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Year-to-date through September 10th, our proprietary index of the five largest U.S.-based title insurance companies has lost –1.0% compared with a gain of +2.3 % for the S&P 500. Last year, our title insurance index gained +53.7%, handily outperforming the S&P, which delivered a +28.7% gain. Note: Because there is no decent index that tracks the performance of the title insurance group, my staff and I decided to create our own. This helped us get a better sense for the industry's recent performance. Our proprietary index includes five of the nation's top pure-play title insurance firms -- Fidelity National (FNF), First American (FAF), Stewart Information (STC), LandAmerica (LFG) and Old Republic (ORI). Each firm carried an equal weight in the index. The Business If you’re like most lenders and buyers, then this scenario is very frightening. That’s precisely why almost all real estate transactions in the U.S. (and in most developed countries) involve title insurance. Title insurance companies look for what’s known as title defects on real estate properties. Title defects include items such as unpaid real estate taxes, unpaid bills from contractors and outstanding loans collateralized by the property. Once a title insurance company is satisfied that a particular title deed is unencumbered by such defects, they will then issue a title insurance policy. This type of policy this protects both the buyer and the mortgage lender from liability if any title defects are uncovered in the future. Most title insurance policies also protect the buyer and lender against fraud by the seller. In other words, if the seller tries to hide certain defects when the sale is completed, then the insurance firm will cover the damages. Of course, the title insurance company charges a fee for underwriting the insurance policy. Interest Rate Woes And there’s a good historical reason investors take a dim view of title insurance when interest rates rise. Interest rate hikes in the early 1990s and again in 1994 prompted significant declines in real estate transaction activity. In both periods, the title insurance business got hit hard; in 1990 and 1991 and again in 1994 and 1995, the title business as a whole lost money. However, this is a highly oversimplified view of the title insurance industry. The best in the business today are capable of maintaining solid profitability even if the red-hot housing market starts to cool and rates begin to inch higher. Let’s consider a few of the big, positive developments in the industry since the mid-1990s: Consolidation There are still around 65 title insurers in the U.S., down from around 85 twenty years ago. The reason for the shrinkage: a combination of mergers between profitable firms and failures at some of the weaker competitors. Although the overall number of insurers may have dwindled only slightly, there are far fewer dominant players today than there were even ten years ago. A small handful of big players in the group, formed mostly by recent mergers, now control the lion’s share of the market. That would include the 1999 mega-merger between Fidelity National Financial (FNF) and Chicago Title, a deal worth about $3.4 billion at the time. These larger, merged firms have done a lot to boost efficiency. Not only did the industry undertake massive staff cutbacks in the mid-1990s, but it also spent big on technology to automate clerical functions. The offshoot of all this consolidation: more efficient companies with better pricing power. New Business Lines Like title insurance, most U.S. lenders require appraisal services as part of each and every property transaction. Lenders simply need to know how much a piece of property is worth before loaning money collateralized by that real estate. Title insurers have found this business line to be a relatively easy fit. After all, with every transaction insured, the insurers add to their database of property information. This allows them to keep detailed records of property valuations in particular regions. The story is much the same when it comes to the credit reporting market. Many companies in the title insurance business have collected vast databases of information on consumers--information that’s extremely useful for lenders. Some companies, like First American Corp. (FAF), have carved out particularly profitable niches in the credit reporting business. The fastest growing market for credit in recent years has been in sub-prime lending, essentially lending to borrowers with less-than-perfect credit. This is a profitable business for banks because they can charge much higher interest rates to such customers. However, it’s also risky--sub-prime credit carries a much higher-than-average risk of default. That puts a real premium on the value of quality credit information that can help determine if a particular borrower is a reasonable risk or a bad loan in the making. First American is a leader providing detailed information and credit analysis to lenders. Because most other major credit agencies don’t have access to information on such borrowers, the company stands nearly alone in this profitable niche market. While First American has focused on providing sub-prime credit information, other title insurance companies have specialized in loan servicing. Fidelity National Financial, for example, has expanded into outsourcing. The company will, for example, take on back office operations--such as payment processing and escrow services--from banks on an outsourcing basis. That can help smaller financial institutions cut costs while allowing more focus on new loan origination. Meanwhile, PMI Group (PMI) has been strong in software development. The company sells a model that helps predict default risks for consumers with different credit histories. This critical information helps banks price their loans more effectively. All of these various business lines are related to the lending market in one way or another, and they provide a measure of diversification out of the more cyclical title insurance business. Technology Changes However, that wasn’t always the case with smaller towns and counties. In these areas property records were often held in paper form--this meant hours of labor-intensive work before the validity of a certain title could be established. That clearly added to the cost of doing business. The good news for title insurance firms is that this situation is rapidly changing. As more and more of the country’s records become digitized, title insurers have been able to perform more of their searches electronically. This technological improvement has led to a direct decline in the total cost of doing business. Valuable Databases To develop a database that contains