Timing the cycle

In “IPO hang-over” I argued one of the reasons for the very poor long term performance of initial public offerings (IPOs) is timing – the sellers usually look to maximise their proceeds by selling at the best possible moment in the economic or stock market cycle. Let’s have a look at a live example: Brit Plc1.

Brit is a non-life insurance company specialising in property, casualty and catastrophe insurance lines. This means they underwrite big risks where the probability of paying out claims is low but the financial impact if claims do materialise can be very high. These business models follow their own rather unique business cycle, which usually goes something like this:

– A significant loss event such as an earthquake or hurricane occurs, causing large losses and depletion of capital bases across the insurance industry.

– The lower capital bases mean less competition. Insurance prices start to rise.

– As prices rise, profits and returns start to recover.

– Capital is attracted back to the industry by the higher returns on offer.

– This causes prices to fall again, putting downward pressure on returns.

– Another significant loss event occurs and the cycle starts all over again.

History suggests the valuation the stock market places on non-life insurance companies also follows a cycle. Sometimes, when the market is feeling particularly negative about prospects for the industry, it can value these companies’ shares close to or even on a discount to their invested equity capital base, which implies an expectation of lower future returns. On other occasions, the valuation on offer is at a premium to the equity capital base, suggesting an expectation of sustained high or rising returns. Clearly, as a potential investor, I much prefer to buy the shares on a valuation discount to the invested equity capital. From this low starting level my expected future return should be much higher than if I buy at a premium.

So where are we now in the insurance cycle? Although there have been some notable natural disasters in recent years (floods in the UK, Fukushima etc), none of these have caused significant insured losses. Indeed we have to go all the way back to hurricane Katrina in 2005 for last time the industry really suffered a big loss year. Since then conditions have actually been remarkably benign, allowing most companies to earn decent returns. However, as expected, more and more capital has been attracted into the industry putting downward pressure on prices in some lines, which doesn’t bode especially well for future profitability.

The chart below shows the stock market valuation of the non-life insurance industry over the past 10 years, using the ratio of price to invested equity capital as the valuation metric. A ratio of greater than 1.0x indicates a premium, less than 1.0x a discount. Note that the valuation is almost back to the peak level of 2006. However, back in 2006 the industry had just experienced an enormous loss year following hurricane Katrina. As a result the industry’s equity capital base had been severely reduced while prices and returns were expected to recover strongly hence the premium valuation at that time is not that surprising. The same is certainly not true today.

UK non-life insurance valuation, 280314

Which brings me back to Brit plc. The company was purchased by private equity in 2010 (at 1.0x invested equity capital) at what we can now see was close to the bottom of the valuation cycle. The mooted valuation for the IPO today is around 1.5x invested equity capital – a full 50% higher than the purchase price. Although there is some evidence that the private equity owners have restructured and improved the operational profitability of the business, it is clear that a major source of value creation here is a simple valuation arbitrage of being able to IPO at a much higher valuation than the original purchase price valuation.

In my view, this is an excellent example of how private market investors (in this case a private equity company) can use the public stock market cycle to maximise value for themselves. As a public market investor, I am mindful of the implications of this. If an IPO represents good value for the seller then it is quite likely to represent poor value for me.

Matthew Tillett


1. This is no recommendation to buy or sell any particular security.


Author - Matthew Tillett

Matthew Tillett

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