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Investing in small and micro cap value stocks with Matt Miller of Chanticleer Holdings

Update: This post was included in the Carnival of Personal Finance #272 - The Yogi Berra Edition, the Carnival of Wealth #2 and the The Wealth Builder Carnival #5

Biography: Matt Miller joined Chanticleer Holdings, Inc. in 2005 when the company began operations.  He helped launch Chanticleer Investors II, a value oriented fund, on January 1st 2007 and has served as co-portfolio manager of that entity since its inception.

Chanticleer Holdings specializes in investing in small and micro-cap value stocks that exhibit predictable future returns/cash flows, a margin of safety, strong future business prospects and reputable management.

Why small caps?

Chanticleer Holdings takes it cue from multiple studies that have demonstrated the outperformance of small company stocks versus those of larger company stocks. While this outperformance may only be by 2 or 3 percent per year, this can make a material difference in the total value of a portfolio when compounded over a long period of time. The firm believes that there exist a number of factors for the outperformance of small cap stocks, namely: less analyst coverage, less competition form other investors (especially institutions), lack of abundant information, smaller companies have more room to grow and can be more flexible in managing their business, smaller companies are more likely to be acquired and small and micro-cap companies generally have a higher level of insider ownership. By willing to put in the time, effort and research to uncover these undiscovered gems, Chanticleer Holdings is setting itself up to make big profits for its investors.

Q: Mr. Miller can you tell us a little bit about Eastern Insurance Holdings, Inc. (EIHI), what it does, where it does etc.?

Eastern Insurance Holdings Price Chart - Courtesy StockCharts.com

A: Eastern Insurance Holdings, Inc. is a $100 million market cap insurance company headquartered in Lancaster, PA that focuses primarily on workers compensation coverage.  Earlier this year it sold its group benefits business and the company is contemplating strategic moves with its specialty reinsurance operation.  The company’s focus is on what I would call lower risk workers comp lines in mostly non-urban settings.  By lower risk I mean that the company tends to stay away from lines where the potential for catastrophic injury is more prevalent, like saw mills for instance.  The specialty reinsurance business, which reinsured underground storage tanks, is in run-off and so no new policies are being written.  Unfortunately, this line of business has created a bit of a black eye for Eastern, as over the last few years the company has had to add significantly to its reserves for this segment.  In the recently released second quarter we saw some additional adverse development of those reserves.

Q: Can you talk a bit about the sector and its outlook going forward? How much is this an “industry pick” as opposed to a pure bottom-up pick?

A: We really focus on the individual circumstances of particular businesses.  Now this is not to say that we ignore what is happening in an industry, but our thesis with Eastern is quite specific to Eastern.  We believe, as has been shown with the recent sale of the group benefits business, that Eastern is in the process of becoming a “pure-play” workers compensation company.  When that transformation is complete, we believe the strength of that business will be quite clear.

With all that said, as someone who looks at a number of insurance companies, I do think the industry is at least fairly attractive given the number of companies trading at fairly large discounts to tangible book value.  There are of course head winds given current pricing and macro concerns, but in a number of situations it is my opinion that investors are being more than adequately compensated for those concerns.

Q: How is Eastern Insurance Holdings positioned versus its competitors in terms of market share, margins, competitive advantages etc.?

A: Eastern, which began its corporate career in Pennsylvania, is a top 10 writer of workers compensation in that state.  Back in 2008 the company acquired an underwriter of workers compensation in Indiana that is a top 20 writer in that state.  In terms of these rankings I am referring to their premiums written, but what I think is actually more interesting from our investment thesis perspective is the view from a loss ratio perspective.  Eastern, both in Indiana and Pennsylvania, is consistently among the top two or three most profitable companies on this metric.

Eastern has more recently moved further south with an office in North Carolina and an office in Tennessee.  In those newer markets and some additional states, the company currently has a much smaller presence.

I would say it is really tough to have significant competitive advantages in the insurance business, generally speaking.  Now certainly the company does a number of things right, but at the end of the day price is a pretty big factor.  Eastern really takes the approach of partnering with their insureds and to really try and collectively reduce a company’s loss experience over time.  This obviously helps the company from a profit perspective, but also helps to develop a better risk profile for the insured over time which in turn can reduce what they would expect to pay in the future.

