Odyssey Re: The Truth Shall Set You Free

In my last post I highlighted the reasons why I own Odyssey Re, and also some of the risks in the investment.

Of the 5 risks I highlighted, one was relating to a dispute about some tax transactions in the past wrt to the Fairfax Financial parent company:

"Lawsuits: Fairfax made some transactions in Odyssey stock several years back to be able to consolidate ORH onto its balance sheet for tax purposes. I personally believe that when Fairfax management says that the IRS had approved of this transaction, then the discussion is over. But company critics and a few short sellers certainly have a different view. This may be a grey cloud that hangs over the company for a while until it blows over and is resolved."

An announcement tonight by Fairfax has put the issue to rest (finally). Unsurprisingly, Fairfax and Odyssey management did not break any rules, and adhered to the tax code. The IRS has completed the review of those tax years and has closed the books.

"No changes were made to the above-mentioned consolidated 2003 and 2004 tax returns with respect to that purchase of shares and issuance of exchangeable debentures or the inclusion of Odyssey Re..."

The fact that only days ago Fairfax critics were putting out harassing and misleading PR announcements stating that Fairfax and Odyssey should come clean about the tax issue is just that much funnier.

Since my post in May, Odyssey shares have appreciated slightly while the market has tanked. I believe this announcement only further clears the air about ORH and FFH as solid investment candidates with great management.

Fairfax fought the good fight on this issue. When it was first raised they said that the issue was reviewed by the tax authorities and was signed off. They then were silent as their many critics bantered about the issue ad nauseum. While some may have preferred Fairfax and Odyssey be more vocal in their defense, to me the critics were so out of line with so little actual facts behind their argument that I'm glad they were never ackknowledged and given legitimacy.

Fairfax and Odyssey are now at a point in their businesses where they can let the results speak for themselves... and that is just what they are doing.

Ben

Long ORH and FFH

The Stock I Like Best: Odyssey Re Holdings (NYSE: ORH)

Don't look away, it's a financial:

The insurance industry isn’t exactly viewed as a panacea for the investment woes inflicted on many of us over the past several months. While not as lowly as banking or retail, the insurance industry has certinaly seen its share of pain recently. The most notable problems are due to very soft pricing industry wide, and write downs of all sorts of products from Asset Backed bonds, CDS contracts, and other acronym-filled toxic waste that need no introductions in this format. Both of these problems are well captured by mighty AIG’s most recent results and consequent $20B recapitalization plan.

So what goes down, must come up, is that the thesis here?:

Not quite. For one, Odyssey stock isn’t really down. It’s survived the downturn fairly well in fact and depending on your measurement dates, the stock has actually been up. No the thesis for Odyssey, is based on something much more intuitive in my mind:

• It’s cheap
• It has great management that avoids doing dumb things

That’s pretty much the thesis. I could stop, but some elaboration may be in order.

Business overview:

Odyssey Re is an insurance company. For the 12 months ending Dec 31st, roughly two thirds of Odyssey’s gross premiums came from Reinsurance, and the balance came from standard insurance. From a geographical perspective, the premium breakdown between geographies is: ~60% Americas, 25% EuroAsia, and 15% London.

As of the latest 10-Q, the balance sheet looked like this (also see transcript link):
Total Equity of $2.81B
Total Assets of $9.80B
Total Unpaid losses and loss adjustment expenses of $5.14B (we’ll use this to approximate insurance ‘float’)
Total Investments and Cash of $8.11B

*Investment account breakdown

• $4.26B in fixed income securities
• $1.05B in Stocks and Investments at Equity securities ($61.9M in Fairfax Asia)
• $1.30B in Short term investments
• $1.05B in Cash
• $0.45 in ‘other’ ($0.24B of Credit Default Swaps)
  

The fixed income securities are >92% in AAA rated issues (and before you ask…); there are no ABS bonds, no CDOs, and only $180M worth of Municipals. For the equity investments, of the investments that are publically traded equities, the company has a ~100% hedge via shorts and a total return swap on the S&P500. So you ‘could’ describe this portfolio as conservative if you wanted to make an understatement.

Odyssey Re’s investment portfolio is run by Hamblin Watsa (HWIC) which is a Fairfax Financial (NYSE: FFH) subsidiary. HWIC has a >20yr history of providing dominate absolute returns on both stock and bond investments. Over the past 15 years, equities run by HWIC have returned >15% net of hedges and bonds have exceeded >9%. Odyssey Re, by virtue of being a public subsidiary of Fairfax (>60% owned) has access to the HWIC team for the low price of 0.2-0.3% (depending on performance).

