I spend a lot of time reading financial statements. Often, when I'm done skimming the hundred pages or so of the 10-K, I have absolutely no idea what I just read, nor can I place a value on the company. However, in some cases, I can give a ballpark estimate of what the company is worth. If it's trading at a discount to my quick and dirty conservative estimate, I get interested. Lately, I've put two financial service companies on my "watch list."
What to look for
I went over a lot of these principles in the article "Three Low-P/E Insurance Stocks," so I'll just briefly recap.
When buying a financial-services company, I look for a low multiple of tangible book value and a low multiple of sustainable "cash" earnings, along with growth and strong returns on capital.
However, companies that can earn a high return on capital are clearly worth more than TBV. In those cases, it's OK to pay a multiple of book value, but you'd want to find a company with a high and sustainable return on capital, and plenty of opportunity for growth -- and you'd want to pay a low multiple of earnings power.
Here are a couple of companies I think meet these criteria.
Kingsway Financial writes non-standard auto, trucking, taxi, and motorcycle insurance. Kingsway is the market leader in non-standard auto insurance in Canada and the largest writer of trucking insurance in North America, and it's the second-largest player in both the U.S. and Canada. These markets are filled with strong competitors, including Progressive
What's to like about this company? Besides its dominant market share, the company has a pretty great track record. Over the last five years, book value per share has grown by 18% annually, and gross premiums written have grown at 23%. Since 1995, there was only one year when return on equity was less than double digits, and only three years when the combined ratio was higher than 100%.
At year's end, book value per share was $16.12, meaning that at the current $20 share price, you'd be paying a reasonable 1.2 multiple over book and about 9 times trailing earnings. So why is it cheap? The company wisely refrains from compromising its underwriting standards, so a recent soft market has hurt growth and earnings.
As stated in its annual report, Kingsway performs better during industry downturns (this might remind you of another "contrarian" insurer, Berkshire Hathaway
CVB is a California-based bank with 39 offices and $6 billion in assets. The company has strong deposit market share in some fast-growing southern California cities such as Orange, Ontario, and San Bernadino, where it is, respectively, the fifth-, second-, and second-largest player behind banking behemoths such as Wells Fargo
I'm attracted to CVB because, like Kingsway, the company has a great track record and exposure to growing markets (I grew up in southern California, so I'm familiar with many of its markets). For the past five years, the company's return on average equity has been consistently around 20%, and its return on assets is in the 1.25% to 1.80% range. The efficiency ratio has also been very respectable at less than 50%.
The stock has traded down because, as with Kingsway, growth has stalled. Banking conditions right now are ultracompetitive, thanks to the oversupply of liquidity and the flat yield curve. Furthermore, the company's portfolio is "liability sensitive," so the rising interest rates over the past year mean that the interest rates it pays on deposits and CDs re-price more quickly than the yield it earns on its loans and investments. In time, this will unwind; for now, however, it's put a crimp on earnings growth.
As a result, in 2006, even though average earning assets grew nearly 19%, net interest income was flat, thanks to a net interest margin contraction of 45 basis points. Although the competitive environment kept non-interest-bearing deposits from growing, these deposits still represented a whopping 40% of total deposits, helping to shore up net interest margins.
How to play it
Like Kingsway, this is another company that may require patience. Both of these companies continue to throw off outsized profits. However, their stocks have fallen as less disciplined competitors eat away at their growth. In time, it's not hard to envision those competitors burning out and fading away. Investors with a two- to three-year outlook, willing to overlook a near-term slowdown, might want to take a hard look at both of these companies.
Berkshire Hathaway is a Motley Fool Inside Value recommendation. Bank of America is a Motley Fool Income Investor recommendation. Try any one of our investing services free for 30 days.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.