such records for millions of consumers and real estate transactions is by no means an easy task. The benefit here is that it’s very difficult for a new competitor to break into the business--the cost of gathering all this data is prohibitively high. The result: most title insurers have an extremely wide economic moat. Long-Term Housing Trends In the Industry Spotlight section of our August 24th Market Advisor issue, my staff and I took a detailed look at a number of positive demographic trends in the housing market. The biggest trend of all will be the retirement of the enormous 70 million strong Baby Boomer generation over the next 20 years. As the Baby Boomers retire, their housing needs will change--but not necessarily for the worse. U.S. Census Bureau data suggests that modern retirees are better off financially than ever before. As such, it’s likely that Boomers will continue to demand high quality housing. Immigration also remains a big positive for the housing market. Statistics from the Census Bureau suggest that immigrants wait 10 to 15 years before buying a house in the U.S. The 90’s brought a huge immigration boom; look for these new immigrants to start buying houses in earnest over the next few years. Housing Affordability In addition, the actual level of interest rates isn't the only thing that affects housing demand. It's also important to examine the percentage of an average American’s disposable income that is consumed by mortgage interest. This statistic is known as the debt-service ratio (DSR). Currently, the DSR in the U.S. stands at just 9.5%, around the same level as in the mid 1980s. Although the housing market might slow somewhat going forward, as a result of these and other factors, we do not believe that a big housing bust is on the horizon. Valuations and Demand The other good news for investors is that when it comes to title insurance stocks, Wall Street has already more than priced in an expected slowdown for the business over the next few years. The average PEG (P/E-to-growth) ratio for stocks in the sector is now around 0.7--and that's using a very conservative estimate of growth over the next five years. Remember: Stocks with PEG ratios below 1.0 usually represent compelling values. Therefore, the title insurance business now appears to be a great value play. --------------------------------- Featured Title Insurance
Pick: Stewart Information Services (STC) Revenue Mix The company has also worked to build up scale via acquisitions. So far in 2004 Stewart has already completed three acquisitions--one in New York, one in Colorado and another in Missouri. Stewart isn’t over-stretching to make these buys though--the company has no net debt and a cash pile of well north of $100 million (that’s over $6 per share for a company that is trading at around $38). And as my staff and I outlined above, consolidation in the title insurance industry has led to significant efficiency gains--Stewart is expanding and gaining critical mass. The company's domestic title insurance business isn't the only unit that has posted strong results in recent years. Stewart also boasts a sizeable international business with offices in 30 countries around the world. That includes some particularly fast-growing emerging markets like the Slovak Republic, Poland and Mexico. In fact, in late August Stewart authorized the first commercial title insurance guaranty ever in the Slovak Republic--a guaranty on a transaction worth about $120 million. This is a small development when considered alone, but it certainly reveals a future growth arena for Stewart. In emerging economies around the world, and particularly those in the expanding European Union (EU), real estate markets are in an early phase of growth. Consumers and businesses alike in these countries are just starting to gain access to lending products like mortgages. As the credit cycle heats up in these nations, you can expect strong growth. And the good news for investors is that Stewart has a presence in some of the world's most promising international markets. In addition to title insurance, Stewart handles other documents as part of its real estate information segment. That includes transmitting credit reports, flood certificates and appraisal estimates to lenders prior to closing. The company also reports the necessary real estate transaction and tax information to local government officials. Like some of its larger competitors, Stewart also offers lending services directly to banks and mortgage firms. This can include simple document processing and paperwork filing or more complex services like temporary staffing to help with mortgage originations. The company also markets a software suite to lenders that helps sellers, buyers and real estate agents communicate information electronically during the real estate closing process. It’s important to emphasize that Stewart isn’t just a player in the residential market. The company has also been aggressively expanding into the commercial real estate transaction business. That’s not only a higher-margin business, but it's also less sensitive than residential to every twist and turn in interest rates. Financials and Valuation
No matter which valuation metric you care to examine, this makes Stewart an extremely cheap stock. Take, for example, free cash flow. Over the trailing 12-month period, Stewart generated about $160 million in free cash flow, equating to a free cash flow yield (free cash flow/ market capitalization) of about 23%. At this rate, the company will generate enough cash to buy back all of its outstanding shares of stock every four years! In reality, management will likely reinvest most of this cash back into the firm's business. In addition, some of this cash may end up getting paid to shareholders as dividends--there’s plenty of room for the company to boost its 1.2% dividend yield. On the financial front, analysts now expect Stewart to post earnings per share (EPS) of around $4.25 this year--a number that’s up from about $3.60 two months ago. That gives STC a forward P/E multiple of about 9. And with a projected long-term growth rate of about 8%, the stock sports a very reasonable PEG of slightly over 1. We believe this under valuation is a symptom of the massive overreaction to recent interest rate hikes by the Fed. As a result, investors now have an outstanding opportunity to purchase shares of Stewart Information Services at bargain-basement prices. My staff and I have decided to add STC to our "Watch List" as a possible candidate for future inclusion into our Value Portfolio. We'll bring you further information on the stock in the coming weeks if and when we ultimately decide to add the shares to our holdings.
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