Q: According to Google Finance, Eastern Insurance Holdings has a P/E of 10.24 and a dividend yield of 2.4% at a price of $11.48/sh. What exactly does Chanticleer value EIHI at? Do you have an NAV (or what is the appropriate valuation metric used by Chanticleer to value EIHI)? How does the valuation of Eastern Insurance Holdings compare to its peers?

A: The stock has recently traded down into the mid-to-low $10 range and so the stock is currently yielding a bit more.  We actually began buying shares in the low $8 range and bought more in the mid $10 range after the sale of the group benefits business.

Currently, diluted tangible book value per share, which I know is a mouthful, is $15.95.  We generally start at that figure and apply a discount or premium depending on the business.  In this instance, we actually think around $16 per share is the low end of what we think the stock is currently worth, which incidentally is nearly 60% above the current price.  As the company becomes a pure play workers compensation company and the strength, and by strength I mean profitability and return on equity, of that business begins to show, I think the market will recognize that with a premium to tangible book value per share.  Given the current soft market in a number of insurance lines and the softness in the employment picture, I’m not sure a multiple of 1.2 to 1.4 times tangible book value is immediately on the horizon, but it is surely not out of the question over the next three to five years.  Given the growth prospects of the business and current share repurchases, we suspect that tangible book value could be in the mid to upper $20’s in three to five years.  A multiple of 1.2 to 1.4 times gives you a range of $30 to $42 in that period of time, which I think is an interesting return possibility given our views of the downside.

Q: What is the current consensus sentiment on Eastern Insurance Holdings, and how does your view differ?

A: Generally speaking expectations are not all that rosy. I think there are maybe three analysts following the company, each with varying degrees of support for the company.  The general range of “price targets” is not all that different from the range the stock has been in over the last year.  Our view is different in that we see limited downside and real upside as the company executes on becoming a pure-play workers compensation company.  I would bet that the general consensus just doesn’t see a clear catalyst for the industry and this name in particular to be revalued at close to tangible book value per share.  We are willing to make the bet that that happens over the course of our holding period.  Also, I don’t think enough credit is given to the excess capital of the company and the share repurchases which I think are generating great value at these prices.

Q: According to Chanticleer, how has management at Eastern Insurance Holdings performed thus far? Have they delivered on their promises? What is it about the management that Chanticleer likes and dislikes?

A: We think management hast done a great job over the last few years, notwithstanding the problems of the specialty reinsurance business.  To begin with and go back further, the soon to be retired CEO, Bruce Eckert was one of the founders of the business which grew into an extremely profitable top 10 Pennsylvania writer in approximately ten years.  That is quite an accomplishment in our opinion.  The current strategy to focus on workers compensation is a good one we believe and one area where the company has started to deliver on their intentions.  We think management has done a fine job stewarding the company’s balance sheet through the most recent financial turmoil and as I mentioned, we also are quite impressed by the buyback the company is currently in the process of executing.  At these prices we think that adds tremendous value.  We might like the company to be a bit more aggressive with it, but that is merely a matter of degree.  We appreciate that Eastern is focused on underwriting business profitably in workers compensation, as their results clearly show and we like that the company focuses on important metrics like returns on equity and diluted tangible book value per share.

Q: What catalysts do you see that could move Eastern Insurance Holdings?

I think one thing that could prove to be a catalyst is some transaction involving the specialty reinsurance business.  The difficulties of this run-off operation came to the fore again this last quarter and so clearing that up would be an important step for the company.  It would allow it to remove some of the uncertainty regarding that business and it would allow the company to deploy that capital into value creating initiatives like expanding their workers compensation foot print and buying back more shares.  Fortunately, while we are waiting for all this to play out we are being paid a bit under 3% at current prices from the dividend.

Question: Lastly, what are some potential risks associated with Eastern Insurance Holdings that could hamper Chanticleer’s investment thesis?

A: The big risks here are really two-fold.  The first is most definitely the specialty reinsurance business.  If this business could not be sold or disposed of on reasonable terms or if it became a source of consistent significant reserve strengthening that would hamper book value growth.  The other big risk is that as the company expands its workers compensation business it takes on poor, inappropriately priced business in those new markets.

Thank You, Mr. Miller!

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