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Strategies & Market Trends : Buffettology -- Ignore unavailable to you. Want to Upgrade?

To: cfimx who wrote (1071)	2/20/1999 6:25:00 PM
From: James Clarke	Read Replies (3) \| Respond to of 4690

Ambac 101 Here's in a nutshell what you need to know about Ambac that is not going to be obvious from the financials. It should be obvious that this is not your average insurance company, but the financials get very messy while the story isn't all that hard. MBI is the other major in the industry, bigger than ABK. When I bought Ambac it traded at a significant discount to MBI for no particular reason. Now it trades at a premium, also for no particular reason. In three years I have doubled my money in Ambac without anything particularly sexy happening. The multiple went from 10 1/2 to 14, and earnings grew at 15% a year. That's all it takes. To understand what it would take for these guys to blow the underwriting in their core business, municipal bonds, just understand what they're doing. Jacksonville, Florida wants to do a muni deal to fund a highway or something. They borrow $300 million, but Jacksonville doesn't have a AAA rating. Ambac does. So Ambac takes a premium to guarantee the timely payment of principal and interest on the bonds. As I understand it, in the muni market, that AAA rating is very desirable, and worth the extra basis points of premium. Now that sounds risky, guaranteeing municipal debt. We have all read about defaults in Orange County and other places. So you have to understand what happens in the event of a default. Ambac would continue to pay the interest to the bondholders. But the borrower has the power to tax, or gets a state or federal bailout or something, then they are on the hook to Ambac for the back interest. It is very difficult to lose money in the long run in this business. Defaults are very rare, and even when they happen, they are temporary. You don't see Ambac writing off much of anything. This is an insurer without losses. As the business is structured today it is a licence to steal. So why isn't everybody entering the business? First you need a AAA credit rating, which is hard to come by. (That's also why the ROE is good but not stellar - Ambac has to keep a lot of capital on its balance sheet to maintain that AAA rating). Second you need the relationships with the underwriters and municipal borrowers. Most important, I think, is that the investors in munis have faith in the underwriting and credit of the current players. If some new entrant came in, it might be difficult for them to attract business, because the whole point is giving investors maximum comfort in the AAA credit risk. The risk to the industry is that they are venturing little by little further outside the core business. Not much, but now you see them underwriting asset backed securitizations and things like that, and you see them in foreign markets. Importantly, the foreign stuff is a JV between Ambac and MBIA, the two biggest players. Probably not a lot of price competition in that game. If there is something about Ambac I worry about, it is these extensions of their franchise business. The true beauty of Ambac is its accounting, perhaps the most conservative you will find. When Ambac guarantees that Jacksonville deal, they get the premium in cash up front. But they book no earnings at that time. They amortize the earnings over the life of the bond. Therefore, GAAP earnings are as close to an annuity as anything you are going to find. Growth comes from booking new business. Theoretically, if Ambac's underwriters took the next year off and booked no new business, earnings would be flat. So if the market really gives a premium to steady and predictable earnings, why is Ambac trading at half the market multiple when it has a low-mid teens growth rate? If mutual funds ever really started to understand Ambac's business, I could easily see this stock selling at a 20+ multiple. (And that is when I'd sell, because that's not what the company is worth.) I am no expert on the insurance industry. But between Berkshire and Ambac, I now have about 25% of my portfolio in insurance. I consider both very special cases. Ambac is not a back-up the truck steal at 53, but if you believe the long term story I think it is a pretty good entry point. I could easily see this stock running to 80 this year. Its a very low maintenance investment, and my best guess is that it is currently worth $57-60 a share, with that valuation growing about 13% year after year. Jim