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Author: DCFNewbie Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 46847  
Subject: ACGL : A case study on security analysis Date: 8/25/2004 2:28 AM
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Hi everyone,

Being new to the Foolish Community I'm very interested in understanding some of the differences beetween the several value aproaches to analysing a security.

In a recent thread I was introduced to different strategies on determining value and it has become clearer to me that the quantification of growth will always be what makes a determination of value subjective (who can argue with the historical data?).

I know that there are several posts on this board stating several methods of making that kind of analysis, however I think that in light of the recent "101A: Equity Analysis basics" initiative, I and other newbies could harvest more information out of a more recent discussion.

That said I will take the liberty of sugesting Archer Capital Group Ltd.(ACGL) for a quick (or not) valuation analysis. However, to make things a bit more interesting I will focus more on the structure of the analysis that on the content. Obviously what I'm looking for is some "elderly" guidance on this.

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DISCLAIMER: I currently own only a very small (negligble) amount of stock on ACGL, but will probably take a bigger plunge if, in the following weeks, my additional analysis prove my initial instints to be right.
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One of the first inputs that I would like to receive is regarding the overall structure of an analysis.

Currently I'm going for something like:

1) Valuation

2) Operational Reality

3) Company History/Background

4) Operational Growth/Risk

5) Establishing Price Target and/or exit conditions

(the order ir important!)

In my opinion this captures some of the essence of what is advocated in most of the analysis done in MF articles, MF Newsletters (the ones I've read in past at least) and a great deal of people at the Foolish community boards. And I believe that it respects a lot of the KISS philosophy while being thorough regarding diligence.

Obviously the specific content of these categories is a lot more debatable, I currently would advocate something like:

1) Valuation

P/E - Although its extremelly temptative to bash P/E for its clear faults, I still believe that this should be the very first notion that someone new to investing should acquire. Why? Because for a beginner an expensive stock costs 100$/share while a cheap one costs 5$/share. Its absolutelly fundamental that that myth be debunked in the very first contact someone has with analysing an investment (any investment). It is also admittedly a very important first impression that any investor has regarding the nature of a stock. P/E is one of the many visual filters an investor uses.

ACGL's trailing P/E = 7.24

Debt and Cash - I think this is very self explanatory. Although a very recent discussion in this board as alerted me to "danger signs" regarding a companies tendency to accumulate cash.

ACGL's Cash reserves = 188.12M
ACGL's Long term debt = 300.00M
Debt/Equity ratio = 0.147


Enterprise Value - This is obviously associated with the previous topic. A smaller Enterprise Value than Market Cap is something whose merits should, in my opinion, be continuously stressed.


ACGL's market cap = 2.76B
ACGL's enterprise value = 2.89B

EV > MC

(Yahoos number on Market Cap. is wrong)


Free Cash Flow - I really believe this is the more complex topic to discuss. Both due to the effort in compiling the data (you cannot trust Yahoo to give you correct values on this) and due to the need in subtracting extraordinary incomes (I personally find it very messy and I'm still very bad at it).

ACGL's Free Cash Flow = 1.76 B
ACGL's P/FCF = 1.51
ACGL's EV/FCF = 1.59

(Past FCF is missing but I will do my best to include this in the near future)


ROE / ROA - The notion of management effectiveness is very important, but not as important as its evolution time (I believe a lot of MF articles have aproached that in the recent past). Another thing that I don't think that it's stressed enough is the impact of capital expenditure on ROA. I see a lot of people failing to grasp the big diference beetween the ROE and the ROA of some companies (in the very recent past that included me).

ACGL's ROA = 6.29%
ACGL's ROE = 19.94%

(Past ROE and ROA are missing but I will do my best to include this in the near future)


Growth - Second only to FCF on complexity in grasping, growth has the problem of being too intertwined with analysts predictions. If we can't trust analysts to place price targets or outlook, how can we trust them to accurately predict growth? The company's prediction is one option, but, just like many have commented on the past, companies are more and more freightfull of making any growth outlook due to the exposure to class action suits. One possibility is offering scenarios where growth isn't that important (seems to be popular among some Fools), obviously that puts further straint on current valuation. My short experience tells me that past growth together with industry growth outlook seems to be somewhat better accepted than any other strategy to predict growth. Any ideas on this?


ACGL's Analysts Growth Est. (5yr) = 20%
ACGL's Past Growth (5yr) = 8.9%
ACGL's Sector predicted growth (5yr) = 10.95%

(1) - Optimistic growth (20%)
(2) - Pessimistic Growth (8.9%)

P/E/G (1)= 0.36
P/E/G (2)= 0.81
P/FCF/G (1)= 0.08
P/FCF/G (2)= 0.17
EV/FCF/G (1)= 0.08
EV/FCF/G (2)= 0.18


I hate long posts (specially those that don't get many recs), so i'll wait for some feedback on what I've written before venturing on.

