Traveling with a margin of safety

We are ultimately trying to buy a dollar for fifty cents. That’s essentially all value investing is. Readers of this blog will know that we also require that “dollar” to be a high-quality business with attractive future prospects. We think Travelers (NYSE: TRV), the US-based commercial insurer, is indeed one of these businesses. And we think we’ve bought Travelers with a significant margin of safety.

The term “margin of safety” simply refers to the extent of the discount below intrinsic value you are able to buy a business. Buying a business worth $1 billion for $700 million would give you a 30 percent margin of safety. One view of margin of safety relates to how much upside there could be from your investment. While this is valid, we believe the more important view relates to how much downside is protected in the scenario that your assessment of intrinsic value is wrong.

Any assessment of intrinsic value for any business involves a set of expectations for future key value drivers. These include things like revenue growth expectations, margin expectations, capital requirements, etcetera. Given that predicting the future accurately and sustainably is impossible, there is always the effective certainty that your assessment of intrinsic value will be wrong. This won’t be a problem as long as you buy with a significant margin of safety. The goal is such that, even if your assessment of intrinsic value is inadvertently optimistic, your investment loss will be minimized.

In the case of Travelers, we were able to buy the business at a price that effectively implied two things: (i) no growth in premiums for the rest of time; and (ii) no increase in interest rates for the rest of time. Remember, as interest rates rise, so too do the returns achieved on the insurance float which can be a significant driver of income for insurers.

Now, in our minds, both of these market-implied expectations are way too conservative. Over the long-term, commercial insurance premiums will likely grow with the economy; and interest rates, well, they certainly can’t get much lower and have already started to rise in the US.

A corollary of the above is that: we have bought Travelers with a significant margin of safety. For even if we are wrong, and premiums and interest rates never rise, we still won’t lose money. The potential for upside with limited potential for downside is where we want to be.

Quarter by quarter, Travelers delivers very stable, high quality results. As we have seen in the company’s most recent results filed last week: even in the face of falling commercial property and casualty premium rates, Travelers is able to offset these declines with reduced risk insured. Operationally, Travelers is also best in class. Given its scale and intelligent use of customer data, Travelers has been able to continually increase customer retention. And capital returns remain the top priority for management: 100% of earnings are returned to shareholders in the form of dividends and share buy-backs.

In a business as stable as commercial insurance, a large-scale, diversified player like Travelers that can be bought at a price in the marketplace well below any sensible estimate of intrinsic value is highly attractive, in our view. It may not be as “hot” as a Google or a Facebook right now, but it will continue to deliver quietly with limited downside for a very long time to come.

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Andrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.