The proof is in the pudding:

I highlighted above the Fairfax Financial connection that Odyssey Re has. In 2001, Fairfax was hurting for cash and was forced to spin out ORH in an IPO to raise funds for the holding company. Odyssey Re has been public ever since. The managers of ORH are distinct from the Fairfax parent, but the companies are indeed closely linked. The question is; do the managers have skill? Since the IPO year end (2001), until the most recent quarter Odyssey Re has compounded book value by >17% annually. Amazingly, this was done without taking gigantic risks and maintaining a very cautious investment portfolio. It was also during a time when there were multiple devastating hurricanes/floods in the US and several natural disasters around the world.

Skill or luck?:

In the last few years, while other insurers and banks were fumbling around and selling default insurance on various bonds and businesses to make a tiny extra return, Odyssey Re was quietly buying a portfolio of CDS on companies like Countrywide, Washington Mutual, and other perceived ‘strong’ financial institutions. From 2005 to the beginning of 2007 this was a losing strategy for Odyssey as the risks in these institutions were not seen or perceived by anyone. However, as we all know, 2007 ended with quite a bang for financials and 2008 has been a wild ride (mostly down) so far. Consequently, the CDS wager that Odyssey had been losing money on for a few years has paid itself back several times over in the last 12 months which has helped to grow equity per share by 40%.


Interestingly enough, while the insurance industry is expected to write down upwards of $200B in Asset Backed and related paper (which would rival the largest insurance disasters in history in dollar terms) Odyssey will write down approximately $0.00. At the same time through their CDS investments, they will profit from the pain of others. And in the end, Odyssey will be flush with cash right when their competitors are hurting the most; an envious place to be. This positioning is beginning to show its strength as Odyssey has made some joint investments recently in distressed debt; most notably their $100M investment in Abitibi-Bowater 8% convertible bonds. As the recession begins to unfold, there should be more interesting things that HWIC decides to buy.

That's great, but is it cheap?:

Above, I tried to capture some softer points about why Odyssey Re is a good company, and a brief industry macro view, but value investors know “Price is what you pay, value is what you get.” So is this a value?

• At the current quote of $37 and change, Odyssey Re trades at roughly a 10% discount to stated book.
• You can sleep well at night knowing that in the next earnings report you won’t find out that company put all their ‘cash’ in a CPDO/ABS toxic waste money market fund that is locked up and devalued by 10%. There are no skeletons in this closet.
• The current investment portfolio of $8.11B comes to about $120/share… which if you assume a 6% return and 35% tax rate, would place normalized earnings at >$4.50/share assuming that the insurance side of the business makes enough underwriting profit to pay interest on the company's small debt load.
• Recently, the management (who have been shown to be shrewd allocators of capital) has been repurchasing shares at a fast clip in the $35’s and $36’s. In the first quarter, the company repurchased 3% of the outstanding shares, and just since March 31st to the quarterly call, the company repurchased 1.1 million shares.
• The debt to capital ratio is only 15%, so the buybacks are not sacrificing the balance sheet in any meaningful way.
• Average diluted EPS (GAAP) over the past 5 years has been >$4.00/share (this includes the Rita/Katrina disaster years).
• Odyssey Re has a 26% stake in ‘Fairfax Asia’ on the balance sheet listed at $61M. Fairfax Asia is a private subsidiary that owns a 24% stake in ICICI Lombard, a large Indian insurance company. Pricing of the ICICI parent company IPO last year would imply a valuation of the 24% stake in Lombard at >$800M, which would put Odyssey Re’s stake at a value of >$200M (likely more as Lombard is growing like a weed), so this would increase book value by 5% if accounted at market prices.

So what I think you have here is an interesting company. It’s a very conservative organization that’s well capitalized, they don't reach for yield, and they are heavily hedged against a recession and general economic weakness. On top of that, the stock is trading for likely <80-85%> of book value.

So is this risk free?:

As with all investments, there are risks here to be aware of.

• Soft insurance market: Odyssey Re, Warren Buffett, and other insurance veterans are noting that a soft market is well under way in all areas of insurance. As Odyssey Re has a total return philosophy to insurance, they don’t write business for market share, and they are letting their premiums scale back where pricing is unacceptable. This will continue to have a negative effect on the stock as revenues decline; until it doesn’t anymore. Insurance companies’ earnings are cyclical, and no one knows when the next hard pricing market will come; but it will.
• Hurricanes / Earthquakes / Etc: Odyssey has “Re” in its name. Reinsurers generally have the most volatile earnings in the insurance sector (in exchange for the average highest ROE). Odyssey is no exception. As disasters strike Odyssey will lose money. This isn’t the kind of company you try to predict the next 5 quarters’ earnings with any particular accuracy; it’s not likely possible given the vagaries of Mother Nature.
• Lawsuits: Fairfax made some transactions in Odyssey stock several years back to be able to consolidate ORH onto its balance sheet for tax purposes. I personally believe that when Fairfax management says that the IRS had approved of this transaction, then the discussion is over. But company critics and a few short sellers certainly have a different view. This may be a grey cloud that hangs over the company for a while until it blows over and is resolved.
• Lack of shareholder control: Odyssey has about 68M shares outstanding as of now. Fairfax controls 42.4M of those shares (or >62%). Now, I’d argue that Fairfax has been a fair steward of capital for both private and public subsidiaries. For example, whenever Fairfax makes a sweet investment deal, Odyssey gets cut in on a piece of the action as well (the Abitibi Bowater convertibles are case in point), but lack of any control by public shareholders will likely keep a stigma on the stock until people begin to fully trust management at Odyssey and Fairfax.
• CDS volatility: While Odyssey has made a lot of money on their CDS positions in the past 12 months, these investments continue to be very volatile. Tens of millions of dollars can appear or disappear each day on these positions and the future value is highly uncertain. Odyssey Re and HWIC have proven adept so far at managing investments and a portion of the thesis in Odyssey Re is certainly a continued belief in HWIC investing prowess.

