Why We're Buying Loews

My favorite kind of business is a holding company with an intelligent capital allocator at the helm. This is a great business because management allows capital to flow to the subsidiaries best suited for providing the best long-term returns. In addition, good capital allocators tend to use share buybacks as a weapon, something that most corporations routinely fail to do.

The most well-known example of this type of business is Berkshire Hathaway (NYSE: BRK-B), a collection of businesses assembled over multiple decades by two of the best investors of our time: Warren Buffett and Charlie Munger. Loews Corporation (L 2.76%) doesn't quite have the same following, but it shares many of the characteristics that have made Berkshire a long-term outperformer.

The Loews story
Loews was founded over 50 years ago by Bob and Larry Tisch. Since its inception, Loews has been a long-term compounding machine that has generated much wealth for its shareholders. Over the last 50 years, Loews stock compounded at a rate of 14% annually, compared to a rate of just 6% by the S&P 500 over the same time period.

Today's Loews Corporation is run by the next generation of the Tisch family and has a different look than it did under its predecessors. Its main businesses are offshore drilling, natural gas pipelines, property and casualty insurance, oil and gas exploration, and luxury hotels. While the portfolio of businesses may have changed over the years, the long-term value focus remains very much alive today. Add in a cheap valuation, and we have what appears to be a compelling buy from today's price.

My interest in Loews comes from its strong history of growth and its currently cheap valuation. Over the last five years, we see that Loews compares quite favorably to Berkshire and several other Berkshire-like peers:

Source: S&P Capital IQ. *Markel Corporation's book value is for the 2nd fiscal quarter of 2007 and 2012, since the company has yet to report third quarter results.

From the above table, we see that Loews has performed quite well compared to this exceptional group of companies. It's been the fastest grower in the peer group over the past five years yet carries the lowest price-to-book multiple today. Paying such a low multiple for a quality, long-term oriented business is a favorable proposition -- one I am taking advantage of today.

The below-average multiple assigned by the market implies a period of low growth ahead, but I expect Loews to outperform those expectations handily. Loews has grown book value per share at a healthy clip in a tough environment that included a debilitating recession. Moreover, it boasts a collection of businesses with great prospects for near-term growth despite the tough macroeconomic headwinds facing the world today.

Long-term growth opportunities in energy
Loews got into the offshore drilling business in 1990. The ownership of offshore drilling rigs allows the company to benefit from the long-term trend of hard-to-reach oil and gas. As conventional sources of these hydrocarbons continue declining, new production coming online is coming increasingly from unconventional sources. This means offshore, shale, and oil sands production is becoming more and more prevalent as time goes on.

This has driven up the marginal cost of production over time, since producing from these hard-to-reach sources is more expensive. Diamond Offshore (DO +0.00%), majority owned by Loews, is a nice way to play this long-term trend of offshore drilling. Diamond Offshore leases out its drilling rigs to companies that are looking to increase their offshore oil and gas production.

Another of Loews' energy-related subsidiaries is Boardwalk Pipeline Partners LP (BWP +0.00%), which benefits from the increased storage and transportation of natural gas. While natural gas producers are struggling to make money in today's low price environment thanks to the greatly increased supply from the gas shales, infrastructure players like Boardwalk are doing very well since they operate more of a tollbooth-style business that earns steady fee income.

The future is bright for Boardwalk, since new natural gas-powered power plants will continue to come online, CNG vehicles are slowly gaining traction among truck fleets, and industrial usage continues to trend up. All of these things mean Boardwalk will be able to take advantage of the increased natural gas production by providing storage and transportation infrastructure so that more gas can be moved around as production goes up.

Finally, we have Highmount Exploration, Loews' wholly owned oil and gas producer. The majority of Highmount's production is natural gas, which does not fetch much cash given today's low price. In order to combat this, the company has been diversifying into oil production. It acquired 70,000 net acres of leasehold in the Mississippi Lime formation last year, an area that should help diversify its production mix and help it earn strong rates of return on its drilling capital expenditures.

As Highmount increases its oil production and as the price of natural gas slowly recovers, it should begin to contribute an increasing amount to future earnings.

The conglomerate discount: an advantage
My assessment of Loews' value shows upside from today's price. Here's how the parts stack up:

Source: S&P Capital IQ and company filings.

The value above is very close to Loews' latest book value per share of $50.41. Yesterday's close of $42.33 represents a 16% discount to its book value per share. I expect management to continue buying back shares at the current level, as well as invest in its subsidiaries for future growth.

Adding up CNA, Diamond Offshore, and Boardwalk gives us a value of $38.54 for the public subsidiaries. This implies a value of less than $4 per share for the parent company's investment portfolio, Highmount Exploration, and Loews Hotels. This is a classic case of the conglomerate discount, in which a group of businesses trades at a discount to fair value because it's tough to determine what they're actually worth.

While others might be upset with the discount, Loews' management loves it. Carrying a valuation that undervalues the core assets gives Loews a distinct advantage when it comes to share buybacks. For example, buying shares worth $50.60 at yesterday's close of $42.33 yields an immediate return on investment of almost 20%. To put it another way, that's like buying dollar bills for about $0.83.

