The collapse of housing prices in the United States over the past four years has shattered numerous assumptions made by market participants, many of whom previously based their economic models on the idea that a nationwide decline in real estate prices would never occur. The impact of foreclosures and the “robo-signing” scandal has captured headlines recently but more subtle effects are even more widespread. While the human misery created by the housing collapse is impossible to ignore, intelligent investors naturally seek opportunities amid the wreckage.
For most home buyers, title insurance represents just one more annoying charge that appears on the closing statement and often throws budgets into disarray if the cost was unexpected. However, like most forms of insurance, a title policy seems like a bargain when it is actually needed *.
Industry Overview
Title insurance protects home owners and lenders against defects in title that could arise from a number of factors. Such defects could call into question whether the buyer has clear title to the property. Title insurers are responsible for performing an examination of the land records to ensure that the seller has proper standing to convey ownership to the buyer. In the event that the title proves to be defective at a later date, the title insurer is responsible for covering the resulting losses up to the coverage limit of the policy. For mortgaged properties, the buyer is required to purchase a title insurance policy for the lender. Purchasing an owner’s policy is not required, but highly recommended.
Title insurance is different from most other forms of insurance because it protects the policyholder against past events. In contrast, most other forms of insurance protect against future events that cannot be precisely predicted in advance. In theory, rigorous title examinations should make it possible for title insurers to eliminate losses. However, in practice, the land and property records in most parts of the country are not digitized and are prone to potential errors. Regardless, title insurers tend to have relatively low loss ratios and high expense ratios due to the labor intensive process of title research.
According to the American Land Title Association’s market share statistics (Excel) for the second quarter of 2010, Fidelity National Financial had the largest market share at 38.4 percent, followed by First American Financial with 26.6 percent. Stewart Title was in third place with 14.7 percent market share and Old Republic was in fourth place with 10.4 percent. The top four have over 90 percent of the market so the industry is quite concentrated. In this article, we will focus on Investors Title Company, one of the “regional” companies with a market share well under 1 percent.
Investors Title Overview
Investors Title Company was incorporated in North Carolina in 1973 and remains highly concentrated in the Southeastern United States. North Carolina accounted for 44 percent of premiums in 2009 while North Carolina, South Carolina, Virginia, and Tennessee accounted for 65 percent of premiums. The exhibit below shows Investors Title Company’s direct premiums written by state:
The company’s concentration in areas that were not at the center of the housing bubble is a significant advantage. While title insurers are not directly exposed to losses in the event of a foreclosure, title claims tend to rise in areas where the housing market is in distress because various parties have greater incentives to discover title problems under such circumstances. Additionally, transaction volumes often decline most precipitously in areas where many homeowners are “underwater” on their properties and reluctant to sell.
Title insurers are dependent on property transfers or refinancing when it comes to generating premiums. If homeowners are reluctant to sell because their property has declined in price, they may also be unable to refinance at today’s attractive rates. One additional problem facing title insurers occurs when they contract with unscrupulous third party agencies. Defalcation, fraud, and other misconduct by agencies can cost a title insurer significant sums because agents handle large amounts of money in escrow accounts during a real estate transaction. In periods of rising markets and robust transaction activity, corrupt agents can hide fraud in a ponzi-like manner as new escrow funds are arriving regularly. In bad markets, the dominoes can collapse quickly exposing title insurers to losses.
Financial Record: 1999 to Q3 2010
At a recent price of $29.15, Investors Title has a market capitalization of $66.5 million while book value as of September 30, 2010 stood at $102.5 million. The company had no intangible assets on the balance sheet as of September 30. While title insurance revenues have declined significantly over the past few years, the company has been profitable in every year except for 2008 and has continued to pay a modest dividend throughout the housing crisis. From 2000 to 2009, book value per share advanced at a rate of nearly 11 percent thanks to retained earnings and periodic share repurchases.
The exhibit below presents annual income statement data from 1999 to 2009 as well as data for the nine months ending September 30, 2010. In addition, we present selected ratios to help spot trends in losses and other costs. Click on the exhibit for a larger view of the data.
From the data, we can see that title losses have declined significantly from the levels of 2007 to 2009 and have actually been below the long term average ratio for the first nine months of 2010. The company has been trimming employee costs in response to lower revenues, although some effort is still required to bring the ratio of employee costs to revenues down to historical averages. The agency retention ratio has remained roughly in line with historical averages over the past few years. All things considered, Investors Title has turned in a solid performance during the crisis, much of which must be attributed the fact that the company lacks major exposure to the bubble markets of California, Florida, Arizona, and Nevada.
Valuation History
As we pointed out previously, the company has a solid record of growth in book value per share over the past decade due to retained earnings and share repurchases. During the boom years of 2003 to 2006, the company delivered earnings per share ranging from $4.09 in 2004 to $5.14 in 2006 and typically traded at a premium to book value and at P/E ratios from 6 to 10. A summary of the past ten years appears in the exhibit below (click on the image for a larger view):
After posting a loss of $0.50 per share in 2008 due to a very high loss ratio and realized investment losses, the company posted earnings of $2.10 per share in 2009 and $1.75 for the first nine months of 2010. It should be noted that these profits were posted at a time when market activity is still very depressed. While the past decade has been anything but “normal” in the housing market, average earnings per share from 1999 to 2009 were $2.85 per share. We will not begin to guess whether $2.85 represents “normalized earnings”, but it is an interesting data point that spans both boom and bust market conditions.
