S&C Messina Capital 2016 Letter: Value In Insurance
To My Partners,
As of December 31, 2016, the partnership was up 23.16% YTD versus 11.96% YTD for the S&P 500.
This represents an outperformance of +11.20% YTD. As we outperformed the S&P 500 by more than
11%, we had a good year in 2016. However, we put little weight into our performance over such short
time periods. Our goal remains the same: we wish to outperform the S&P 500 by at least 2% each year on
an annualized basis over many, many years.
Our performance in 2016 was driven by the steady appreciation of underlying book values of the P&C insurance carriers in our portfolio. Furthermore, market volatility in 2016 provided attractive entry points, allowing us to add to our positions at cheaper valuations. Lastly, with interest rates starting to rise from historic lows, multiple expansion in the P&C insurance sector contributed positively to our performance. One thing to note is that, all drivers of performance aside, such performance was achieved using minimal leverage, reflecting the highly attractive risk/reward proposition of our strategy.
When Interest Rates Rise, Where Do You Want to Be?
Interest rates have started to rise from historical lows. As shown in the chart below, one can see that the recent rise of rates marks a major inflection point. Rates have been on the decline for the past several decades since the early 80s. The reversal of this trend is of enormous significance. Where do you want to be as rates continue to rise from their historic lows?
For us, we want to own the right P&C insurance carriers because of their levered exposure to short- to medium duration bonds. P&C insurance carriers take in investment premiums and invest those premiums with a significant allocation to short- to medium-duration bonds. In other words, P&C insurance carriers make more money when rates rise; they earn more investment income. As long as their underwriting does not suffer while interest rates rise, every incremental basis point that P&C insurance carriers earn in investment income will fall to the bottom line, resulting in higher ROEs. While we look to invest in companies that achieve 10-15% ROEs, it would not be surprising to see these ROEs jump to the 15-20% range in a normalized interest rate environment. The key, however, is to own these companies before rates return to normalized levels based on historical norms. If one waits, then it will be too late because the market will by then have already priced in such higher earnings power.
As you are aware, we have moved our operations to the East Coast. Mark will continue to handle the dayto-day operations whereas I will continue to expand my industry knowledge to scout for companies that we may add to our portfolio. We are happy with our current group of investors. As we are a private fund that can only accept up to 99 investors, we are careful in inviting the right investors. For 2017, we have decided to open up 10 investor slots for newcomers. We look forward to reaching out to you again in our 2017 mid-year letter. In the meantime, feel free to reach us at anytime.
Noh-Joon Choo Managing Partner S&C Messina Capital Management, LLC www.scmessinacapital.com
Appendix Ground Rules
1. Our goal is to outperform the S&P 500 on the basis of annualized total returns, including dividends reinvested, over a period of 5 years. Year-over-year performance is guaranteed to be lumpy and volatile, but over 5 years we aim to compound invested capital at a higher rate than what would have been achieved had such capital been invested in the S&P 500.
2. As an intermediate assessment, every calendar year we will measure the annual total return for an investment in the partnership against the annual total return in the S&P 500. We will call it a “bad” year when we underperform the S&P 500. Conversely, we will call it a “good” year when we outperform the S&P 500. It is an absolute certainty we will have bad years.
3. A minimum of 5 years is the length of time one should use when judging our annualized performance or compound annual growth rate versus that of the S&P 500. If the partnership does not outperform the S&P 500 over a period of more than 5 years, everyone, including myself, should start thinking about other places to put their capital. However, if there is a raging 5-year bull market, outperformance should not be expected.
4. We would much rather outperform in any given year when the S&P 500 has declined, meaning we prefer being down -10% when the market is down -30% rather than being up 30% when the market is up 10%. We look down before looking up, prioritizing downside protection and preservation of capital over the long term.
5. If the S&P 500 is up for the year to a degree approximating its historical averages, we are happy if the partnership achieves a positive return close to this figure. If the S&P 500 has an exceptional year, especially during a frothy, bullish period, we will most likely underperform for the year. The S&P 500 for the previous ten years has achieved an annualized total return of approximately 7% per annum. Historically, this figure has been approximately 10%.
6. We cannot predict whether the stock market is going to go up or down. We cannot predict economic cycles nor changes in the general or global economy. We cannot predict when trading multiples will expand or contract. If you think the ability to predict the aforementioned is critical to a successful investment strategy, you should not join the partnership.
7. We cannot guarantee results for members of the partnership. However, I can promise the following:
- a. Each P&C insurance company owned in the partnership’s portfolio will be selected based on its ability to compound shareholder value (represented by its book value per share and market price per share) over the long term;
- b. The partnership will only pay prices that are fair or discounted with a margin of safety relative to the intrinsic values of its portfolio companies;
- c. The risk of permanent loss of capital (not short-term mark-to-market declines in value) will be minimized by limiting the partnership’s ownership of P&C insurance companies to those:
- i. That have downside protection in the form of underlying book values backed by real, tangible assets (i.e. marketable securities, bonds, stocks and cash) that can be liquidated today at close to 100% of their marked values on the balance sheet;
- ii. That have downside protection in the form of wide, competitive moats defending their ability to compound book value per share over long periods at above-market rates of return;
- iii. That can be purchased at fair intrinsic values or below with a margin of safety, with such intrinsic values being estimated to the best of our ability by conservatively discounting long-term growth in book values per share;
- iv. That we would be comfortable buying in their entirety (i.e. 100% of outstanding stock).
- d. I aim to have almost 100% of my entire net worth invested in the partnership alongside fellow members of the partnership. To further align incentives, “qualified clients,” as defined by our confidential private offering memorandum, may opt to pay a 0% annual management fee coupled with a high water mark and a 25% annual performance fee applied to returns above a 5% hurdle. In other words, we don’t get paid unless the value of your investment is above its high water mark and your investment has increased at least 5% annually.