Thursday, April 30, 2009 3 comments ++[ CLICK TO COMMENT ]++

Montpelier Re doing something positive for shareholders

Montpelier Re (MRH), my only core investment right now, has been a dissapointment lately. I don't follow it closely but do keep an eye on it once in a while. It suffered huge losses on their investment portfolio last year, which is never a pretty sight when the insurer is mostly investing in supposedly "safe" assets. As I indicated in my outlook for 2009, I am bearish on insurers. If interest rates stay low, we may see a period like the 40's or 50's, when insurance companies, who mostly own bonds, don't earn much off their investment portfolio. For this reason, I am not too optimistic with these companies in aggregate. However, specific companies can be good investments.

In any case, in the latest quarterly conference call, I noticed something that I wish more businesses were doing. Namely, buying back bonds:

The second was a repurchase of 21 million of our outstanding 2013 Senior Notes or 15 million resulting in an immediate $6 million gain and a 1 million annual interest savings going forward.

Some would argue that buying back shares is the best thing to do right now. Shares seem cheap to many. I'm probably in the minority camp who feels that shares may not be cheap. Clearly we have many, including Warren Buffett (at least if we use his opinion piece from October of last year), saying that shares are undervalued. I'm just a newbie with little experience but I am not certain that shares are cheap here—even though we have seen two major stock market crashes in the last decade. Since, in my opinion, the risk to earnings is to the downside for most companies (i.e. corporate profit margin for the next 10 years likely to be worse than the last 10 years), buying back shares can be risky. Leverage cuts both ways and when earnings collapse, it will amplify the pain. If it works out, it will look great but if it doesn't, it would look like some idiot who bought back his shares at $50 only to see it trading at $30 two years later.

Others would argue paying out dividends is the best thing to do now. Dividends are becoming scarce and the hence it will be valued more by the market than it was possibly at any point in the last 20 years. By increasing the dividend by, say, 5%, you can attract the passive investors who blindly buy on screens (such as companies that are increasing dividends.) In Montpelier Re's case, dividends probably don't matter much since it is a very risky company and very few would consider it a 'divdend stock.' In general, though, I am not a fan of dividends and hence I don't like companies raising dividends.

On the other hand, I think it is probably better to buy back bonds, assuming you are certain you have excess cash. Bonds look even cheaper than stocks to me. Many bonds are trading 20% to 40% below par value. In this case, it seems Montpelier Re bought back the bonds around 29% below par value. Buying back bonds will also reduce leverage going forward. Some investors seem to like leverage but I don't view it as positively as many others, especially if one is not confident with future profitability.

So, companies that are sitting on large piles of cash, and are certain they won't be needing that cash, should start buying back their bonds.


3 Response to Montpelier Re doing something positive for shareholders

May 3, 2009 at 2:51 PM

You said
"In general, though, I am not a fan of dividends"
What do you mean?
Are you saying that companies that retain their earnings should be better investments than those that pay them out.  Would you expect that most companies can reinvest their earnings at a higher rate of return than their shareholders could manage with the divdends?
Certainly, a company like Berkshire Hathaway has used its capital far better than most investors could have done.  But I question whether most businesses could reinvest 100% of their earnings and generate more than a dollar of earnings for each dollar invested.
Or perhaps I'm reading too much into this and you are just saying that you don't invest in dividend/income type equities as your preferred style.

May 3, 2009 at 2:57 PM

I agree with your thoughts on share and bond buybacks.
Some junk bonds are still yielding in the double digits.  It must be tempting for a company to buy back its bonds.  After all, this is like investing the money at a nice guaranteed return.
Of course, one of the ironies of the market is that companies with extreme yields on their debt typically don't have the financial strength to buy them back.

May 4, 2009 at 12:55 PM

I do not like dividends for the reasons Warren Buffett doesn't like them. Also you do not need to re-invest the cash flow; you can buy back shares as well. The main reasons I do not like dividends are:
(i) Dividend taxes are higher in some jurisdictions: I think the US dividend taxes have been made equal to the capital gains tax but in most places, including Canada, where I live, dividend taxes are higher than capital gains taxes.
(ii) Buying back shares can be better: This depends on how good management is but buying back shares can generate far higher returns for shareholders than dividends AS LONG AS they are not purchased when shares are severely overvalued.
(iii) Re-invested profits can generate far higher returns: This leaves the possibility of management wasting money but, if we assume that the majority of re-invested cash produces high profits, then this will generate far higher returns than an average investor can. Coca-Cola would generate far higher returns re-investing $1 billion than you can buying their shares (under normal circumstances). Having said that, this depends on the business opportunities available and mature companies like Coca-Cola really can't re-invest successfully.
Now, one might say that most executives don't know anything about capital allocation--certainly the record in the last 5 years of many firms buying back shares near peak valuations attests to that--but my view is the following. If I have little confidence in management's capital allocation, I wouldn't own the company in the first place (except for turnaround contrarian situations or other special cases.) Furthermore, as long as you are not investing in mature industries, it is probably better if the company re-invests the money (hopefully in a good manner) than if it paid dividends.
In the case of Montpelier Re, it would be better off buying back shares or re-investing than paying dividends. It's small and hasn't reached the mature stage where it can't find opportunities to re-invest capital.

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