What to do? One simple response is to say, 'raise the risk premium within your required rate of return'. That’s a way of saying that, since all valuation formulae have an interest rate lurking in the background, raising the risk component of that interest rate will help compensate for uncertainty by driving down estimated value. Instead of capitalising a stream of profits at, say, a 10 per cent rate, use 12 per cent and drive down estimated value by 17 per cent, giving a wider margin for safety.
That’s fine as far as it goes, which is not that far when choosing the discount rate is often the least of the difficulties. The snag is that where a company is changing fast – especially if it’s shuffling its activities by quick-fire acquisitions and disposals – then it can be a struggle to come up with trading data to plug into valuation formulae that look even halfway credible.
Take insurance-industry services provider Randall & Quilter (RQIH), which announced results for 2018 this week that bore little relations to 2017’s. For example, gross premiums were stable at £183m (£188m), but net premiums were 56 per cent lower at £65m; pre-tax profits from continuing operations were 45 per cent up at £14.3m, but net profits from all operations were 66 per cent lower at £7.8m; meanwhile, cash flow from operating activities swung from a £26m inflow in 2017 to a £37m outflow.
The reason for these gyrations is that Randall & Quilter, whose shares have been quoted since 2007, has reinvented itself. From being a diversified provider of services in non-life insurance, it now focuses on just two activities – run-off insurance (buying job lots of insurance policies in discontinued lines from which it ekes out profits), and so-called ‘program management’.
The latter capitalises on the growing importance of managing general agents (MGAs). In the insurance industry trail between sellers of risk (the clients) and the ultimate buyers (the insurers), MGAs are sort of super brokers, whose expertise – often in niche lines – is such that insurers authorise them to underwrite risks. In turn, MGAs increasingly pass the risk to the likes of Randall & Quilter’s program management business, which does further bundling of policies and shuffles the risk to reinsurers (although Randall & Quilter may keep a little underwriting for itself).
As the insurance industry splinters and specialises ever more, program management has been growing fast. Hence Randall & Quilter’s enthusiasm to apply well-proven skills, acquired when it managed Lloyd’s syndicates way back when, in this newish area. Its bosses are pleased that the program management arm has already secured 30 contracts, which should generate gross premiums of $500m (£380m) a year. Further contracts adding another $200m of annual premiums are in the pipeline.
Yet program management comes with two drawbacks. First, although ultimately it’s a commission business, it requires capital upfront. Partly for that reason, in February Randall & Quilter had a fat share placing – effectively, one new for two existing shares – which raised £103m. True, the issue may have been in a good cause and existing shareholders had waived their pre-emption rights; even so, it can’t have been much fun for them to find their interests had been diluted by a third over night.
Second, program management may be little different from so many other variations on insurance – it will be a boom-and-bust activity, much dependent on the availability of capital. Currently – while the going looks good – capital is galloping into program management start-ups, much of it coming from private equity in search of yield. Randall & Quilter says that start-ups won’t have its experience or its authorisation to write a comprehensive range of business in both the US and Europe. Quite likely true; even so, excess capital drives down returns whenever it invades insurance.
Still, buying legacy insurance portfolios for run-off also offers growth opportunities, as witnessed by Randall & Quilter’s $80m acquisition of Global Re, a US reinsurer, from Axa, which will complete shortly.
Nevertheless, all this change means that coming up with forecasts that have continuity with the past becomes guesswork, and not even very glorified. Sure, as commission comes through from business written in program management then it is feasible to imagine Randall & Quilter’s revenues and profits rising smartly. Set against that, however, profits must now be distributed across an extra 50 per cent of shares in issue, which – at the very least – is likely to keep Randall & Quilter’s distribution stable (technically, it doesn’t pay dividends).
For these reasons – and the near certainty of more acquisitions and share issues to come – I see its shares as the riskiest holding in the Bearbull Income portfolio. My worry is that Randall & Quilter may be another Charles Taylor (CTR) in the making. Taylor occupies a similar space in the insurance industry, looks great on paper but has consistently failed to deliver.
Sure, I can live with the risks for the time being. But the absence of the solid data from which to build a plausible estimate of value means Randall & Quilter’s share price does not have anything grounded to relate to. Often, that’s how it is in the investment game, but it does mean setting stop-loss levels tighter.