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A Conduit to bigger things

Betting on the strength of the Berkshire model.

This article was published in February’s The Investor

Legendary investor Warren Buffet’s business and investment strategy has been analysed and copied for years – sometimes successfully, other times less so. The space, certainly internationally, is now crowded with investment holding companies that own insurers and or reinsurers with strong operating cash flows that are upstreamed to the parent companies.

This model generates cash flows, or “float” that these Berkshire Hathaway copycats invest – either back into the insurance business or into other companies. 

In South Africa the model is less apparent, but one company Conduit Capital (CND), has attracted investor attention over the past year, following the apparently peaceful coup d’etat and implementation of a new strategic direction by CEO Sean Riskowitz.

Riskowitz invested in the company in 2010 through his investment companies Midbrook Lane and Protea Asset Management but became frustrated by the conservative investment strategy of CEO Jason Druian. “He [Jason Druian] was sitting on quite a bit of capital which we were questioning at the time,” says Andrew Dittberner, CIO at Cannon Asset Management, also a longstanding shareholder in Conduit. “He wasn’t doing a bad job, but I suspect Riskowitz wanted to see Jason Druian being a little more proactive with the cash.”

Over time Riskowitz built up a holding of about 14% across a number of investment vehicles, and with the support of other shareholders and board members, voted Druian off the board, persuaded him to sell his shares and accept a severance package – with no fuss, fanfare or public yelling last April.

“We backed Riskowitz,” says Piet Viljoen, chairman RECM, “even though we were not unhappy shareholders. It wasn’t a bad business, though it was cheap at the time. Druian was growing the book value, even though he did not want to allocate the capital necessary for the short term insurance business to grow.

The share price speaks for itself: Between 2013 and 2015 Conduit traded between R1.16 and R1.50, below its book value.

“To my mind Sean saw an opportunity in a small insurer that could be taken over and he had a clear strategy to do so. This does not look dissimilar to a mini Berkshire Hathaway,” says Dittberner.

In April 2015 the new board was nominated and approved by shareholders and Riskowitz was appointed as an executive director – initially as chief investment officer and subsequently as CEO.

The business has two divisions: an insurance and risk business called Constantia Insurance, and the investment services business. 

No time was wasted implementing and explaining the business strategy. “The objective is to increase the intrinsic value of the company on an annual basis at an absolute rate in excess of the market generally,” Riskowitz wrote in the 2015 annual report. (He declined an interview for this story).  “Growth in intrinsic value is roughly measured by the change in adjusted net asset value per share over the period.” 

To achieve this, he says, the company will:  

  • Invest in and sustainably build top quality insurance businesses;
  • Pursue non-insurance investment opportunities; and
  • Grow its investable assets at no cost by achieving combined ratios well below 100%.

This is where the beauty of the insurance model perfected by Berkshire becomes apparent. The combined ratio is a measure of an insurance company’s ability to generate profits from underwriting activities. Generally, the lower the ratio the better, as it means the insurance book is profitable.

It also means it will be in a position to generate more investable assets, Riskowitz says. The cost of the increased capital base is measured by the combined ratio. “If the combined ratio is below 100%, we would have increased our investable assets at no cost (as our capital available for investment would have increased).”

There are other ways of doing this of course: borrowing money, retained earnings growth or raising capital from shareholders.

He adds, “the increase in investable assets at no cost, combined with our ability to invest these assets productively, will allow us to achieve our objective of compounding intrinsic value per share at a high rate over the long term. “

While insurance businesses can generate high free cash flow relative to their size, Constantia needs additional scale if it is to generate meaningful returns. A rights offer, concluded in December last year provided the business with R150 million of additional capital to pursue its insurance and investment opportunities.  

The proceeds are being used to support internal growth in existing insurance operations. In addition the company is on the look-out for acquisitions – both in the insurance and non-insurance space. Beyond this the group will also invest in listed companies as a means to support the insurance operations and earn long-term returns on capital.

What is interesting is that neither Cannon Asset Managers nor RECM followed their rights.

“While not quite the same, his investment philosophy has similarities to ours,” says Dittberner, “which means that there is some overlap in the portfolios, making the investment case less attractive.”

In this case he is referring to companies like Calgro and CMH. 

“Our strategy is to have influential stakes in businesses and we don’t have a big enough stake in Conduit,” says Viljoen. “That said, we like what he is doing. He is a smart guy and as an outside passive investor I would back him.”

Dittberner sounds a tiny note of caution. “He is undoubtedly smart, determined and focused. There are not too many people who can go to New York and raise capital to invest in SA – and his investment company Midbrook Lane has shot the lights out. But while not wanting to take anything away from his success, one always needs to be cautious of highly concentrated portfolios. Big returns can quickly turn into big losses. However, I don’t doubt his ability. He may be relatively young, but I wouldn’t bet against him.”

Investors may have to wait until the six month results to December are released in March. The previous results (ten months to June 2015) included just three months under the new investment strategy. More light will also be shed on new acquisitions and investments.

For investors looking for dividends, this is not the stock. Riskowitz’s strategy aims to create more than a rand of value for every rand invested by the company. For the time being he believes shareholders will do better if the company pursues these reinvestment opportunities.

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