One of my first lessons in investing came from a physician who lived in the building where I worked as a doorman while in college. The year was 1981 and I was just finishing my sophomore year.
The job didn’t pay much, but it offered plenty of solitude to study during the week. But the weekends were a different story.
Saturdays brought lots of unsolicited advice from the residents — mostly about how to be successful in life. Years later I came to believe those Saturday afternoons were just as valuable as my formal education.
One weekend, a doctor who lived in the building told me to buy stock in Chrysler. He said it was a great stock at its current price of $3 per share. I didn’t know much about investing, so I did my homework.
I quickly learned that most analysts thought the company was heading to liquidation. In fact, just about everything I read told me to avoid the stock at all costs. But the doctor told me they were wrong…
Trusting the doctor, I combined my next paycheck with a small loan from my dad. I bought 100 shares of Chrysler — my entire life’s savings at the time. It was my first stock purchase.
Fast forward to 1983 and the stock was trading at more than $25 a share. My $300 investment had grown to more than $7,500 in just two years. More importantly, I learned that investment professionals often fail to see the “big” picture.
That lesson has stayed with me for more than three decades.
How This Is Relevant Today
Much like Chrysler in 1981, AmTrust Financial Services (Nasdaq: AFSI ) is being clobbered by analysts and investors alike. The property casualty (PC) insurer is down roughly 50% from its February levels.
The reason is clear. The company has been hard hit by a possible accounting scandal that resulted in a restatement. Here’s what happened…
It is alleged that AmTrust’s accountants cut corners in an attempt conceal losses from 2009 to 2012. The company’s auditors (BDO USA) claimed the numbers were legitimate.
But one of BDO’s own employees blew the whistle on both companies. At first, it seemed the whistleblower was correct. Adding a bit of intrigue to a rather boring accounting issue were further allegations of secret recordings of meetings between the major players.
This brought FBI involvement to a fraud investigation worth approximately $300 million. But as details of the investigation become pubic, the story has turned out to be very much ado about nothing.
It turns out the BDO whistleblower was an inexperienced auditor who left the firm soon after making his claims. But more importantly, as soon as AmTrust’s board learned of the allegations, the company took immediate action.
AFSI hired one of the toughest auditing firms in the world (KPMG) and ordered a three-year audit. Last April, KPMG signed off on AmTrust’s most recent annual report, which included a $136 million earnings restatement for the period in question.
Now let’s keep this in perspective. The restatement represents 9% of the company’s earnings during the period. In other words, the relatively small restatement won’t have any material effect on the company’s business going forward.
And because there’s no evidence of any cover-up, the SEC is unlikely to impose a huge fine. Additionally, the FBI says it isn’t actively investigating any financial crimes committed by AmTrust. So, for all intents and purposes, the investigation is dead in the water.
Where Does That Leave AFSI?
The company’s insurance products include worker’s compensation, commercial auto, commercial property coverage, and warranty insurance. The company focuses on small account sizes with low hazards.
Since going public in 2006, the company has expanded to 125 offices in 70 countries with nearly $8 billion in annual premiums. Last year, AFSI generated 81% of its gross premiums in the United States, but has expansion plans for Europe and Southeast Asia. This will help mitigate geographic risk.
Since 2012, the company has maintained a loss ratio in the 0.65 to 0.67 range. When paired with its expense ratio of around 0.25, the company’s combined ratio is a healthy 0.90 to 0.93. A combined ratio below 1.00 indicates an underwriting profit.
Its gross premiums have increased from $526 million in 2006, to $7.95 billion in 2016. In that time, premiums have grown by 31% each year, on average. Much of this growth comes from an aggressive acquisition strategy. Since its founding in 1998, AmTrust has acquired more than 40 companies.
From 2006-2016, AFSI’s book value per share increased by 19.4% each year on average, as illustrated in the graph below.
The company’s investment income remains strong, too. From 2011 to 2016, investment income grew at a 30% compound annual growth rate ( CAGR ). Year-over-year (YOY) investment results were an impressive 28%.
Investment income added to the company’s underwriting profit was a key reason the company raised its dividend by 13% in 2016. The stock now yields 4.6% with a payout ratio of just 38%.
A Hard-To-Find Value
Since the news of the company’s bookkeeping woes broke, the AFSI’s value has been sliced in half. The stock currently trades at a trailing P/E of just 8.7. On a forward basis, it’s even cheaper at 6.8. But unlike Chrysler in 1981, AFSI doesn’t deserve the punishment meted out by Wall Street.
Analysts were wrong in 1981, and they’re wrong in 2017, too.
Risks To Consider: While it appears that the company’s accounting issues are not as serious as once believed, it is possible the company’s renewal business could suffer as its customers fear that the company may be impaired for future claims. Additionally, the company still faces civil liabilities for its past accounting practices.
Action To Take: Buy AFSI up to $15.50/share. Mitigate your risk by applying no more than 2% of your portfolio to AFSI. Use a 35% trailing stop loss to provide enough room for the stock to move until the EC investigation is complete. Tighten the stop to 15% once the SEC ends its review.