Unico American Corp. (UNAM) Investment Thesis – $9.12
Note – This idea is not relevant for larger funds as UNAM is a relatively illiquid microcap – yet patient, smaller funds and/or those who decide to buy it in their personal account shouldn’t have too much trouble building a decent size position (we didn’t).
The quote below was taken from the notes of Joel Greenblatt’s special situation value investing class at Colombia in September 2006 , where guest lecturer Richard Pzena discusses some of his thoughts on investing…
“What we try to do in this spectrum is find great franchises at statistically cheap prices. Unfortunately, they don’t overlap very often. Typically, they only overlap when there is some question as to whether they really are good businesses. Usually when there is something wrong. The patterns that these companies evidence over time. You have a company whose earnings are chugging along doing just find and then you have a break and earnings fall. The stock market can react negatively, sometimes precipitously. But the problems may not be permanent problems.
Identifying these companies is easy but making a judgment (are they really good businesses and temporary not permanent) is difficult. Are they really good businesses and are the problems really temporary. And should the earnings rebound to that historic trend line? That’s the hard part, but if you want to get the best of both worlds, pretty much the only opportunity you have to do this is when something ugly happens. So that is what I like to do.
I like to do it because you have two ways to win in your investment. One is this—if you buy something at a low price, and you can debate whether book value is meaningful, earnings or cash flow or sales—but you buy low price relative to its size or earnings capability is, you win in the long run. You have opportunity to have exposure to that.
You also have exposure to earnings growth, which can be really rapid if the company succeeds at restoring its earnings power back to its historic metrics. And you avoid buying companies that have that pattern—no break but a low apparent P/E (valuation) but earnings are above historical norms. There is enough compelling evidence to suggest that historical trends are meaningful. And I will share some of that data with you. This is fairly dangerous to buy companies when they look good.
If you can pull this off — to get that kind of franchise at that kind of price when its earnings are depressed and they then recover, that is a recipe for making a lot of money.”
What would you say if we told you that you could purchase an investment grade portfolio consisting primarily of U.S. treasuries for roughly 65 cents on the dollar (with a high quality insurance operation run by a capable, highly incentivized, and shareholder friendly management team thrown in for free). Would you be interested?
If the answer is yes, let us introduce you to the Unico American Corporation – a small, California-based property and casualty insurer that is currently unknown, underappreciated and most important of all, drastically undervalued.
Why is it Mispriced?
UNAM is an obscure microcap, so it is perhaps no surprise that almost no one on Wall Street follows, let alone recommends, a company as closely held and infrequently traded as Unico – businesses of this size are generally not of any interest to bigger players. Also, we believe that the indiscriminate selling of all things small/financial during the market meltdown of late ’08 – early ’09 in combination with the Street’s newfound aversion to all things illiquid, has resulted in a wide variety of micro-caps still selling at extraordinarily depressed levels (post the recent parabolic market rally).
Considering the “pinch me I must be dreaming” discount to UNAM’s AAA assets, investors need to get comfortable with the fact that today’s price is not depressed for some undisclosed fundamental business reason. In order to do that, they must ask (and satisfactorily answer) three basic questions:
(1) How good has management been at pricing policies historically?
(2) How adequate has its loss estimates and loss reserves been?
(3) How well has it invested its float (have they invested intelligently)?
In regards to the first question, in in-depth analysis of management reveals an impressive paper trail of quality underwriting (both on an absolute level and relative to its peers). Consider that during the “soft” market of the last three years – a competitive period where many of UNAM’s comparables were writing unprofitable policies to achieve their top line growth targets – UNAM remained focused on the bottom line and exhibited a willingness to sacrifice premium growth to maintain profitability. Again, in an era of competitive pricing and complete turmoil in the financial markets UNAM remained consistently profitable, growing its book value in one of the most tremendously difficult environments on record (the combined ratio over the last three years has varied between the mid sixties to the mid eighties) – an incredibly impressive feet, all things considered.
In regards to the second question – whether or not management has a history of being conservative in its reserving policies and loss estimates – our analysis revealed equally positive results (further bolstering our conviction in management and minimizing our fear of experiencing the type of nasty surprises that are so common with undisciplined insurers). A multi-year analysis shows that UNAM’s actual claim experience has been consistently better than what they had reserved for. For example, since 2001 UNAM has enjoyed significant net favorable developments from their loss reserves on a consistent basis. To reiterate, the historical performance of their policies suggests that management is more than adequate in estimating its loss estimates and loan reserves accurately.
