What makes a great business model?
To attack that question, let's take a page from mathematician Carl Jacobi via Charlie Munger and "invert." In other words, let's first determine what makes a bad business model. Here are three traits I came up with (if you come up with additional bad business traits, please add them in the comments section below):
- Not getting paid until long after services have been rendered to customers who have negotiating strength.
- Having high levels of capital expenditures and low returns on invested capital.
- Operating in a commodity niche with low barriers to entry and exit.
That means that a good business:
- Gets paid up front by desperate customers.
- Has low capital expenditures and high returns on invested capital.
- Operates in an area with high barriers to entry and exit that also requires specialized expertise.
If you agree with all that, then you'll want to find companies that meet those criteria. Personally, I think a small company called Enstar Group (Nasdaq: ESGR ) fits the bill -- and I've put my money where my mouth is.
Though the inner workings of Enstar are a bit of a black box, its business model is elegantly simple. The company buys insurance and reinsurance companies in run-off -- meaning they've stopped writing new policies -- and gains control of the reserves, manages the claims that arise, and then invests the proceeds either in other insurer acquisitions or in promising outside hedge funds.
It's a scalable model with upside; that is, it requires low levels of maintenance capital expenditures and offers high returns on capital. All that has to happen is for senior management to continue to price and execute acquisitions properly, manage the insurance side, and find outside investments as deftly as in the past.
There are also some added side benefits. For example, the sellers of the small and/or high-risk insurance lines in run-off that Enstar specializes in managing tend to be pretty motivated to get those liabilities off their books. Also, there aren't many companies that compete with Enstar in this space because it requires seed capital as well as investment and valuation expertise. After all, one needs to be pretty savvy to make money off of insurance lines that big insurance companies such as Travelers (NYSE: TRV ) have deemed no longer worthwhile.
Enstar has a good acquisition track record and often turns a substantial portion of the negative goodwill it books with each acquisition into cash for its balance sheet. The company also tries to settle the claims against the policies it's purchased before they come in, either by making an upfront payment or by buying back the policy altogether. That strategy reduces Enstar's uncertainty and increases its reward, freeing up cash and avoiding litigation -- but only if it has accurately analyzed the insurance book and potential claims.
Which leads to the obvious question: Can we trust management to keep executing?
The folks behind this savvy model
Enstar is run by an impressive group. Two of the main players are board chairman and Goldman Sachs (NYSE: GS ) alumnus John Oros, and J. Christopher Flowers, a board member and greater-than-10% shareholder. These two have solid track records in the financial industry and are in charge of investing Enstar's cash, much of which gets invested in Flowers' various hedge funds.
The run-off business is headed up by CEO Dominic Silvester, a man with more than 15 years experience in the niche and a 17% shareholder. Thus, we have personnel with superior pedigree and decades of experience -- the two traits we'd need to believe that Enstar can continue to value portfolios better than would-be competitors and excel in this specialized niche.
The weakness in this model is that it relies on these key personnel to continue to make good decisions about acquisitions and capital allocation. The good news is they all have solid track records, they seem to be a legitimate brain trust, and they're vested. Together, insiders own more than 40% of outstanding shares. Incidentally, money managers Chuck Akre and Chuck Royce -- two intelligent investors who seek out businesses that can compound capital at high rates for long periods of time -- are also big investors.
Enstar's stock is down with the rest of the financial sector. But the business model here is a good one, the people are top-notch, and the balance sheet is strong, with more than $2 billion in cash and short-term investments net of debt. There's also the added potential catalyst of insurance lines coming up for sale, as companies such as AIG (NYSE: AIG ) look to shore up their balance sheets while others such as Everest Re (NYSE: RE ) look to spur industry consolidation.
Put that all together, and Enstar looks to be the type of superior stock that will not only survive the current crisis, but scoop up distressed assets that will fuel its business model and drive future growth in book value along the way.