Scales of justice

Is Lancashire Holdings really cheap?

Scales of justiceFull disclosure: early in January 2015, I purchased shares in Lancashire Holdings Limited (LON:LRE).

At the time they were trading at around 550p and seemed very cheap. Two months plus a 20% gain later, I’m not so sure. To be honest, I’m not sure my reasons for the purchase — into a value portfolio — stack up all that well.

Obviously I’m not complaining — a 20% return in two months is not to be sneezed at — but I am thinking about selling.

I try to continuously evaluate my investments with an open mind, as I believe that from fixed viewpoints cometh many losses… In this article, I’ve tried to explain the thought processes that led me to buy, and now consider selling, Lancashire Holdings.

1. Cheap valuation?

Lancashire’s shares nose-dived at the end of November, after two founder non-executive directors left the board, just a few months after the firm’s founder, Richard Brindle, also left the firm.

Such departures are often a sign of bad news, but so far there hasn’t really been any, making the short spell the shares spent between 500p and 550p look like a good buying opportunity for income seekers.

That’s when I bought in, tempted by a 2014 forecast P/E of less than 8 and a near-10% dividend yield.

I was also reassured by the firm’s low valuation relative to its history of strong earnings: although specialist insurers like Lancashire inevitably have good and bad years, the firm’s 10-year average earnings of 73p per share gave a PE10 of 7.6 at my 552p purchase price, and of 9.1 at the current price of around 665p.

Lancashire’s other metrics also seemed impressive. Since 2009, the firm’s combined ratio has ranged between 45% and 70%, which seems outstandingly low compared to mainstream insurers, which generally seem to operate with a combined ratio above 90%. Return on equity was good, averaging 18.8% between 2009 and 2014.

Finally, shareholder returns were clearly a priority, so I was happy to buy in to what looked like a cheap and very profitable firm, even though it wasn’t trading below book value. (I’ve previously used book value successfully for insurers, buying into Aviva and Friends Life Group when they traded below book value — both subsequently enjoyed a strong re-rating).

2. Maybe it’s always this cheap?

So far, so good. But as Lancashire’s share price rapidly re-rated over the last two months, I started to wonder where this would lead — how would I judge when the shares were fully valued?

As the portfolio containing the shares is value only, not income, then holding for the dividends, regardless of valuation, wasn’t an option.

Here’s how Lancashire’s current 2015 forecast P/E compares to some of its peers:

  • Lancashire: 2015 P/E 10.7
  • Amlin: 2015 P/E 12.1
  • Hiscox: 2015 P/E 14.5
  • Catlin: 2015 P/E 12.3

On this basis, Lancashire still looks a little cheaper than average, although not by a huge margin.

However, another consideration is the historical norm: some companies always trade on low multiples, for various reasons.

A look back at the figures suggests Lancashire could be such a company. For this list, I’ve calculated an approximate trailing P/E for the shares using the share price in March after the listed year’s results would have been published (e.g. share price in March 2014 following publication of 2013 results):

  • 2010 P/E: 5.0
  • 2011 P/E: 9.7
  • 2012 P/E: 10.7
  • 2013 P/E: 9.5
  • 2014 P/E: 8.6

It’s very approximate, but this list suggests to me that today’s forecast P/E of 10.7 is about right. Lancashire has not tended to trade much above this, relative to actual earnings.

3. I don’t understand it

My last point above brings me onto the final reason I am considering selling my shares in Lancashire Holdings: it may be a great business (I believe it is), but I don’t really understand it very well.

Conditions are said to be soft in the specialist and reinsurance sectors at the moment, due to an influx of new capital seeking higher returns. Lancashire is showing discipline and maintaining solid profit margins, but it’s also benefited from a period of low claims. I don’t really understand how things will pan out, over the next year or two.

Ultimately, I don’t think Lancashire currently fits my criteria for a value investment: a company that is trading at a low valuation relative to its likely earning potential or book value, offering the opportunity for a re-rating.

Given this, I am probably going to sell mine over the next few day, although I believe Lancashire shares could make an excellent long-term income stock.

Disclosure: This article is provided for information only and is not intended as investment advice. At the time of publication, the author owned shares in Lancashire Holdings Limited and Aviva. Do your own research or seek qualified professional advice before making any trading decisions.

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