As far as the third question is concerned – whether or not management has a history of intelligently managing their float – our analysis yielded more of the same (surprisingly positive results). For example, at the moment UNAM’s float is currently comprised almost entirely of short duration, low-yielding, U.S treasuries. For a variety of reasons we feel that their present positioning is both prudent and wise. After all, why stretch for yield or extend duration in today’s uncertain, low interest rate environment? Management’s emphasis on shorter duration, higher quality securities in our opinion reveals a team that is artfully balancing downside protection with upside optionality – something we like very much. Consider that owning a high quality short-dated portfolio of treasuries goes a long way toward ensuring that their balance sheet will remain fortress like and intact under any scenario short of Armageddon. At the same time, by simultaneously insisting on short-duration assets with near term maturities, they ensure that they will remain flexible enough to immediately react, not to mention capitalize on a rising rate environment. We believe rising interest rates at some point over the next few years is a certainty – It’s not a question of if they rise, just when, how fast and how far. Anyhow, the bottom line here is that looking out a few years UNAM’s investment portfolio is not only conservative, but perfectly positioned to do well in pretty much any environment.
An in-depth analysis of management’s historical record revealed each of the above concerns to be entirely unjustified. UNAM’s management team has an impressive paper trail of intelligently underwriting risk, being conservative with its capital (on both sides of the balance sheet), and avoiding large investment losses. Equally as important, they have cultivated a culture that focuses on underwriting discipline and improving long-term shareholder value, rather than focusing on growth at all costs – management doesn’t worry about quarterly results or growth targets, just profitable underwriting and the risk-averse investment of capital for the benefit of shareholders.
With a tangible book value of $13.68 per share and a current price of $9.12, UNAM is priced at a roughly 35% discount to its tangible book (notably 91% of UNAM’s TBV is comprised of U.S. treasuries). Therefore, investors in UNAM at or around today’s price are effectively purchasing t-bills (i.e. risk free assets) at a roughly 35% discount to face. Talk about heads I win, tails I don’t lose! Why would anyone buy treasuries when they can buy Unico, which not only pays a comparable yield (current cash yield is roughly 2%), but effectively allows them to purchase t-bills at 65 cents on the dollar.
But it gets even better… not only are investors who purchases shares at or around today’s price essentially buying completely risk-free assets at a deep discount, they are getting a high quality, consistently profitable insurance business for less than free. This is a good business, run by top notch owner-operators with a proven ability to consistently generate costless float and a long history of using excess cash for the benefit of shareholders – it also happens to currently be operating at a level that is nowhere close to its normalized earnings capacity, a dynamic that should reverse sharply over the next few years. Perhaps (unsurprisingly) that’s why management (who already owns roughly 60% of the company), recently reactivated its buyback program and has been buying back stock hand over fist ever since.
To conclude, no matter which way you slice it this business is drastically undervalued. A business with the qualitative and quantitative characteristics of Unico should never trade at a throw away price. Again, this is a good business with a proven, capable management team that has been able to accomplish the very things that most insurance companies strive to achieve yet cannot – i.e., the ability to consistently generate costless float as well as develop and maintain a culture focused not on maximizing top line growth, but on earning an economic profit on each and every policy written. As we see it (at least based on the rear view) it doesn’t seem like much of a stretch to conclude that this team has the right combination of discipline, independence of spirit, expertise, and experience necessary to build a sustainable franchise in an industry as highly competitive as insurance. Again, management’s track record when it comes to the things that matter, such as appropriately pricing policies, accurately estimating loss estimates and reserves, and/or investing their float in a conservative, risk-averse manner, etc. supports such a conclusion. The bottom line here is that Unico should trade hands at a premium to book (1.3x seems reasonable, all things considered).
I covered most of the traditional risks involved with Unico (underwriting, etc.) above, a few more are discussed below.
Liquidity Risk – Granted this is an illiquid microcap, so clearly a position in UNAM needs to be sized accordingly. With that said, I think investors (at today’s price) are getting paid more than enough to assume the additional liquidity risk. Also, like so many cheap micro-caps, there is always the risk that they stay cheap and the investment in question remains “dead money” for far too long. This is a valid concern (to quote Klarman, “long duration mistakes are the mistakes that keep on taking.”), yet we don’t think this will be an issue in this case, both because of the sheer cheapness of UNAM at today’s level and because of the multiple catalysts in place that should help bring about the realization of value. If today’s discount persists for long enough our guess is that management will simply just keep on buying back stock and ultimately just take the company private. Bargains of this magnitude don’t last for long, they never do.
Catastrophe Risk – Exposure to disasters is part and parcel of this business and is always a very real risk. Considering UNAM operates primarily in California the obvious worry that comes to mind is their level of exposure to earthquakes and wild fires. What makes us comfortable that this will not be an issue going forward, besides management’s history of intelligent underwriting, is simply that they do not write earthquake policies, and as far as exposure to wild fires is concerned they do not write policies anywhere near areas where wildfires are a real risk.
