Historical note: WEB adjusted net income to include 25% of the increase in the unearned premium reserve. This is based on a rule of thumb suggested by Mr Graham to deal with a distortion in GAAP which applied at that time – see pages 107-109 of Graham & Dodd (3rd edition). Whilst not directly addressed by the authors, this rule of thumb becomes material where gross written premium increases fast and, logically, it ought to be applied in reverse when gross written premium falls.

The distortion is not as important these days, because acquisition costs tend to be spread rather than expensed up-front. I won’t try to elaborate on that, but take a look at the above referenced passage in Graham & Dood.

Anyway, it looks like WEB was able to estimate PE at less than 2x (with the above adjustment), even though, based on GAAP earnings, the PE would have appeared to be a lot higher. In other words, he found a bargain in plain sight, just by understanding better than others the economics of the business and the shortcomings of the relevant accounting practices.

Cheers.

this will work perfect

Thanks

Western Insurance Securities, an historically profitable company, was selling at less than two times earnings and at less than half of asset value. It isn’t possible to find opportunities like this anymore. A short history lesson on stock valuation might tell us why.

Prior to the late 1920s, stock prices approximated asset values. By 1929, however, primary emphasis had switched to earning power, and asset values were essentially ignored. (Investors as a whole bought the idea that future performance could differ so much from past performance that asset values were irrelevant.) This logic led to severe overvaluations and equally severe subsequent declines.

By 1933, many issues (I think 20% of the Moody’s manual) were selling below liquidation value. Ben Graham wrote a prophetic article around this time titled “Is American Business Worth More Dead Than Alive?”. He and his colleague, Jerome Newman, bought stocks selling for less than their net working capital and liquidated most of the companies. The strategy worked very well, and it firmly established the margin of safety, buy-at-a-discount philosophy. Obviously the success of this approach has diminished because many people practice it.

“My history with Amex’s IDS unit, which today contributes about a third of the earnings of the company, goes back even further. I first purchased stock in IDS in 1953 when it was growing rapidly
and selling at a price-earnings ratio of only 3. (There was a lot of low-hanging fruit in those days.) I even produced a long report – do I ever write a short one? – on the company that I sold for $1 through an ad in the Wall Street Journal.”

It doesn’t seem that the report was on IDS. However when I return to school in September, I will check my sources.