White Mountains Insurance — a Baby Berkshire or Something Else?

White Mountains Insurance (NYSE: WTM) has a lot in common with Warren Buffett-led Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B). The company’s insurance-based businesses have fueled the company’s investment portfolio, to name the key similarity. However, there are some big differences investors should be aware of before adding White Mountains to their portfolios.

A full transcript follows the video.

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This video was recorded on June 18, 2018.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It’s Monday, June 18th, and we’re doing an episode about a company called White Mountains Insurance. For listeners, that’s ticker symbol WTM.

Thanks to a listener for pointing out the company and asking for us to talk about it. I will include in here my typical plug: listeners, if you have a stock that you’re interested in in any of the sectors that we cover and you want us to talk about it, email us, tweet us, send us a letter if you want to. [laughs] Really anything is appreciated. We are very happy to dedicate whole episodes to stocks or industries or questions that listeners have because it’s a cool opportunity for us to examine something that maybe we wouldn’t have thought about otherwise. So, thanks to a listener, we’re going to be talking about White Mountains. Again, that’s ticker symbol WTM in particular.

But, of course, first, we’re going to start talking about insurance more generally, then we’ll be talking about two of our favorite insurance companies, Markel (NYSE: MKL) and Berkshire, and comparing them a little bit to White Mountains and understanding the interplay between those different investments, and how we tend to approach investing in this particular area of the market.

With all that said, insurance at its core is a pretty simple business. Personally, I think I’m a pretty good driver. I don’t get in car accidents very often. When they do happen, I don’t want to be on the hook for that expensive paint job and for fixing up my bumper. Insurers take the opposite end of that equation, taking on the risk in exchange for premiums that folks like you and me pay them. Insurers make money one of two ways: underwriting profits and investing income. Let’s talk about that a little bit, Matt.

Matt Frankel: Sure. First of all, I want to piggyback on what Michael said and thank the listener for suggesting White Mountains. It’s a stock I used to follow, up until about ten years ago, because it used to be in Warren Buffett’s portfolio, which we’ll probably mention a little bit later, too.

Douglass: Probably five or ten times. [laughs]

Frankel: [laughs] Probably five or ten times, especially when we start talking about Berkshire. But, this is kind of what you were talking about. It gives us a great opportunity to talk about a stock that might have fallen off of our radar, or we just otherwise wouldn’t have gotten a deep dive into, so, thank you!

Going back to how insurance companies make money, there are two main revenue streams. First is collecting premiums and making what’s called an underwriting profit. That is that the amount of money that’s coming in as premiums is greater than the amount of money being paid out for claims. Responsible insurers or well-run insurers, you want to look for a positive underwriting profit consistently. It’s not going to happen all the time, especially if there’s a major natural disaster that happens during a quarter, you might see a negative underwriting profit. But generally, that’s what you want to look for.

The other is investment income. This is really how insurers, especially the ones that we love, make a lot of their money. The beauty of the insurance business is that you’re getting billions of dollars paid in premiums, and there’s a time period between when those premiums come in and when you have to pay out claims to policyholders. Insurance companies can invest that money in the meantime while they’re waiting to pay out claims, and essentially keep all the profits they make on the investments. So, underwriting profits is one area, and investment profit is the other one. And insurance companies have very different ways that they make investment profits, which we’re about to get into.

Douglass: Yeah, there’s a lot to unpack there. But, generally speaking, think of it as these two buckets. The real big question with insurers, and one of the things that really makes Markel and Berkshire different from a lot of other insurers, is what they then do with, hopefully, an underwriting profit, but at least with the float, that is, the premiums that have been paid that they haven’t yet had to pay out for losses or damage, whatever happens, that they’re then able to invest. That’s one of the key things in insurance. You’ve got to have a good capital allocator that invests exceptionally well if you’re going to really do well as a company.

With that in mind, let’s turn to White Mountains specifically. Interestingly, White Mountains used to be more of an insurance business. They had about $28 billion in assets under management. But now, what they’ve really done is slimmed down the insurance side so they can really focus in on the investing side, more specifically operating different businesses.

If you think about, insurers tend to invest in other companies one of three ways: one of them is fixed income, one of them is equities, and the third is actually owning outright other operating businesses. White Mountains certainly has some fixed income and has some equity, but they’re also putting a lot of focus on owning other businesses outright. Again, if that sounds like Markel and Berkshire, well, it’s because it is. It’s similar to what they do, but at a much smaller scale.

