Law of Large Nos. (for Ads)

Auto insurance industry competition is intense, but that's not new. Because auto insurance is a commodity product, media spending has always been important. But, this graph depicts the dramatic increase in spending, causing me to ask myself, "what has changed so much since 2003?" My only guess is the Internet.

BRK reports that while its GEICO policies issued have risen from 5.7 million in 2003 to 8.1 million in 2006 for a 42% increase, the media spend at GEICO has risen from $238 million to $631 million during the same period. The current media spend at GEICO is now nearly $80 per policy. GEICO wouldn't spend the money unless it was effective. So, who's the loser? Here again I have only one guess: insurance agents. Just as travel agents have seen dramatic changes due to the Internet, so too, it appears that the personal auto insurance industry is being rapidly reshaped.

A Fee-ding Feast

The daily barrage of information about the latest private equity purchase of a public company has me asking, "what's the point?" So far I have gathered that the private equity funds are freeing the public companies of short-term thinking and the constraints of Sarbanes-Oxley. If this were truly the case, I would imagine that such companies would be purchased with large pools of money, such as insurance company balance sheets or pension plans. However, they are generally purchased by pools of money created by aggressive investors who have heavily leveraged these assets in order to purchase these companies. Such leverage incents the short-term thinking that such a structure is supposed to avert. Even more striking, the only way to ultimately pay off such debt is to take the companies public once more.

In reviewing the purchases of Berkshire Hathaway (BRK), I have noticed that BRK's purchases of private companies into this public company are motivated by giving the owners of these successful private companies a long-term home and their families an estate planning solution. Clear enough. In addition, BRK's purchase of GEICO and public utility companies are motivated by BRK's ability to supply large amounts of capital for capital intensive plans. Finally, BRK's purchase of publicly traded stocks are based on price and business model. Never does the management of BRK imply that its management can add value. For this reason, BRK's annual report always states, when looking for acquisitions, "future projections are of no interest to us nor are turnaround situations." If BRK cannot add value to these situations, either publicly or privately, what is the idea of these private equity purchasers?

As far as I can tell, the object is to create a higher return by the aggressive use of leverage while paying extraordinary fees to do so. Unless these purchases are being made at extraordinarily cheap prices, such a process seems doomed to failure. As I shared with a friend of mine, "It's hard to borrow yourself out of debt," but these private equity managers will fee-ed themselves first and leave the leftovers behind. Caveat investor.

Allstate is All-star

In an earlier post (3/20/06), I commented that the "good hands" people at Allstate (ALL) seem to be in Good Hands themselves. ALL's good fortune continues as illustrated by the following graph:

The graph illustrates that an investment in ALL would have produced results superior to the property and casualty insurance industry and the market overall no matter when the investment was made. This is a stunning result. While certain years produced better results than others, the ability to achieve superior returns through an investment in ALL was not dependent on picking the right year.

It appears that ALL's results were due to three factors. First, ALL has a generally low expected return because its enormous market share means slow growth. This low expected return shows up by its average valuation being 60% of the stock market's metrics. Second, ALL has not squandered its returns by reinvesting in "growth opportunities." Instead, ALL has returned 68% of its earnings to shareholders over the last ten years. Third, ALL has not followed Wall Street's siren call to compete aggressively. ALL has focused on profitability by discontinuing new homeowners coverage in California, Connecticut, Delaware, Florida, New Jersey and eight coastal counties in New York.

Of course, one payoff for ALL's unwillingness to lose shareholder money is consumer and political outcry. But ALL's discipline actually contributes to a more sensible assessment of risk in catastrophe-prone zones.

Aircraft Leasing

Despite my affection for aircraft, I have always viewed the aircraft leasing business apprehensively. As a long-term holder of AIG, I had preferred that the aircraft leasing division (named International Leasing Finance Corporation or ILFC) was not part of the package (as well as the derivative trading division). However, today's NYT article changed my mind.

Steve Udvar-Hazy runs ILFC and, as the article showed, has always run it. In my analysis of AIG, I had believed Mr. Hazy to simply be another "corporate guy" who had climbed the long ladder of corporateness to success. Was I ever wrong. He is a billionaire who created the industry entrepreneurially and still dominates it.

The aircraft leasing industry, as the article states, "leases airplanes for the same reason that cash-short consumers lease cars - they can get new models for lower payments." Aircraft leasing works particularly well because the fuselage of an aircraft has significant longevity. Mr. Hazy's early love for aircraft helped him understand the relatively strong residual values of an airplane. As a car-man friend of mine said about car finance, "the car's got to outrun the note."

