkley is 68 years old, but his son Robert Berkley is only 41 and ready to take over the reigns of leadership when necessary. Robert has 16 years of experience with the company and is currently president and chief operating officer. Founding leadership of the company focused on long-term business success will continue for decades to come.

The long winter of low interest rates is coming to an end, which will benefit insurance companies because they will be able to earn higher rates of return on their fixed-income investments. As CEO Berkley stated in the 2012 annual report (page 12):

With every passing quarter, it is becoming more apparent that the property casualty commercial lines market is going through a time of positive transition. It has been many years since we, as an organization, have been so encouraged by the market.

Although a return to pre-2008 annual profitability of 20%-plus ROE may take some time, I am confident that the company’s ROE is set to rise substantially over the next several years. Not only will a combination of higher interest rates and stronger economic activity boost the company’s profits, but increased regulations will hamper the big insurers and give small competitors like Berkley a competitive advantage that may lead Berkley to even stronger growth through market-share gains. Specifically, in the wake of the 2008 financial crisis, Congress passed the 2010 Dodd-Frank financial reform legislation, which directs the U.S. Treasury’s Financial Stability Oversight Council to designate some large non-bank financial firms as “systemically important financial institutions” (SIFIs) that are subject to increased regulation. Competitor AIG has already so designated and MetLife is under the microscope. W.R. Berkley is small and has nothing to worry about. In fact, last June CEO Berkley said that he actually “feels sorry” for AIG because of the restrictions it faces as a SIFI designee:

Federal oversight is a real pain. It makes your life very difficult; you have less flexibility; you can’t turn on a dime—no matter how good you are. It makes more cumbersome demands on the business. It takes away a lot of risk, but makes it harder to run. The designation puts these carriers under a competitive disadvantage.

AIG’s pain is Berkley’s gain . . .

W.R. Berkley’s stock valuation remains reasonable at an EV-to-EBITDA ratio of 6.38 , its current PE ratio of 10.9 is below the five-year average PE ratio of 11.5, and its price-to-book ratio of 1.3 is far below the two times book it routinely sold for prior to the 2008 financial crisis.

W.R. Berkley is a buy up to $47; I’m also adding the stock to my Value Portfolio.

 

Momentum Play: WisdomTree Investments  (Nasdaq: WETF)

Back in the 1990s, one of my favorite investment magazines was Individual Investor (II), a tip sheet for small-cap momentum growth stocks. Especially before, but even during the early days of the Internet, stock-screening tools were rare and magazine-based stock picks were in high demand. II’s “Magic 25” portfolio performed very well over several years during the Internet bubble. The founder and CEO was Jonathan Steinberg, son of insurance executive and corporate raider Saul Steinberg who ended running Reliance into bankruptcy due to heavy debt and poor underwriting standards.

Jonathan’s Individual Investor empire started to crumble when he spread himself too thin, dividing his time between acting as an editor for II magazine and a money manger for hedge-fund startup called WisdomTree. Conflict-of-interest allegations soon arose that accused “Jono” of using II”s trade recommendations to pump and dump microcap stocks owned by the WisdomTree Fund. Steinberg tried to solve the problem by prohibiting the WisdomTree Fund from owning any Magi 25 stocks, but this created new accusations that he was saving the best stocks for his hedge fund and leaving magazine readers with inferior picks.

In the end, none of this stuff mattered. What caused II to fail was the popping of the Internet stock-market bubble, which destroyed the value of most momentum stocks (II’s micro-cap stocks worst of all), and an economic recession that caused magazine advertising to fall off a cliff. In July 2001, II ceased publication and soon thereafter Steinberg sold the magazine subscriber list to Kiplinger, liquidated his hedge funds, and the company’s stock was delisted from the Nasdaq, barely surviving in suspended animation on the pink sheets. CNBC news anchor Maria Bartiromo, who married Steinberg in 1999 before the company collapsed, must have been having second thoughts about her decision . . .

Steinberg still had intellectual-property rights in a performance-weighted stock index called “America’s Fastest Growing Companies” and spent the next three years trying to convince Wall Street to fund his brainchild: a rules-based exchange-traded-fund (ETF) business. ETFs are like open-end mutual funds, but they are more tax efficient, offer real-time portfolio transparency, and trade like stocks on an exchange that can be bought and sold at any time the market is open – unlike mutual funds that can be transacted only once per day after the market close. In a recent interview, Steinberg explained his ideological conversion from discretionary small-cap growth investing to value-based ETF investing this way:

When the liquid, transparent, tax-efficient structure of the ETF became apparent to me, I had an idea that if you could create a better index and marry it to the ETF-structure, you could give investors a better investing experience.

Steinberg renamed his moribund company “Index Development Partners” in 2002 and finally convinced hedge-fund legend Michael Steinhardt to bankroll his venture in 2004, which was renamed WisdomTree Investments in 2005. Steinhardt’s involvement opened the floodgates to other investment luminaries including Wharton finance professor Jeremy Siegel (author of Stocks for the Long Run), former SEC Chairman Arthur Levitt, and former Merrill Lynch asset management executive Frank Salerno.