What’s interesting is that White Mountains has also really slimmed down their exposure to actual insurance underwriting risk so that they can focus in on those businesses. That’s a really big difference.

Frankel: A lot of the other insurers that focus on these kind of out of the box investments, like Berkshire and Markel, like we’re about to talk about, are still focused on insurance, largely. Berkshire has Geico and a massive reinsurance operation.

White Mountains is not focused on insurance anymore. They’re focused on other operating businesses. It’s kind of like, they use the insurance money to build up these operating businesses, then sold their insurance businesses for the most part. They have a small insurance operation left. Then, they’re kind of just relying on their operating businesses going forward.

Douglass: Yeah. It’s almost like they’ve just taken the conglomerate part of it and siphoned that off, and are continuing with that. With that in mind, then, let’s cover the major businesses they own in whole or in part. The first one, of course, HD Global, which is that still-core insurance company. It includes both Build America Mutual, or BAM, for short, and HG Re, which does reinsurance for BAM.

Frankel: I love that the company is called BAM. [laughs]

Douglass: [laughs] Never going to get tired of saying that, yeah.

Frankel: Essentially, what BAM does is provide reinsurance for municipal bonds. When municipalities issue bonds to cover, say, essential projects — that’s one of White Mountains’ big focuses, essential project bonds — there’s risk to them. So, they lay off a little bit of that risk to White Mountains’ HD Global or BAM division.

Douglass: Yeah. When you look at BAM, they have about 55% of the transaction market share as of the end of Q1 2018, but they’re only at about 16% of the total addressable market. That implies lots of room to grow. Of course, at the same time, their market share has actually been falling from about 20% year-ended 2015. That’s not exactly the trajectory you generally want to see, and I think that’s a concern.

Looking at the business itself, I’m not really that excited about HG Global. It seems like a pretty sleepy business. They’re in munies, but it’s not any American territory or really any place outside of American states. It’s not a market that I’m really that personally excited about.

Frankel: From my point of view, it seems like a reasonably strong business financially. It’s just not that exciting. It’s also worth mentioning that, as interest rates are rising, a lot of municipalities will issue fewer and fewer bonds, which can shrink this market. You mentioned that they have a 16% market share right now, but if that market becomes half the size, then investors aren’t going to be very happy.

Douglass: Right. Turning to another of their insurance-focused businesses, let’s talk about PassportCard and DavidShield. You may have heard of PassportCard and DavidShield, perhaps. PassportCard is for travel medical insurance, and DavidShield is for expats medical insurance.

My wife works in the travel industry and we love to travel. We have not personally worked with PassportCard or DavidShield, but we’re familiar with some of the issues. You go to a foreign country, you break your leg. Things happen, right? The problem is that, with a lot of travel medical insurance, it can be a pretty painful process. You go to the hospital, you pay out of pocket, you’re hoping to get a reimbursement two, three months down the road. That’s not really a fun experience.

What they’ve done with PassportCard is, they load the card with the copay. You give that to the hospital, they take their cut, and then everything else has already been pre-negotiated, as long as you work within their network. Then, you don’t have to do that reimbursement later. There’s nothing more out of pocket for you. Which, if you’re traveling on a budget, a really attractive thing.

Also, I have to say, it’s a really interesting business with a lot of growth potential. They’re annualizing it just over $100 million in premium. They’re still pretty small. A majority of the business is in Israel. They just expanded to Australia. They’re planning to expand to Canada, Great Britain, Germany in the near future. They’re a small fish in a $20 billion market, and they grew over 30% last year.

Their model, as well — and this is something that you’ll see a lot with White Mountains’ work across the board — they’re mostly fees and pass-through to insurers. They’re not retaining any risk. What they’re doing is just getting fees and commission from the actual insurance carriers who are underwriting these policies.

Frankel: Yeah. This business definitely has a lot of potential over the long run. Like you said, it’s a pretty small piece of the pie right now. But, as you said, they’re planning to expand into a few countries going forward. The fact that it’s fee income takes the risk out, but it makes for a less exciting business than if they were actually the insurer themselves here. It’s definitely a high-potential business, and I’m curious to see where this goes over the next five, ten, 20 years.

Douglass: Yes. Travel in general is a really interesting space. Another insurance-adjacent business that they have is NSM Insurance Group. This one is … it’s a little weird. [laughs] They operate in 19 very different niche industries. We’re talking brewery and winery insurance, private and charter school insurance, pet insurance, addiction treatment centers, just to name a few. These are really inefficient, small, niche markets, so there’s probably some nice opportunity for them.

