Rules of Engagement, Odyssey

"A Bubble, said one wise friend, can be depressingly de-professionlizing"

James M. Stone, The Plymouth Rock Company
2001 Annual Letter

I have started reading some P & C annual letters for the past two weeks and have come across some interesting companies. I was indirectly challenged by a top executive from our company who came from headquarters to talk about the year ahead ('08) and the year forgotten ('07). In doing so, he mentioned a couple of interesting industry numbers.

They include:
-In 2006, the P & C industry Combined ratio was the lowest since 1951.
-From 1987-1998, the industry had single digit return on equity ("ROE")

Next, he mentioned more subjective information:
-Today, there is more transparency than ever before with analysts. He said, "I listen to all of our competitors conference calls, and the Q & A session is very much an open forum"
-The metrics used now-a-days to evaluate an insurance company are more comparable then years before because of transparency.
-The number of companies that have gone out of business will always be out there in this industry.

Finally, a prediction:
-"There will be more soft market years than hard market years in the future"

Hearing that, I made a note to really look in depth at more insurance companies from all lines of businesses ("LOB's"). Although I believe the statement to be true in a general sense, I think many of the monoline companies in specific hazard classes across various LOB's will have about even soft market years/hard market years. That's where I am right now with my research, it will be a long process.

I've also heard various media folks wonder out loud if what happened to the mortgage/housing/banks could happen to insurance companies. I'll take a stab at it, my answer is no because insurance pricing is based on more information than the mentioned "crisis mode" companies. I at least have never head of a NINJA (no income/no job) insurance policy every being sold.

Moving on to the Rules of Engagement

Anytime you challenge yourself, as is always the case in investing to make a "pick" for a new year, I try to follow the Rules of Engagement. Sir Buffett two rules include:
1. Don't Lose money, and
2. Don't forget rule number oneO

Following these rules, my 2008 "pick" is Odyssey Re Holdings (ORH). Last week, I stated: "Thus far, the position in question represents a little over 8% of my portfolio of businesses and I hope to increase to 15-20%. It is an insurance company, run by superb management, trading at book value, and offered at a 4% premium to the average price the company has been buying back shares over the past nine months. Management, has been aggressive with their buyback and I will say no more. Well...until next week!"

This past week, I increased the position from 8% of my portfolio of sound businesses to approximately 12%, an increase of 50%, well within reach of the desired 15-20% of portfolio. I think the value of this company is "utterly unknowable" for many reasons.

• The company has sound investment philosophy led by the brilliant Mr. Watsa of Fairfax.
• Their CDS portfolio with a notional value of $5.1 billion dollars and term to maturity of 3.9 years represents a "put option" on the financial contagion. It has increased in value since last quarter, that is a fact.
• As a side note, Mr. Nejad, from the Rational Angle blog had a post on some of the CDS positions. Link to specific post here and link to his blog which I highly recommend here.
• Next, when a company as allocative efficient as Odyssey, with the majority shareholder Fairfax (60%) is buying back shares aggressively, you know they see value in the business. But, when the CFO states at the end of their Q3 conference call, "[And] we certainly believe there's a lot of value in the Odyssey's share at this price." And when the person saying that is not Angelo Mozilo, you believe it. The CC happened on Nov. 2, 2007, the price at the end of closing on Nov. 1st was 36.13, and today is 36.71.
• On the buybacks, some numbers to consider, Through the nine months ending, they have purchased a total of around 2.4 million shares at a cost of approximately 87 million (price average of 36.25). Today's share price is a little over 1.3% above the average price of the buyback. I have reason to believe that if Book Value increased during the current quarter, they will have purchased an additional 20-25 million dollars on buyback.
• They write sound business and it has to make sense.

You could certainly research Odyssey more in depth to put a value on the business and I recommend that you do. Currently, there is a floor price and that happens to be the market price being quoted today. Moreover, I really thought about this "pick" for a while and while considering other possibilities (some sexy), none followed the "Rules of Engagement" as well as Odyssey.

So we'll take the price at the end of closing on December 31, 2007 for Odyssey, 36.71 for our record, and I will update any significant news.

Until next time, Hope everyone had a good 2007 and wish for a better 2008.

Take care,

S.K.