Over time, the investments that you don't make are every bit as important as those that you do. The longer that I manage money, the more I realize that success comes from cultivating the self-control to say no to all but the best investment ideas, knowing that with patience and diligence eventually a better pitch will float your way.
In looking for the basics of a great stock idea, I often find attractive stocks with just one little, nagging concern that I find I just can't live with. In the past, I occasionally shrugged off such "little" negatives as insignificant, especially if I really liked the story. I have learned my lesson. More often than you think, that one little thing will turn into a big, ugly thing. If there was one thing investors learned in 2002, it should have been to pay attention to the little cracks in the foundation. You never know when one of them will swallow you up. With the benefit of experience, I have learned to not be so forgiving.
A good example of a stock that I have followed for several years but never purchased is Fairfax Financial Holdings (NYSE: FFH), which has recently come under intense scrutiny from the financial media. The company is run by Prem Watsa, otherwise known as the "Warren Buffett of the North." From 1985 to 1999, Watsa compounded book value at an astounding 40% average annual rate. Over that same time period, according to a recent Forbes magazine article, Fairfax shares increased 188-fold in value. Watsa was not only emulating Buffett's style but the latter's wealth-compounding track record as well. The stock hit an all-time high of over $600 per share (Canadian dollars) in early 1999 before swooning to below $200 in 2000, which is when I began to dig hard into the story. While I was (and still am) mighty impressed with Watsa's achievements, there was (and is) one very good reason not to invest in Fairfax: the $2.3 billion in debt on the company's balance sheet.
While I tend to be averse to debt in general, a highly leveraged property and casualty insurance company like Fairfax is playing on dangerous turf. That's because P&C insurance companies already carry a fair amount of what I call "invisible debt," which are eventual claims it must pay out to policyholders. The problem is insurance companies don't know when this "debt" will come due -- or how much it will cost. They can only estimate potential losses and do their best to ensure that they receive adequate premium revenue to be able to pay out claims as they come and still have enough left over (after investing it in the interim) to make a profit. Unfortunately, even the very best companies in the insurance business have occasionally been guilty of poor pricing discipline, and everybody gets hurt by the occasional terrible and unpredictable loss events that occur every now and again. Insurance companies must have rock solid balance sheets to survive the proverbial 100-year storm, which tends to hit the industry with higher frequency than advertised.
In looking at Fairfax, I could never get past the debt issue. That debt means there's little margin for error for the company, and, therefore, there's no margin of safety for its shareholders. Recently, concerns that Watsa won't be able to come up with enough cash to make a $350 million debt payment caused the stock to spiral downward. I'm not sure things are as bad as the media has suggested, but I have no doubt that the right mix of circumstances could bring Fairfax down. That's why even now, with the stock trading at less than half of book value, I can't bring myself to buy shares. I remain a big fan of Prem Watsa, and I would love to see Fairfax emerge from its current difficulties. It may be a reasonable speculation for those investors willing to risk a permanent loss of capital, but personally I don't knowingly make those types of bets anymore.
American Safety Insurance (NYSE: ASI) is a more recent example of a stock that I looked at long and hard before deciding to pass. It is an interesting little business: part insurance company, part real estate investment trust. Its core business is in the area of environmental insurance. Specialty insurance companies can often carve out profitable little niches for themselves in areas where they have unique expertise, and it appears that American Safety Insurance has done just that. In addition to its insurance operations, the company has also gone into the property development business. It is currently building a large condominium community complete with marina, golf course, and beach club amenities in Ponce Inlet, Fla.
Its insurance business appears to be growing rapidly, and a recent look at the cash flow statement was enough to make my pulse quicken. The company generated operating cash flow of $20.8 million in the last 12 months for a stock with a market cap of $33 million. A lot of that cash finds its way back to shareholders in the form of dividends -- American Safety Insurance's yield at a recent price of $7 per share was about 6.8%.
For the reasons noted above, I was very intrigued with the company as an investment, but only until I read the footnote in the annual report on related party transactions. There, it is disclosed that American Safety Insurance routinely enters into reinsurance agreements with two companies that are owned and controlled by "a senior officer of the company."
The footnote states that these agreements are to "provide limits of coverage on terms not readily available in the commercial reinsurance market." This concerns me. For one thing, who's to say that American Safety Insurance is paying a reasonable rate for this reinsurance coverage? For another, how do I know that these companies owned by "a senior officer" are adequately capitalized to make good on the contracts? Finally, why does a senior officer of American Safety Insurance need to also own and control two other reinsurance companies? The whole thing just doesn't look right to me. It's perfectly possible that American Safety Insurance will turn out to be a great investment idea, but I'd just rather invest in companies where I am 100% sure that the managers are dedicated to creating value for the shareholders.
There are 11,000 publicly traded companies out there, and I have room in my portfolio for only about 30 of them. No stock will be perfect, of course. But one good reason not to own a stock is generally reason enough for me to move on to the next one.
Guest columnist Zeke Ashton has been a long-time contributor to The Motley Fool and is the managing partner of Centaur Capital Partners LP, a money management firm based in Dallas, Texas. At time of publication, Zeke did not own shares of any stocks mentioned in this article. Please send your feedback to [email protected].
