value investing

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.

I’ve read too many investment books. They all emphasize the importance of thinking independently. They all say: “Here, I’ll teach you how to think independently. Then you'll be able to think independently like me. (Or like Warren Buffett!)” Only one book I know reveals what thinking independently might actually mean.

The 2008 bear market brought many value investors unstuck. Even Warren Buffett got his investments wrong.

Despite being born in the same decade as the rest of our analytical team, I’m known around the office as something of a cantankerous old bastard.

Harsh, I’d say. But if thinking that people should accept some responsibility for their own actions means you’re cantankerous, then I’m guilty. The solution to our financial predicament seems to be to rescue everyone who’s been spending more than they earn and living in houses they can’t afford, by printing as much money as we can and deflating the wealth of those who actually had the temerity to save (yes, that includes me). Apologies, but it riles me.

And it’s also causing me troubles from an investing perspective. As they attempt to save the world, central bank printing presses are running red hot. As well as degrading their currencies and balance sheets, I expect the logical outcome of all the hyperactivity will be inflation. It will return, and perhaps quite shockingly.

The stock market represents today’s expectations of what the future holds. Now that a recession is blatantly obvious to all and sundry, it’s time to start thinking about what the world will look like on the other side.

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