Qualiport

The Market Beating Test (Again)
Friday, 9 October 1998

And more on Independent Insurance

Along with each Qualiport report, we update the performance of our real money portfolio. Veteran Fools will notice that we've now changed the format of the numbers to hopefully give you a better feel for how the portfolio is progressing. You know that I feel uncomfortable using the Value Per Share method of accounting for this particular portfolio, so it has been relegated to the bottom of the page.

Because we didn't start out the Qualiport with a lump sum of cash, the hardest thing to judge is whether we are actually beating the market. Periodically I will show the following table, as I feel it is the closest we can get to knowing the real answer. Of course, there is no denying and hiding from the fact that the Qualiport has lost money. Its total value peaked at over £19,000 in July, whereas now it is hovering around the £14,000 mark. That's a 26% fall for us, practically in line with the fall in the market.

                        Buy     Now   Up/(Down)
 
Rentokil Initial       FTSE    5020    4823   -4%
Purchased 19/12/97     Shares   255     308   21%
    
EMAP                   FTSE    5922    4823  -19%
Purchased 17/04/98     Shares  1185     880  -26%
    
Marks & Spencer        FTSE    5969    4823  -19%
Purchased 11/05/98     Shares   554     439  -21%
    
Unilever               FTSE    6116    4823  -21%
Purchased 17/07/98     Shares   672     526  -22%

As to whether we're beating the market, we'll leave that up to each and every individual's own judgement.

Now, we'll move on with our search for great companies to join the Qualiport quartet.

On Wednesday, we introduced Fools to insurance companies, with a view to seeing whether Independent Insurance make the Qualiport grade.

Just to recap, I see good insurance companies as investment vehicles. They raise investment funds through their underwriting activities. This is a cheap form of loan finance. An insurance company that makes an underwriting profit is essentially raising its investment float for a negative cost. Think about that again -- this is better than getting investment money for free.

For normal companies, the cost of capital varies depending on its source. The cost of equity capital (from shareholders) is usually put at about 15%. As shareholders, we demand a premium return because of the added risk of investing in equities. Raising debt finance costs a company anywhere between 6% and 10% at current interest rates. Yet good insurance companies get their investment capital for free, or less.

You will note that we've highlighted the word good a couple of times in the above paragraphs. Many insurance companies make underwriting losses. They often chase business almost regardless of the premium versus risk/reward level. Whilst they are able to raise the overall level of their investment float, the chances are they will make underwriting losses, hence also raising the cost of that float.

Forgetting about the investment aspect of insurance companies, the actual core industry in which they operate is:

• highly competitive with razor thin profit margins.
• commodity product based.
• low on brand loyalty.
• not typified by predicable or consistent earnings.

Are these the types of qualities we usually look for in a Qualiport company? I think not.

Hurricane Cessy (introduced to readers in yesterday's Daily Fool) could come in and make a mess of underwriting profits in one pass. The April floods in Britain hit insurers hard. There are many more natural disasters lurking out there just waiting to happen. They will happen -- no-one knows where or when, except that sometime in the future something will happen to wipe out an insurer's profits in any given year or years.

Yet, even given all this, insurance companies are often misunderstood. The financial press and City will concentrate on the performance of their insurance underwriting almost to the complete exclusion of their investment performance. As we shall see, the majority of the gains insurance companies make over a period of time come from their investment portfolio.

Before we look closer at our chosen insurance company, it should be remembered that the main business of Berkshire Hathaway, chaired by Warren Buffett, is insurance. The skill that sets Buffett apart from almost every other investor is his ability to invest the float into great companies, whether they be quoted or not.

Independent Insurance

In every year from 1993 to 1997, Independent Insurance has made an underwriting profit. As we have seen, that means they are raising investment funds that cost less than zero. That is one of the reasons I was attracted to the company.

Anyone who has read through Warren Buffet's chairman letters, available at the external site www.berkshirehathaway.com, will have learnt a fair bit about the insurance industry. Buffett explains how GEICO, the fully owned low cost insurance subsidiary, doesn't chase volume just for the sake of it. GEICO refuses to get involved in insurance premium wars, preferring to keep its prices higher and live with the inevitable drop in business. Because the insurance industry is highly cyclical, Buffett knows it is only a matter of time before some of the low premium players are either forced out of the market because of long and sustained underwriting losses, or are forced to increase their premiums for the same reason. It's at these stages, when others are struggling, that GEICO's strength and patience comes to the fore.

The same theme comes flooding through the Independent Insurance annual and interim reports. Also, in an industry typified by lumpy earnings, up to 1997 they've reported eleven years of uninterrupted profit growth -- and the twelfth is virtually in the bag.

They differentiate themselves from their competitors in a number of ways:

• By writing insurance contracts with periods of 3 to 5 years. This allows them to retain business, offer price stability to policyholders whilst avoiding the annual tendering process, and gives some visibility to future earnings.

• By not competing directly against the direct insurers who concentrate on the motor and lower end of household insurance markets.

• By deliberately eschewing the pursuit of insurance premiums at the expense of profitability. This is done by quoting a premium commensurate with the risk, and not just a premium that enables them to get the business.

• By dealing with a select group of brokers, chosen only after passing exacting criteria.

• By increasingly looking to cover non-standard risks, where rates are firmer.

Next week, we'll look at the various ways to assess the value of a company like Independent Insurance. As we shall see, earnings per share (EPS) do not usually give you the full story. By the end of next week, I want to be able to have made a decision about the company's Qualiportness.

Have a great weekend, Fools. The message boards will be open all weekend for your questions, comments and queries.

Bruce Jackson (TMF Googly)

Qualiport Numbers

                     9/10/98 Close

                 Company   Change    Bid
                   EMA      0.39     8.80
                   MKS      0.05     4.39
                   RTO      0.06     3.08
                   ULVR     0.24     5.26

Qualiport Stocks

Last Rec'd  Total # Company  In At  Current  Change
 19/12/97   1565      RTO     2.55   3.08    20.8% 
 11/05/98    736      MKS     5.54   4.39   (20.7%)
 17/07/98    595      ULVR    6.72   5.26   (21.7%)
 17/04/98    337      EMA    11.85   8.80   (25.7%)


Last Rec'd  Total # Company  In At    Value    Change
 19/12/97   1565      RTO   4040.63  4820.20   779.57
 11/05/98    736      MKS   4052.24  3231.04  (821.20)
 17/07/98    595      ULVR  4048.38  3129.70  (918.68)
 17/04/98    337      EMA   4043.37  2965.60 (1077.77)


Cash:                                £67.82
Current Total :                  £14,214.36

Total Invested:                  £16,184.62
Profit/(Loss) :                  (£1,970.26)

Value Per Share

                  Day    Month    Year    History
Qualiport        2.93%  (5.68%)  14.97%   17.56% 
FTSE 100         2.65%  (4.76%)  (6.08%)  (3.92%)
FTSE All Shares  2.21%  (5.05%)  (7.65%)  (5.71%)

For an explanation of Value Per Share accounting, please click here.