In our opinion, the more interesting valuation yardstick for Investors Title is the price to book ratio which currently stands at 0.65. Without looking at the historical data, a discount of this magnitude for a fundamentally sound business seems unjustified. Apparently, the market usually agrees with this assessment. If we look at the year-end book value for the past ten years and compare this figure with the stock’s high and low price for each year, we can see that the stock’s high for the year has exceeded book value in every year except 2001, 2009, and so far in 2010. The exhibit below illustrates the relationship between the stock’s high and low price for each year compared to period-end book value:
While we should not read too much into past trends in price vs. book value, it is interesting to observe that we are looking at a company that has not historically traded at a major discount to book value even during periods of significant market stress.
Risks
When we discuss risk, we are not referring to the typical measures of volatility used by many market participants. Instead, we need to examine whether the investment thesis may have weaknesses that would expose the investor to a permanent loss of capital if the business is purchased at the current market quotation. In the case of Investors Title, we can purchase shares at a significant discount to book value, but what are the risks that book value could be eroded in the future?
The risk that is likely weighing most heavily on the market is the prospect of years of continued depression in housing. A sustained depression would result in low transaction volumes as “underwater” borrowers are reluctant to move and new construction continues to bounce along the bottom with very low levels of housing starts. While this risk is not negligible, Investors Title has a geographic concentration that does not include the bubble markets of California, Florida, Nevada, and Arizona and is therefore protected from the worst regions. Additionally, the company seems to have proven the ability to post profits in periods of exceptional stress, with the exception of 2008.
Another risk is that loss reserves may prove inadequate to protect against future claims. This is a universal risk facing investors in any insurance company and, as outside observers, we can only rely on management’s track record in the past and the fact that most title claims occur within five years after the policy is issued. With the exception of 2008, title losses have generally ranged from 10 to 15 percent. It appears that management has adequately reserved for the 2008 loss year but, of course, nasty surprises cannot be discounted entirely.
Investors Title has a $131 million investment portfolio with nearly $90.9 million in fixed maturity securities subject to interest rate risk. As of September 30, 2010, 43 percent of the value of the fixed maturity portfolio was due in under five years with an additional 41 percent due in five to ten years. 81 percent of the fixed maturity portfolio is invested in municipal or agency securities, of which the vast majority are classified as Level 2 securities. The remainder of the portfolio is invested in corporate securities, most of which are also Level 2 securities. (Level 2 securities are valued using third party pricing services rather than quoted active market prices which are classified as Level 1.) The company also has $12.9 million in common and preferred stock investments. While the prospect of declines in market price of investments due to interest rate increases or default cannot be discounted, Investors Title has a relatively short duration bond portfolio and management does not have a history of incurring major losses on investments.
Summary
There are many reasons that could account for Investors Title’s current valuation, but it is likely that “guilt by association” with the real estate industry may be the major culprit. In addition, the company has a very small market capitalization and is not one of the major players in the industry. This is not to say that the company is entirely unknown. Markel Corporation, led by President and Chief Investment Officer Thomas Gayner, owns ten percent of Investors Title common stock.
While we cannot know the specific reasons for the current wide discount to book value, it seems very likely that the market will eventually assign a more appropriate valuation to a company that has demonstrated a long term record of profitability, book value growth, and resilience during a period of unprecedented stress in the housing market. Investors purchasing stock at the current quotation are likely to enjoy appreciation of close to fifty percent when the price eventually rises to book value without accepting much risk of a permanent loss of capital.
Trading Note:
Investors Title is one of the least liquid stocks we have come across in some time. While some shares usually trade each day, volume is often extremely limited and bid/ask spreads are very wide. Average volume is only 1,200 shares per day and often only a few hundred shares trade. As an example, on a recent day, typical bids were in the $29.50 range while asks were around $32.
In situations like this, it pays to be patient and refuse to bid up to the asking price. On several occasions, lower bids were eventually taken in the last half hour of trading. Needless to say, it is critical to place limit orders. In addition, placing small orders of 100 to 300 shares on a “all or nothing” basis can avoid very small fills (we had one order filled for a mere 12 shares which incurred a regular commission.)
For larger investors, it may be nearly impossible to build a position in a reasonable period of time. Larger investors may want to look at Stewart Information Services which also trades under book value, albeit at a narrower discount, and with a less impressive track record over the course of the housing crisis.
Resources:
Investors Title 2009 10-K
Investors Title Q3 2010 10-Q
* A personal note: The author can personally vouch for the value of title searches and surveys after narrowly avoiding the purchase of undeveloped acreage several years ago that had a major defect: The home site’s future location resided on a neighboring parcel of land and there were no alternate building sites. Therefore, for a few hundred dollars of survey and title search costs, several hundred thousand dollars of losses were avoided.
Disclosure: The author of this article owns shares of Investors Title and Stewart Information Services.