Competitive Industry – The insurance industry is obviously a very competitive industry – where a real sustainable competitive advantage often proves fleeting. Nonetheless, this doesn’t worry me (see the concerns section above).
Ratings Downgrade – Obviously, a significant deterioration in UNAM’s financial strength – as a result of higher than expected losses on policies – would affect both the volume and pricing of policies written after the fact. It could cause them to be essentially unable to write new business on profitable terms. Yet considering the conservative underwriting posture of this firm and their outstanding track record, on top of the fact that they actually just received a ratings upgrade from AM Best, we feel this shouldn’t be a material concern.
Asset Quality – With any insurance company there is always the risk that their reserves and/or book value could be meaningfully misstated or that they will suffer large losses in their investment portfolios (perhaps leading to a ratings downgrade or even bankruptcy). Considering what we know about the composition of UNAM’s investment portfolio as well as management’s long history of being overly conservative in estimating losses and building reserves, this is not something we really worry about. In fact, if anything (at least if history is any guide) Unico’s long history of consistently favorable developments regarding their loss reserves (i.e., they almost always overestimate the amount they need to put away for future losses) argues that the current book value is very likely not only correct but probably understated.
Prolonged “Soft” Market – This issue doesn’t worry us, as company’s focus on bottom line profitability should continue to allow it to generate a combined ratio well south of 100 in case the market remains soft for the foreseeable future (just take a look at their results over the last few years).
The Road Ahead – Unico’s results going forward are likely to be materially better than its past:
As briefly mentioned in the valuation section, we feel that Unico is currently operating nowhere near its normalized earnings capacity. Why?
Interest Rates Can’t Stay at Zero Forever – With historically low interest rates and a portfolio that consists primarily of short duration treasuries, it doesn’t take a genius to understand that the present amount of interest income that the investment portfolio throws off is incredibly depressed. Yet the bright side of this reality is that the moment interest rates begin to rise (it’s not a matter of if, but when) these short dated assets, as they mature, will be essentially immediately available for reinvestment at higher, more attractive yields – substantially boosting interest income in the process.
Today’s “Soft” Market Can’t last Forever – Although we can’t predict when the market will harden, we can predict that at some point it absolutely will. Because management refuses to write unprofitable insurance, the top line is destined to contract during periods like present. Luckily, soft markets cannot last forever and when the insurance market begins to firm at some point over the next few years, we expect both pricing and volumes to ramp considerably – Substantially boosting the absolute level of UNAM’s underwriting profits.
Recent Investments in IT Should Begin to Pay Off – Unico’s recent investment in an IT overhaul should further improve their efficiency in quoting and underwriting more policies, which will eventually result in improved operating performance for the firm as a whole. The end result will be more excess cash hitting Unico’s bottom line.
New Specialty Programs Are Likely to Add Value – New specialty program covering bars, gas stations, and convenience stores, etc., offers UNAM the opportunity to apply their money making ways to new markets and hence create additional earnings power for the firm going forward.
Recent Ratings Upgrade – A.M. Bests recent upgrade will allow Unico to write more policies and on better terms – yet another aspect of this company’s rather attractive underlying fundamental dynamic that should result in further bolstering both sales and margins.
Note: Not only should each of the above augment UNAM’s ability to generate more excess cash – taken together, I wouldn’t be surprised to see some significant “lollapalooza” effects grab hold as each of these dynamics interact with each other over the next few years.
Over the next few years today’s headwinds will undoubtedly become tomorrow’s tailwinds. As this dynamic plays out we expect UNAM will begin to approach its normalized earnings capacity – as it does, our guess is that it won’t be long before the combination of rapidly accelerating earnings and/or the recognition of their AAA asset base will lead to material multiple expansion (as the market assigns a much more appropriate valuation on this quality businesses assets and earnings power).
Sheer Value – Today’s price is just too cheap to last long.
Improving Operating Performance – Any resumption of revenue/EPS growth due to the firming insurance market, investments in operational efficiencies bearing fruit, and/or rising interest rates (and the resultant explosion in interest income that would result due to maturing assets being reinvested at more attractive yields).
Continued Value Accretive Share Repurchases – additional buybacks at anywhere close to today’s deeply discounted price will rapidly accelerate the growth in per share value.
Potential Buyout – Considering the high quality of UNAM’s assets and highly profitable policy base, an acquirer – with the ability to wring out excess costs and/or is looking to achieve some policy diversification – could pay 1.3x book and would still be getting a fantastic bargain.
2000 Profile on the company and management
*The author has a position in the Unico American Corporation (UNAM). This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only