I've realized that great companies are very similar to the great value investors that buy their shares. They both seek out undervalued, unappreciated opportunities in which to earn high risk-adjusted returns, and they both care little about what the crowd is doing, even if means being unpopular in the short term. Torchmark (NYSE:TMK), a long-term Berkshire (NYSE:BRK-B) holding, perfectly describes such a situation. I recently spoke with Torchmark Chairman Mark McAndrew and CFO Gary Coleman, to learn more about the company.
Emil Lee: How does Torchmark make money?
Mark McAndrew: Primarily two-thirds of our earnings come from underwriting income, which is premiums less claims, marketing expenses, and administrative expenses. The other third is excess investment income, which is net investment income less interest credited to reserves and less interest on debt.
EL: What are the competitive dynamics that Torchmark faces?
MM: We're not your typical life insurance company. Over 60% of our revenue comes from life insurance. We're not going after high-end -- our market is middle- and lower-income customers. We sell basic protection products; we're not into variable annuities or asset accumulation products.
In the markets we're in, we have very little competition. American Income [a unit of Torchmark] sells primarily to labor unions. It's the only "all labor union" insurance company that we're aware of. Globe Life, our direct response company, has almost no competition in its markets. We've seen numbers where we represent 80% of direct mail solicitations in our marketplace.
EL: How can an outside observer try to judge whether a company is aggressive or conservative in setting reserves?
Gary Coleman: Cash flow will essentially tell the story. Depending on if it's life or health insurance, which determines how long the tail is, at some point the cash flow will tell the story if the actual claims are higher than the claims assumed in setting up the reserves.
MM: In all of our markets we have 10-20 years of history. When we set the reserves we have a lot of confidence that they're reasonable.
EL: It seems Torchmark has taken the contrarian decision not to move into "investment" products -- is this due to the lack of float, lower margins (no underwriting income)?
MM: We write a little bit of annuities. When we look at the risk versus reward, the return on investment, we don't believe the asset accumulation business is a risk we want to assume. Our earnings are very predictable -- our lowest operating EPS growth is 8% in the past 8 years. This is strictly from internal growth -- our last acquisition was in 1994. It's really a matter of weighing risk versus reward. The asset accumulation business is controlled by outside influences -- interest rates and equity markets.
EL: Your underwriting margin might be the best in the industry. What are the components of this?
MM: In direct response, our acquisition costs are lower. Also, our administrative expenses are lower, they're a little over 5% of premiums versus the competition at 9%-10%. It's also our distribution. Having a captive sales force means we don't have to have the lowest premiums or pay the highest sales commissions.
EL: How do you keep administrative costs so low?
MM: It's ingrained in every member of management -- it's always been one of our primary focuses -- being as efficient as possible.
GC: I would add that you mentioned customer service earlier -- we keep those expenses low and maintain our customer service. If you do things more efficiently you can do them well and at less cost.
MM: I hate to use the term culture, but it's a way of life.
EL: I've heard stories where Buffett loves companies where, for example, he'll walk into headquarters and the CEO is using a beat-up secondhand desk to save money ...
MM: We spend the money as if it were our own. If we can't justify it, we don't spend the money. That's why we don't do image advertising -- we can't show a return. It's not measurable. So we don't spend the money on things where we can't document a return on investment.
EL: What are some metrics you think investors should pay attention to when reading Torchmark's financials?
MM: Most investors don't appreciate the stability and extremely low risk involved with our company. I can't comprehend a circumstance where we would not have growth in earnings per share, let alone a loss. These are just extremely low risk operations. We probably don't have the ability to grow EPS by 25% -- but we do believe we can maintain growth in EPS with extremely low risk.
GC: On the investment side, we are very conservative -- 95% of our assets are in corporate bonds and we have very low exposure to MBS and ABS. We keep a conservative investment portfolio; we're not trying to hit home runs, but rather to be consistent and protect our investments.
EL: Can you talk a little bit about your competition, who do you admire and why (or who don't you admire)?
MM: There's a lot of people we don't admire -- particularly in the health insurance world. I don't like to name names, but there's companies out there that have tried to buy market share in long-term care, a very risky product we chose not to put on our books. A lot of companies are jumping into Medicare advantage. I think that market will change over the next couple of years.
As far as companies that I admire -- I'd have to say Aflac (NYSE:AFL) -- they found their niche and did the best they could in that niche, which is our philosophy. We don't try to be everything to everyone. We try to find things we can do well.
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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.