Summary:

So what you have here is a solidly run insurance company, trading at a low (but admittedly not crazy cheap) price. They have made steps in the past and successfully avoided the problems others have stepped into (namely real estate and financial woes). On top of that, they not only avoided but profited from the follies of others in their sector. Now as losses begin to pile up, you have a company that is well positioned; flush with cash, buying back its stock as fast as possible, trading for less than a reasonable estimate of book value, that will probably grow book by >15% annually over the next 10 years. It is certainly a company that is at least worth a look in my opinion.

Disclaimer: At the time of this writing Ben Hacker and his clients had positions in ORH and FFH but no other investments discussed in this article.

US Fixed Income: (In)Efficient Market?

I certainly wouldn't consider myself an 'income' investor per se; I'm an equity or cash guy in most circumstances. However, I do own insurance companies that have large bond portfolios, and the general market does take some cues from the fixed income markets so in my opinion it is always good to pay attention to what is going on in the general credit markets.

Recent market action in the MBS, ABS, CDO, and SIV markets have received much coverage for good reason. The TED spread (difference between LIBOR and Fed Funds) is even getting some mainstream attention these days for its historically large deviation from the mean. However, just recently I was doing some (very frustrating) research on the bond insurers and I stumbled upon something absolutely bizarre to my eyes. (Click here for the Bloomberg interest rate summary)

It turns out that the current rates for 30yr AAA (insured) rated Municipal Revenue Bonds are ~4.50%. (Note that these Muni bonds are federally tax exempt for US taxpayers.)

At the same time, you can see that 30yr US Treasury Bonds have a YTM of <4.3%.

Now I have to admit that I am most certainly not a municipal bond market expert or even watcher (usually), but when Muni's yield more on a nominal basis than their maturity matched UST, I just can't help but thinking there is an inefficiency or pair trade that is waiting to be exploited.

At 4.5%, the taxable equivalent municipal yield (for a 35% marginal payer) is 6.9%.

While there is certainly some finite amount of extra default risk that you take on when purchasing a AAA insured Muni vs. a US Agency Bond, I believe is is immaterial. Over the last 30 years, there have been zero AAA rate muni bond defaults (even AA and A have been zero). The bigger risk here, and in my opinion this is what the market is freaking out about, is that there is a tremendous amount of liquidity risk with Munis. And as we all know right now, the market is valuing liquidity above all else. In fact, in the limited data I've been able to dig up, it appears that it has not been unprecedented to see Muni yields surpass treasuries in times of stress.... although historically the mean ratio is ~0.9 (Muni/UST); which would make sense given that the marginal pricing for Munis is probably set by tax paying investors. (In fact, I would have guessed that the ratio would be even lower...)

As an investor (or speculator) attempting to profit from this, it seems to be pretty straight forward: You can go long any number of leveraged or unlevered Muni-Bond CEFs and simultaneously short an equivalent of UST (maturity matched) bonds or funds.

An example of one simple way to approach this would be the following pair trade:

1) Long MLN (a new National Muni Bond ETF from Van Eck - Fact Sheet)
Duration is 10yr, Maturity is 25yr, 90+% A rated or better, Weighted Average Yield - 4.7%
2) Short TLT (iShares 20+ Gov Bond fund - Fact Sheet)
Duration is 14yr, Maturity is 25yr, 100% Agency, Weighted Average Yield - 4.35%

A Tax paying investor would capture the spread (net of fees and factoring in expense ratios) between the two funds. The cost to pay the TLT interest would be tax deductible and the interest received on the MLN position would be federally tax free.

In addition assuming the spread narrows, there could be a good chance to pick up some capital gains here.

Overall, this smacks a bit of the Long Term Capital Management strategy of picking up nickles in front of the liquidity bulldozer, but the intellectual in me thinks that it would probably be a good trade for a small position of the portfolio, assuming you can keep fees in check and ignore any mark-to-market losses for several months at least.

I have no plans to deploy this trade at this time, but that may change in the future.

Ben

Disclosures - None