What NSM Insurance is doing is, it’s another commission business, so they’re passing on this business to other insurance underwriters who are putting up the capital, and what they’re just doing is collecting a fee, basically, for sourcing and structuring this business in a way that other insurance carriers can work with.

Frankel: I would prefer if they were the insurer themselves here, because this is a pretty lucrative business model, when you do it correctly. A lot of these, like you said, pet insurance, school insurance, brewery and winery insurance, these are things that a lot of risk assessors don’t know how to assess the risk on. So, it could be a very lucrative market, especially if you’re one of the only companies writing policies in a certain niche.

I would prefer that they were the insurer, but it’s definitely an interesting business. It’s a business, like I mentioned, where a lot of these niches don’t really have much competition. That’s definitely a big competitive advantage. But like I said, I’d prefer if they were they insurer themselves.

Douglass: One of my other concerns here is, what’s to stop an insurer from just cutting them out? With PassportCard and DavidShield, they’ve created a process flow that makes things easier, that can enable an insurer to focus on offering the insurance, and them to focus on the customer service. Those of you who have dealt with insurers know that customer service tends not to be a strong point. [laughs] So, that actually makes sense, as them being an intermediary and taking a cut.

But with this, it’s really helping source business. You would think that those insurers, once they’ve had enough time to build up a book of business and get used to certain things, and say, “OK, here’s what the loss ratio is going to look like,” it’s not very clear to me what would prevent another insurer from saying, “NSM Insurance Group, it’s been great. We’ve spent the last five years really learning from you. Now we’re going to insure breweries and wineries ourselves and take you out as the middleman so that we can offer a more competitive product.”

Frankel: And another reason it would be great if they were the actual insurer.

Douglass: Yeah. This one is just kind of odd to me, particularly because they have plenty of capital. We’ll get to that, I’m sure, a bit more.

Let’s turn to another insurance-adjacent business. Are you seeing a trend yet? A lot of insurance-adjacent businesses. One of their other really big ones is called MediaAlpha. This is a company that specializes in what’s called vertical search. Consumers in certain areas — think folks looking to buy a plane ticket or purchase insurance or rent a car — start entering in some very specific data in very specific websites that are designed to facilitate transactions — think an Expedia or a KAYAK, for example. Basically, by entering in that information — like travel dates, city of origin, city they’re trying to fly to, and that sort of thing — they’re basically saying, “Hey, I’m price-shopping right now. I’m trying to make this decision right now.” That’s what this idea of vertical search is. Think auto insurance. You have a lot of different options. Chances are good you’re on there because you’re trying to get an auto insurance locked down now, because you just bought a car. It’s high-intent.

It’s a really interesting business. And, folks offering products really want to get in front of those people and are willing to pay a lot per lead to do so, because these are people who are trying to make the decision right then. Being the first on the page, or the most attractive initial offer, might just get it done.

What MediaAlpha does is figure out dynamic content and pricing and things like that based on what they know about the user. It’s a fee-based business, again, so no capital at risk. But it’s an interesting business, because again, this is something where, if you have a really specific set of expertise, which is in how to market and how to use data to price things, that can give you an inherent advantage over the insurers, who are really just looking to go through the clearing house and make sure that something is going to make them money. They’re not digital marketers at heart. So, it’s a really interesting business.

One of my concerns, though, is just how many niches they can get into, as well as the fact that there are a billion and one media companies trying to do something similar. There are ad agencies all over the place. If they have an advantage now — and it appears that they do — it’s not clear how long or durable that advantage is going to be, given the incredible disruption going on across the internet every day.

Frankel: Yeah. The counter to that is, this is arguably the strongest area of White Mountains’ business right now, especially in recent results. Their first quarter wasn’t particularly strong. Municipal bonds were issued less by municipalities, so that market declined a little bit. MediaAlpha has more than doubled in revenue over the past year. Some of that was due to an acquisition, but a lot of it is just growth. This has been a very successful area so far. But, like Michael said, it’s just tough to identify their durable competitive advantage here.

Douglass: Yeah. Again, this isn’t to say that it’s not the best business in its space right now. It may well be. It’s just that, frankly, eight other people with laptops might be able to figure out something similar, not immediately, but over time.

Frankel: Right.