In June 2006, the company launched its first 20 ETFs based on a back-tested “fundamental indexing” formula developed by Wharton professor Jeremey Siegel. All of the stock portfolios were dividend-weighted instead of the traditional market-cap weighted. In a Wall Street Journal op-ed entitled The Noisy Market Hypothesis, Siegel explained the philosophy behind fundamental indexing:

Fundamental indexation means that each stock in a portfolio is weighted not by its market capitalization, but by some fundamental metric, such as aggregate sales or aggregate dividends. Like capitalization-weighted indexes, fundamental indexes involve no security analysis but must be rebalanced periodically by purchasing more shares of firms whose price has gone down more than a fundamental metric, such as sales, and selling shares in those firms whose price has risen more than the fundamental metric.

It can be rigorously proved that if stock prices are subject to noise, then capitalization-weighted indexes will offer investors risk-and-return characteristics that are inferior to those of fundamentally weighted indexes. From 1964 through 2005, a total market dividend-weighted index of all U.S. stocks outperformed a capitalization-weighted total market index by 123 basis points a year and did so with lower volatility.

If you are a fan of indexing, as I and so many other investors are, you are no longer trapped in capitalization-weighted indexes which overweight overvalued stocks and underweight undervalued stocks. Devotees of value investing who are searching for a simple, low-cost indexed portfolio in which to hold their stocks need wait no longer. Fundamentally weighted indexes are the next wave of investing.

The rest is history. Today, WisdomTree is the only publicly-traded company that focuses exclusively on ETFs and is the fifth largest ETF sponsor in the United States (page 3)  with assets under management (“AUM”) of approximately $34.9 billion..

The company offers 61 ETFs  in several different asset classes (e.g., equity, fixed income, currency, managed futures), both rules-based passive index investing and active-management discretionary investing. Performance is mixed, with 85% of the $34.9 billion invested and 56% (28 of 50) of the non-currency ETFs outperforming their comparable Morningstar average since inception. Of the top-ten ETF sponsors, WisdomTree had the second-highest organic growth rate in assets under management (AUM):  78.5%.

WisdomTree’s market opportunity is huge and the company has just started to scratch the surface. The company’s $35 billion in AUM constitutes only a 2.1% share of the US ETF marketplace and is growing four times faster than its AUM market share would indicate with an 8.0% share of new ETF fund inflows.

ETFs were first introduced 21 years ago in 1993 with the introduction of the SPDR S&P 500 ETF Trust (SPY). By the end of 2013, there were approximately 1,500 ETFs in the U.S. with AUM of $1.7 trillion – a number that has doubled in the past four years. Analysts project that the AUM of U.S.-based ETFs could double again to $3.5 trillion by 2017. Simply put, ETFs are the fastest-growing investment class in the history of finance. 

That said, barriers to entry into the ETF space are low. WisdomTree must compete against larger ETF competitors (page 5) such as BlackRock’s iShares, State Street, Vanguard, and PowerShares. In March 2012, WisdomTree obtained a patent for its dividend-weighting formula (page 15), which provides a small competitive advantage and compelled competitor Research Affiliates to withdraw its patent infringement lawsuit against WisdomTree.

In a January 2014 interview on CNBC, Steinberg noted that WisdomTree’s Japan Hedged Equity ETF (DXJ) attracted more cash flow inflows than any other ETF on the planet in 2013 except the SPDR S&P 500 ETF (SPY). So, that’s proof that WisdomTree knows how to develop and market a winner against the competition. On the negative side, DXJ accounts for a whopping 35% of WisdomTree’s entire AUM (page 17) and 70% of its entire net inflows (page 33). That’s pretty lopsided, which is a concern since a single ETF is unlikely to repeat such tremendous performance and it would be preferable to have other ETFs of equal size to pick up the slack when style preferences change (as they always do).

Still, WisdomTree’s growth and profitability are impressive, and its stock-price performance has seemingly unstoppable momentum:

WisdomTree’s Stock-Price Momentum

	WisdomTree (WETF)	BlackRock (BLK)	State Street (STT)
1-year Total Return	71.2%	30.4%	17.9%
3-year Total Return	194.5%	63.2%	55.2%
5-Year Total Return	2.334.4%	259.4%	175.2%
10-year Total Return	51.833.3%	529.5%	38.9%

 
WisdomTree’s Accelerating Growth

	Trailing Twelve Months (TTM)	2012	2011
Return on Invested Capital (ROIC)	59.4%	28.7%	11.0%
Earnings Per Share (EPS)	$0.29	$0.08	$0.02
Revenues	$130 million	$85 million	$65 million

 
The company has zero debt and insiders collectively own a substantial 20% ownership stake (page 31). The two biggest insider owners are Steinhardt with 13% and Steinberg with 4%.  I’m confident that Steinberg is fully motivated to do right by shareholders because he is both a founder CEO with a successful legacy to preserve (especially given his father’s ignoble end) and the owner of a sizeable stake in the company.

Valuation is not cheap at an EV-to-EBITDA ratio of 36.4 and a P/E ratio of 53 times trailing earnings. However, when you take into account that analysts expect WisdomTree to grow earnings at a five-year compounded annual rate of 59%, the PEG ratio is below 1.0 and the stock’s current valuation suddenly looks reasonable

WisdomTree Investments is a buy up to $19; I’m also adding the stock to my Momentum Portfolio.