Mr. Hazy exploited this structure, turning $150,000 in 1973 into a multi-billion dollar business for himself, two partners and AIG. IFLC has 824 Boeing and Airbus aircraft with another 254 on order. IFLC has 35% more aircraft than American and more than Air France, Lufthansa and British Airways together.

The aircraft leasing model is used extensively for airlines who prefer the latest models and can precisely estimate its costs. But the following graph shows an interesting issue - an almost complete lack of participation by U.S. airline companies:



If there are any "cash-short consumers," it would seem to be U.S. airline companies. Their underrepresentation at ILFC would appear to be the result of two factors: cheaper money elsewhere and little concern that ILFC's deep pockets will be needed later. Mr. Hazy expressed some frustration at their unwillingness to buy ILFC's tougher terms, commenting that U.S. airlines "act almost like superior beings." Nevertheless, Mr. Hazy has been disciplined and not loosened ILFC's terms. The shareholders of AIG have a real gem in Mr. Hazy and ILFC.

It's a Mad, Mad World

Graphs like this one "melt it down" (to use some Marvinology) for me. As I read about U.S. companies piling investments into a communist country in which property rights are unclear, where fraud is rampant and where using the word "democracy" can land one in jail, I am baffled. Yet this graph shows why China is compelling. U.S. wages are 30X higher, not including benefit structures, meaning a company can either hire a U.S. worker for an hour or a Chinese worker for one week.

In addition, the Chinese worker saves half of his salary, effectively lending it to the U.S. Little wonder the U.S. Government has difficulty putting pressure on Chinese practices. Is it only me who senses something very wrong that the individuals making the most money are, in essence, borrowing from the people who make the very least?

Moody's World

The recent expansion of debt may be good or bad, depending on your point of view. For Moody's (MCO), the expansion has been highly profitable as their traditional business has been rating issues. However, their non-traditional business of structured finance has also profited from and heavily contributed to the expansion of debt.

Structured finance is the "largest, least understood area in finance" according to Brian Clarkson, Co-COO of Structured Finance and Public Finance for Moody's. Originated in 1984, structured finance now makes up over 52% of their ratings business. Extrapolating growth rates out, MCO will basically be in the structured finance ratings business. So, what is causing such extraordinary growth?

When MCO begin work in structured finance, "securitization" (which is the essential work of structured finance) was described as "the transfer and pooling of cash flows and assets to remove operating risks of the originator from (or by means of) issued securities." In this way, securitization allowed for "originators," such as banks to remove operating risks, such as credit cards, so that they would not be clawed into bankruptcy by retention of concentrated risk. So far, so good; banks could diversify their risk.

By the mid-90s, the description of "securitzation" has evolved to "the pooling of current or potential cash flows which may or may not be transferred and may or may not remove operating risks of the originator from issued securities." Securitization began to allow for the monetization of such assets as film or music royalties. At this level, exposure to certain types or risks and/or cash flows could be calibrated.

Currently, Moody's describes "securitization" as "an ever-changing set of financial techniques, engineering or modeling using by market participants to achieve a specified goal." In the same way that paper money ultimately became the means to transact between widely differing products over differing periods of time, so too has "securitization" produced securities which are tailored to the needs of the investor, the lender and the borrower.

Look at the growth rates of collateralized debt obligations (CDO) done by MCO alone:

MCO is not only profiting from the advances in financial technology and debt demand, but is creating growth by "blessing" these complex structures. Apparently, MCO does not have any real "skin in the game" as MCO has no actual financial investment in these structures.Questions do remain about the level of MCO's responsibility: is it as a journalist or as an auditor?

Debt Still A Four Letter Word

Despite the growing belief (and widespread evidence of proof) that we may borrow our way into heaven, McGraw-Hill Publishing (MHP) still retains its debt-free status. MHP is a powerhouse company with three divisions: the financial services of Standard and Poor's (S&P), the educational division and the information/media section owning Businessweek. MHP's financial metrics are superb.

MHP's debt-free status is especially noteworthy, as MHP has a steady stream of income and thus is highly "leverageable." Further, MHP arguably employs the best and the brightest analytical minds in its S&P business who could capably access this leverage. After all, MHP rates over 90% of U.S debt issued. (Most debt issues require two rating agencies, so MHP and Moody's generally get the nod.)

Interestingly, while Wall Street cries for higher leverage and employs S&P analysts to ascertain and bless these "optimal" capital structures, these same analysts are employed by a company that remains steadfastly debt-free. When it comes to employing debt, it may be good to remember the country music lyrics, "all that glitters may not be gold."