Douglass: There’s one other major business we’re going to call out, and then we’re going to head to a quick commercial break. Kudu Investment Management. White Mountains recently did a $250 million round investing in Kudu Investment Management with Oaktree, which, for the hardcore investors among you, that’s Howard Marks’ shop. Howard Marks wrote one of the books that has most influenced me as an investor. It’s called “The Most Important Thing.” I highly recommend it. I think it’s a great read. It really changed how I thought about growth and value investing. What Kudu does is, they’re advisory services primarily. Then, they also provide capital to asset management companies in very specific circumstances.

One thing that they’re particularly focused on is, when you have senior partners in an asset management firm, maybe they’re looking to retire, but, of course, they want to get paid well to leave this lucrative business that they’ve built up. You have the younger, junior folks, who are usually pretty hungry and really want to take the reins, take this firm to the next level, but they don’t have capital. What Kudu does is provide that capital in exchange for an equity share and usually a pretty significant portion of revenue that they get to siphon off and keep for themselves.

It’s a really attractive business model, assuming that asset management does well long-term. Which, if asset managers can do a good job of handling indexing and robo advisors, that seems like a reasonable bet.

Frankel: Yeah. I just worry about the fees that they’ll be able to command dwindling in the future, as we talked about, with the robo advisors and the other disruptors in the area over time eating away at the fee structures that they can command.

Douglass: Yeah. So, looking overall at their businesses, there are a couple here that are pretty attractive, but I do see all of them being pretty open to being pretty significantly disrupted. I think the most attractive one to my mind, in terms of underlying profit and protection against disruption, is the PassportCard and DavidShield. The question there is, what’s the scale going to look like long-term? Can this really get big? And that’s not clear.

Frankel: Personally, I wish they would stick more with their core insurance business. In municipal bonds, they have a pretty big market share. There’s only one other major, major competitor out there, Assured Guaranty. I wish they would try to build on that a little bit more. I do love the PassportCard idea. I think that’s a very high-growth market. It solves a big problem. I really like where that’s going to go in the future, too.

Douglass: Yeah, we’ll see how that works out. We spent a lot of time really digging into these underlying businesses, because that’s going to be the real key to White Mountains’ long-term success from here. I think that’s going to be really core to the investing thesis if anyone is interested in buying the company. Let’s also talk about their equities and fixed income investment portfolio, because that’s a pretty big amount of money, and it’s certainly doing a lot to drive — or not, as the case may be –results.

Frankel: It is. The investment portfolio is about $3.4 billion right now. About two-thirds of that is fixed-income investments — bonds, mortgage-backed securities makes up a pretty large portion of it. The bonds have pretty staggered maturities. Generally, about six to ten years seems to be the average, mostly investment-related.

On the equity side, which makes up close to one-third of the portfolio, this isn’t an equities portfolio in the sense that Berkshire Hathaway has the Buffett stocks. This is a bunch of mostly passive ETFs. This is essentially, an S&P Index Fund would be an example of something that they could invest in. We don’t really have a long, detailed list of how they invest their money, but they do say it’s mostly passive ETFs and stock portfolios managed by third parties. This is not the Buffett portfolio.

Douglass: Right. I think that’s one of the key things to keep in mind here as a difference between this and a Markel or a Berkshire. This is a company that really isn’t necessarily trying to find the next great investments that are going to beat the market. What they’re mostly looking to do is invest in sectors through ETFs.

That’s a thing that, certainly, if they have a core area of competence which is something else, that makes a lot of sense. But, at the same time, when you have a company that’s largely dropped its insurance business, which theoretically was its core area of competence, and it’s also not really picking stocks on the investment side, a lot really starts to depend on those wholly or partially owned companies that it’s operating. And I think we have a lot of question marks about those. So, that’s certainly a big concern for me.

Frankel: Yeah, definitely. It’s not an investment portfolio in the sense that they’re investing the float, like you just said. They’re investing their own capital at this point to try to achieve a return, and it’s a much different business model.

Douglass: Yeah. Which is interesting, because, again, they used to be more comparable, but that’s definitely become a little bit less so over time.

Let’s think a bit about how this company stacks up to, say, a Markel or a Berkshire, just in terms of thinking about companies in the insurance business and whether they make attractive potential investments.

One of the things for me is, let’s consider the size difference. White Mountains, as of this morning, has a roughly $3.4 billion market cap. It’s fairly small, particularly when you compare it to Markel at $15.4 billion and Berkshire at almost $500 billion. These are companies that are operating in very different leagues from each other, and there’s a really big scale difference there.