Management has used this advantage to retire 70% of its shares over the last 40 years, reducing share count from 1.3 billion to just under 394 million today. That's not to say management should always buy shares. Loews also has several subsidiaries that offer opportunities for strong organic growth. These are businesses with strong runways for growth despite the weak economy today.

There is one downside to the conglomerate discount: Significant multiple expansion is unlikely. That means we will only make a good return on our investment as long as Loews posts solid growth in book value over time. That means we're looking for continued intelligent capital allocation by management and solid execution by each of its subsidiaries. It's a tall order to replicate the excellent returns over the last several decades, but I believe management is up to the task.

A turnaround story
As shown above, a third of Loews' value comes from CNA, the troubled insurer that the company has owned since 1974. CNA has performed quite poorly over the last decade, which is the other major reason for the low valuation multiple assigned to Loews today. The low multiple does give management the chance to execute favorable share buybacks, but we want to take a look and make sure CNA will be positioned well for the future.

Fortunately, CNA is already in the midst of a turnaround led by Chief Executive Tom Motamed, who came over from Chubb Corporation (NYSE: CB) where he served as COO. Since his arrival in 2009, he's been busy instituting changes at CNA.

Underwriting discipline
The ability to walk away from unprofitable business even when others are being irresponsible is the most essential trait of any insurer. In the insurance industry, premiums are received today for liabilities that might not be settled for 2 to 15 years, depending on the type of coverage. Poor underwriting today might not be discovered for a few years, by which time it could be too late to undo the damage to the company's balance sheet.

Management has been preaching the virtues of disciplined underwriting and thus far has lived up to that promise, pushing for rate increases where possible and walking away from unprofitable business altogether. As time passes, I'm looking for the loss ratio to come down over time because of these improvements.

Repositioning and focusing the portfolio
Instead of writing any and all kinds of business, CNA has been repositioning its portfolio into seven core industry segments. This helps develop expertise in its lines of operation, which will help improve underwriting performance in the future as risk is priced more accurately. Also, focus helps build better customer relationships over time. Customers aren't looking to flee from reasonably priced policies with companies that know their businesses and serve them well.

Managing run-off businesses
Unfortunately, CNA is paying for the sins of its past. The company is suffering from long-tail liabilities that are still hurting results. Motamed got rid of some of these old liabilities when it entered into a transaction with National Indemnity in 2010 to transfer over its asbestos and pollution liabilities. The Life & Group business, which was placed in runoff in 2003, still remains under CNA's umbrella. This segment generated a $208 million loss in 2011 and goes a long way toward explaining why results don't look better than they do.

It's suboptimal to be carrying a segment that will remain a drag on results for some time, but there's a silver lining here. As time goes on and higher quality policies continue to be written, the loss-making run-off policies will become a smaller slice of the overall pie. Looking at the results over the last 10 years, this appears to be the case.

From 2002 to 2006, CNA averaged a combined ratio of 118.6. For perspective, a combined ratio of 100 or below means the company is underwriting at a profit. From 2007 to 2011, the average is a much more respectable 103.6. Despite carrying the terrible loss-making policies, CNA's results already show improvement thanks to the discipline that is being instilled. Going forward, we should see further improvement as the run-off segment continues to shrink.

Understated asset values
At CNA's current price-to-book multiple of 0.6, the market is expecting a permanently lowered return on equity with no future improvement. I expect earnings power to be impaired for the next three to five years, but not indefinitely. As the runoff business shrinks even further and interest rates begin to recover years from now, CNA will begin posting higher ROE.

This implies upside for CNA's valuation from here -- and it's not the only undervalued entity within Loews. Much like the carrying value of Berkshire Hathaway's subsidiaries are understated because they are based on historical cost from a long time ago, so it is with Loews' businesses. For example, Loews hotels has a history spanning over six decades. That means the hotels acquired decades ago are likely on the books for much less than the replacement cost of those assets.

Put it all together, and it's highly likely that the company's book value and my estimate of per-share value understate the true value of Loews' assets. Better yet, we get to buy at a discount to the already understated book value.

Risks and why I'd sell
The first risk that comes to mind is CNA's underwriting, which is in the midst of a turnaround. While the company has improved greatly in recent years, it's not always easy to change one's identity so quickly. I'll be watching to see if the company maintains its focus on underwriting discipline, especially with excess capital on the sidelines.

Also, CNA depends very heavily on interest rates since it holds a lot of fixed income investments in its portfolio. This will lead to below-average investment income for quite a long time until interest rates improve. I've already built this into my expectations, but I'll be watching this situation closely.

Finally, if Loews management were to make a splashy acquisition, we'd have to trust that management made the right call. Leadership at Loews has proven to be good stewards of capital over time, but the possibility exists that an acquisition could turn for the worse. If management stops following its disciplined approach to value creation for some odd reason, I'd consider selling this stock.

Foolish bottom line
Loews is a nicely growing company trading at a cheap valuation. I expect this will remain a core position in our portfolio for a long time, as long as the company keeps creating long-term wealth for shareholders as it has for many decades now. Tomorrow, I'll be purchasing shares for the Street Fighter Portfolio, which I co-manage with Matt Argersinger.