When I first bought shares of Life Partners Holdings (Nasdaq: LPHI ) , it looked like an almost ideal stock. The company was showing a pristine balance sheet with no long-term debt and more cash than total liabilities. Its business -- life settlements -- combines all the glamour of a funeral parlor with a revulsion factor in line with the modern-day anti-smoking campaigns.
In part because of the negativity surrounding its industry, its valuation looked incredibly attractive, too. With a better than 5% yield at the time, a price-to-earnings ratio around single digits, and a business that looked well-positioned to thrive in a still-shaky economy, it looked like a no-brainer pick.
What's with the industry?
Life settlements is a somewhat macabre business. In a standard case for the industry, a person finds himself or herself insured by a no-longer-needed life-insurance policy. That person can either:
- Continue to pay on the life insurance.
- Surrender the insurance for whatever cash value it may have.
- Sell the policy to someone else for somewhere between the cash value and the death benefit.
It's that third situation where the life-settlements companies like Life Partners Holdings play. They're essentially a matchmaker between investors wanting to buy policies and insured folks wishing to sell.
It may be macabre, but it looked like a potentially lucrative investment -- not to buy the policies, but rather to buy shares in the company that helped facilitate the connections between buyers and sellers. After all, so called "sin stocks" -- broadly defined as stocks of companies in industries that your mother would never approve of your partaking in -- often make strong investments. And what could be more "sinful" than anticipating someone else's passing -- the essence of the life-settlements business?
From no-brainer to zombie apocalypse
Unfortunately, there were some extremely large problems lurking just under the thin veil of the company's apparent success. For one thing, while it's darn near impossible to predict when anyone will pass away, it's a standard actuarial task to project the rate at which large groups pass away. In rating the policies it was selling, Life Partners Holdings was apparently way off the mark, according to a Wall Street Journal article.
Given a large enough sample size and accurate enough actuarial models, you'd expect about half the people in a given population to pass away by their life-expectancy date. In Life Partners Holdings' case, more than 80% of all insured people whose policies Life Partners Holdings sold between 2002 and 2005 lived past their expected death date. I think that's either lousy actuarial estimates or something nefarious. The SEC is investigating and is threatening civil action if it believes there to be funny business going on.
In large part because of its questionable life expectancies, the company is having difficulty accounting for its operations. It delayed several of its earnings filings, just filing both its 10-K annual report for February and its May 10-Q report within the past week, and its overdue August 10-Q finally came out yesterday. As if the delay weren't bad enough on its own, the company's auditors didn't approve of the company's internal controls, citing material weakness in the way it recognized revenue.
Bad accounting. Bad actuarial estimates. And an SEC investigation into the core of its operations. Yuck. The whole experience certainly reinforced the point that it's not enough for a company just to have good reported numbers -- it needs trustworthy management at its helm to assure long-term success.
What to do next?
I was wrong about Life Partners Holdings. It looked almost too good to be true, and it turned out to be a real lemon. I still like the concept of "sin stocks," though, and now (or rather, when Foolish disclosure rules allow) might be the perfect time to trade in my Life Partners Holdings shares for a better-run sin stock.
The sin stocks currently on my watchlist include:
- Philip Morris International (NYSE: PM ) , the non-U.S. tobacco business spun off from Altria (NYSE: MO ) to protect that part of the business from U.S.-centric litigation. Its 4.3% yield looks reasonable, though lower than the 6% of the company that spun it off -- a reasonable tradeoff for shares with less of a legal overhang attached.
- Diageo (NYSE: DEO ) , the British purveyor of adult beverages, including my personal favorite -- Guinness. The company currently has a deliciously tempting 4% forward yield and trades below 13 times next year's anticipated earnings.
- Service Corporation International (NYSE: SCI ) , the funeral services and cemetery provider. While not generally considered as much of a "sin stock" as the others on this list, it still profits from people's deaths. It certainly has the advantage of a business model that will continue as long as people pass away and that is needed no matter how poor the economy.
Any one of them looks like a potentially more lucrative investment than the overoptimistic marketer of life settlements I currently own. Truth be told, though, I haven't made up my mind on what to do yet, and I'd appreciate your opinion in the poll and comments.