Frankel: The scale difference could be a good thing or a bad thing. One of Buffett’s biggest complaints is how big Berkshire is, that it’s really tough to effectively invest his money. So, this is an area where it actually works out in favor. One of the businesses we talked about, NSM Insurance, is one Buffett probably wouldn’t even look at. It’s a relatively small player. Same with MediaAlpha, that’s another one that Buffett probably wouldn’t give a second look to, because it really wouldn’t move the needle on Berkshire’s balance sheet. These are opportunities that a smaller player in the industry could invest in, and it could really make a meaningful difference if they’re successful.

Douglass: Yeah. And that’s a very legitimate thing. That’s one of the reasons why they’ve been able to go after these really niche businesses that might have some really attractive scale-up opportunities long-term. For me, I just keep coming back to the fact that this is a company that’s really taken away the insurance float side of things and is just investing, basically, cash that they’ve kept on the books now. That feels, in a lot of ways, a lot riskier.

And personally, I’m not as excited about most of their businesses as I am about, say, a Fruit of the Loom for Berkshire, or some of Markel’s ventures. For me, at least, I’m just not terribly attracted to White Mountains as a potential investment from here.

Frankel: And we haven’t even talked about the company’s buybacks yet.

Douglass: Oh, yes! Let’s do that!

Frankel: That’s been a big part of the story over the past few years. I think they’ve bought back about 30% of their shares over the past year or so.

Douglass: Yeah, about 33% since the end of 2015. It’s wild.

Frankel: Yeah, in what’s called a reverse Dutch auction, I think it is. They offer an above-market price to shareholders to get them to sell their stock. What most companies do when they buy back shares is just buy them back on the open market.

For example, before the latest tender offer was made in April, White Mountains was trading at about $806 the day before. They made the tender offer up to $875. It almost feels like they were overpaying for their own stock to be able to get out of these other businesses.

Douglass: Yeah. This is a thing that we’ve actually seen in a lot of financials, where companies will buy back shares at the wrong time. Bank of America was buying back shares at 4X what they were trading for during the financial crisis beforehand. Then, of course, they had to dilute on the other hand to gain cash during the financial crisis, which really hurt them, and hurt underlying shareholders, pain that I think has still persisted, really, into a lot more recently. This feels a little bit like that. More fuel to the fire that, when management is buying back shares, that is not necessarily a good sign for the business.

Frankel: Like I said, I wish they would have just kept some of their insurance operations and not done that. But that’s just me.

Douglass: [laughs] Well, we’re not the only folks who have turned away from the company. Buffett used to be a shareholder. The fact that he essentially divested from White Mountains is also, I think, a part of this story when thinking about this company.

Frankel: Yeah. Just to give you a little bit of context, Buffett had a pretty sizable stake, I think about one-sixth of the company, from about 2000-2008 right before the financial crisis. Talk about a case of good timing, he got out just in time.

Buffett was a big fan of the CEO at the time, who’s no longer the CEO anymore. He essentially invested in White Mountains to help them make an acquisition, which they’ve since divested as part of their “get out of the insurance business” plan. So, it’s a very different company than Buffett invested in.

Like I said, I used to follow White Mountains a lot when it was a Buffett stock. If any of the listeners did as well, it’s worth pointing out, this is not the same company that Buffett owned in his portfolio.

Douglass: Right. Again, when I look at this company, there’s not a lot that I’m really excited by. The fact that it’s small is good and certainly gives optionality. But, I tend to think that if you’re looking for reasonably small, Markel is a better bet, just because, they invest in individual stocks — they’ve had a really good run with investing in tech stocks — they have a very sizable ventures group, which is moving the needle for them meaningfully, and they’re still in the insurance business. And, they’re in these niche, difficult-to-value spaces, similar to what White Mountains is. The difference is, they’re actually pocketing all of that profit on the premium side, on the underwriting side, instead of just trying to do it in a fee-commission way, which can hopefully help them build up more cash in the short-term before insurers cut them out.

Frankel: Yeah. Markel is definitely still using all of their insurance money to invest. They’re the closest thing to a mini-Berkshire in the market right now.

Douglass: Yeah. Cool. Folks, that’s it for this week’s Financials show. Questions, comments, you can always reach us at industryfocus@fool.com. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so, don’t buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Matt Frankel, I’m Michael Douglass. Thanks for listening and Fool on!

Matthew Frankel owns shares of Bank of America, Berkshire Hathaway (B shares), and Markel. Michael Douglass owns shares of Berkshire Hathaway (B shares). The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares), Markel, and Oaktree Capital. The Motley Fool has a disclosure policy.

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