QBE

I spent Saturday night in the Blue Mountains, about an hour west of Sydney. Unlike the sensible people on this cold, wet, foggy night, I wasn’t perched next to a fire with a good book. I was in a trail running race, the 20km Narrowneck Night Run.

Last year, the sunset views from the Narrowneck ridge were spectacular. This year you couldn’t see 10 metres in front of you. About 14km in it was pitch black and my headlamp worked like the high-beam lights on your car; in the fog I couldn’t see a metre in front of me.

It’s a strangely conducive environment for thinking. The field of runners spreads out until you can’t see any headlamps in front of you and can’t hear anyone behind. There’s the sound of your own feet, instinct alone landing them securely on the gravel, sight unseen. The only other sounds were some light drizzle and heavier breathing. So I start thinking about What We’re Missing on QBE.

And it strikes me that it was a bit of a silly post. The QBE argument is not about the numbers. It’s about management, faith in management and the current loss of faith in management. All of a sudden, I could see myself sitting on the other side of the argument.

For the most part, serial acquirers end up blowing up. From Centro, Allco and Babcock and Brown to ABC Learning and Transpacific, we’ve done a great job identifying them and giving them a wide berth. Where we’ve bent the rules, we’ve usually come off second best. Look no further than Photon Group.

Why is QBE any different? If we’d long been skeptical of this company and its hundreds of acquisitions, would we view the current profit woes as a buying opportunity? Or would we see it as evidence of the acquisition-binge coming unstuck? Perhaps the later, would be my guess, had we started on the opposite side of the fence.

There’s no guarantee that QBE’s woes this year are all catastrophe related. That’s what they tell us, of course, but it’s been the perfect year to brush all sorts of problems under the carpet. The line between catastrophe claims and ‘normal’ insurance claims is not a clear one.

Instead of one bad year, as we’ve been assuming, perhaps QBE’s underwriting standards have deteriorated, its latest acquisitions are duds and shareholders are going to wear the consequences for years to come. Management hubris could well exacerbate the problem.

How do we tell if this is indeed the case? The crucial test for me is how QBE’s competitors’ results compare. As they report over the next month or so, I’ll be lining them up against QBE. If this really has been the year from hell for global insurance companies, they should all be suffering equally. As one of the world’s best (that’s our thesis at least), QBE’s combined operating ratio of 96 should still be better than its peers. If it’s not, we’ve got a lot more thinking to do.

All of a sudden lights, voices and the smell of a barbeque appeared out of the fog blanket in front of me. I crossed the line 10^th 11^th in 96 minutes. Not bad. Running definitely helps my thinking; perhaps thinking helps my running as well?

You know what worries me most about QBE? Floods? Storms? Earthquakes? Global warming? Interest rates?

No; none of the above. They are all part and parcel of owning an insurance business. What worries me is that the case for buying the stock is so simple you can work it out on the back of an envelope.

Net earned premium                          $16bn
Insurance margin                              15%
Insurance profit                                 $2.4bn

That’s a pre-tax return of 19% on the current market cap. And it attributes no value to the $7bn odd of net shareholder equity. If you assume zero interest rates – no investment income whatsoever – you’d still make 14% pre-tax.

Insurance is a volatile business but, as I said in the September Quarterly Report, there are plenty of good reasons to think the average profitability will be higher, not lower, than the numbers estimated above.

Here’s what Standard and Poor’s had to say about yesterday’s downgrade:

QBE announced today that exposure to a number of catastrophes during the second half of 2011 and the adverse impact from challenging investments markets will weaken its insurance margin to 7.0%-7.5% for 2011, compared with its expectation disclosed in August 2011 of 11%. As a result, its profit after tax for 2011 will be 40%-50% lower than the prior year. Standard & Poor's believes the strength of QBE's diverse business and financial profile allows its rating to withstand some negative cyclicality in its underwriting performance such as what has occurred in 2011. Nevertheless, the rating may come under pressure should there be an indication of a structural decline in earnings or sustained underperformance against peers.

We note that QBE expects to make an underwriting profit in 2011 in what has been a record year for natural weather events globally and that premiums for many of its product lines are increasing. While regulatory capital adequacy has softened since June 2011, the company's decision to materially cut its dividend should assist in maintaining a minimum capital ratio requirement above the 1.5x minimum target set by the company.

We agree with Standard and Poor’s. Now that is something to worry about. Can someone give me a hand, what are we missing here?

Update: See Narrowneck and Clear Head on QBE for some weekend clarity.

The All Ords index might be up 35% from its low on 6 March 2009, but the opportunities today are as good as they were then.

Firstly, there is substantially more redundancy in the system due to the market recapitalisation of 2009 and 2010. Thanks to $42bn of capital raised in 2008, $67bn in 2009 and conservative dividend payout ratios, the amount of debt carried by our listed companies is significantly more manageable.

Comparing today’s balance sheets for non-bank stocks in the ASX 200 with those of December 2008, the ratio of total debt to total equity has fallen from 82% to 50%. The property trust (or REIT) sector is back to its conservative roots. GPT, for example, carried a debt-to-equity ratio of 87% at the end of 2008. Today it is still a touch too high, but 37% is much more manageable.

Substantially lower debt levels mean most businesses now have the wherewithal to cope with a very serious recession.

Unloved cyclicals have performed spectacularly in this three month rally. There's a good case for shifting back to safety.

Occasional contributor to The Intelligent Investor Tony Scenna once remarked ‘if you’re going to panic, panic early’. With the market down 21% from its peak in November last year, now isn’t the time to be switching to cash.