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  Walking on the wild side

BENJ GALLANDER and BEN STADELMANN

Friday, March 5, 2004

Over the past few years we have tweaked the Contra methodology to put greater emphasis on a corporation's margin of safety in hopes of avoiding the crash-and-burn stories.

After all, sometimes out-of-favour stocks deserve to be neglected. They are, as aptly described by our friend, the noted value investor Norm Rothery, "cigarette butt" stocks: cheap, easy to pick up, but only good for a puff or two.

Nonetheless, we still get tempted on occasion to walk on the wild side. Such was the case with our purchase of the Allentown, Pa.-based health insurer Penn Treaty American last December at $1.61 (USD).

Like all Contra purchases, Penn has traded at far higher prices in the past, but the astonishing speed with which the company imploded is quite extraordinary. The 10-year price chart shows that the stock made a steady climb from the $6 level in 1994 to a high of $35 in 1997. After that, it spent the next four years see-sawing in a downward trend, settling at $17.40 on March 29, 2001. The annual report for the year 2000 came out, and three days later the stock was trading at $2.60.

What caused this implosion?

Insurance companies are particularly difficult for an investor to assess. Like all businesses, they grow by selling more product. In the case of Penn, that's more polices for disability and long-term health care to more people.

Where insurance differs from the vending of most goods and services is that every new sale brings with it a long-term liability — that is, the future claims that the customer may make under the policy. Cash flow from premiums and invested capital is balanced against the money paid out to satisfy current claims.

Computing the liability associated with future claims falls within the realm of actuarial science, which analyzes historical statistics to make predictions. The tricky bit is that conditions change over time, and claims turn out to be much higher than expected.

This results in premium hikes that make for unhappy consumers. And even worse, if the insurance company becomes insolvent, policy holders may be out of luck.

These potentially dire effects on the population elevate the insurance business's decisions into political issues. The industry is heavily regulated — premium increases frequently need to be approved by government bodies, and the companies' levels of capital are carefully scrutinized.

On one level, Penn's ability to sell lots of new policies to an American population terrified of being sick and broke in its old age made the company a terrific success. In 2000, book value was up to $25.81 a share, with net income of $3.17 a share.

But to support that growth, the corporation needed to increase its capital base just as quickly, a feat it found much more troublesome. The repulsive piece of news in that 2000 report was the auditor's pronouncement that Penn might not have sufficient capital to cover its mandated "statutory surplus." That position cast doubt on whether the company could continue as a going concern and brought with it a requirement for a "Corrective Action Plan" from the Pennsylvania Insurance Department; the firm's ability to issue new policies was also severely curtailed.

Since then, Penn has survived by balancing gingerly on a knife edge. The auditors have removed the going-concern warning, and convertible debentures have raised desperately needed capital, causing the number of outstanding shares to rise sharply — and further dilution is likely. Meanwhile, Penn has regained the power to sell new policies in most jurisdictions — most recently in California, a state that traditionally represents about 15 percent of revenues.

We made only a smallish bet on this stock, knowing full well that our investment could disappear into Chapter 11 like a puff of smoke. But if Penn can turn the corner to prosperity and reach our Initial Sell Target of $12.24, we will enjoy one of Cuba's finest.


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