Opinions, corrections, sugestions and criticisms are needed and welcomed. Regards,

DCFNewbie
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Author: educatedidiot Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32779 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 8/25/2004 8:22 AM
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ROE / ROA - The notion of management effectiveness is very important, but not as important as its evolution time (I believe a lot of MF articles have aproached that in the recent past). Another thing that I don't think that it's stressed enough is the impact of capital expenditure on ROA. I see a lot of people failing to grasp the big diference beetween the ROE and the ROA of some companies (in the very recent past that included me).

ACGL's ROA = 6.29%
ACGL's ROE = 19.94%

(Past ROE and ROA are missing but I will do my best to include this in the near future)


Here you go:
	
Return on Inv Cap 6.6% 2.6% 2.7% (1.4%) (4.1%)
Return On Equity 16.4% 3.9% 2.2% (2.9%) (10.2%)
Return On Assets 5.0% 1.8% 1.7% (2.7%) (4.1%)

http://www.anumati.com/DynamicReport.aspx?id=ACGL&report=EFF-A&dates=31/12/2003;31/12/2002;31/12/2001;31/12/2000;31/12/1999

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Author: TMFAdmiral Big gold star, 5000 posts Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32785 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 8/25/2004 11:36 AM
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Enterprise Value - This is obviously associated with the previous topic. A smaller Enterprise Value than Market Cap is something whose merits should, in my opinion, be continuously stressed

Hi DCFNewbie,

What you are essentially saying here is that you don't like debt in a company's capital structure or that they should be holding cash, cash equivalents & investments that exceed debt levels.

But if the debt taken on is producing FCF in excess of that which could have been achieved by issuing equity I think that some debt is just fine. In other words if the cost of debt is lower than the cost of equity why not use some debt?

I would therefore use EV/FCF rather than EV by itself and as a rough guide I like EV/FCF to be below the P/E for a stable mature company

Regards
Philip

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Author: DCFNewbie Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32787 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 8/25/2004 12:37 PM
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Admiraltroll,

I have to admit that probably the evalution of the debt load and cash reservers should belong in the section on "Operational Reality". Like you stated, if debt is more of a facilitator in FCF generation than equity then it's a valid tool for management to use, that makes a lot of sense.

Still I believe that in the spirit of teaching investment basics, there should be an effort to induce some aversion to debt (I'm obviously referring to companies with debt/equity ratios of 0.5 and higher). Mainly to justify due diligence regarding why debt was incurred and how it has evolved in the past

So I'm not talking about eliminating a company just because it has more debt than cash or a a debt at all, I'm talking about creating an aversion to debt so that detailed due diligence is made in understanding management's choice regarding debt's use.

Another important issue is something I've seen in the past associated with Hidden Gem's methodology. Assuming (stong emphasis on assuming) that the market is more inefficient in small caps, then that should be something important to stress while defining a beginners strategy (I believe that the HG's performance is greater than Stock Advisor's and that should constitute some evidence in that). And, just as I see mentioned in a lot of Fool literature, debt adds to the risk in a small cap while cash reserves subtract.

So, while my view on the cash/debt issue is very flexible (because obviously it makes a lot of sense form the FCF generation scenario you pointed out), a strong balance sheet strongly reduces the chances of mishaps.

Again maybe the Enterprise Value/Market Cap. comparison shouldn't be in "Valuation" category but in "Operational Reality".

Regards and many thanks for the feedback,

DCFNewbie

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Author: SirTas Big gold star, 5000 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32794 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 8/25/2004 2:37 PM
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... for a beginner an expensive stock costs 100$/share while a cheap one costs 5$/share. Its absolutelly fundamental that that myth be debunked in the very first contact someone has with analysing an investment (any investment).

Absolutely agree. The first couple of times I started to talk to non-investing people about stock-investing, I found out that this was their assumption. And I've noticed that many newbies here on the boards seem to want to get a start in investing by investing in penny stocks. They just want to dip a toe in the water and they think that's the place to start. I've been trying to think of a good analogy that would express the wrongheadedness of this idea, and my latest thought is that starting with penny stocks is a bit like thinking that it is safer or more conservative to try out travel by water in a rowboat than in an ocean liner. (Admittedly, that's not a perfect analogy. I'm hoping someone here can give me a better one!)

It's strangely related to the misconception that your investment has somehow doubled when a stock splits. (Although, if we make the previous assumption, and recognize that a stock split also means that the price per share splits, then it should turn out that one is now invested in something smaller, for example, a $25 stock as opposed to a $50 stock.

--SirTas



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Author: Jacko2 Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32798 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 8/25/2004 3:40 PM
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DCFNewbie:

Good going for stepping into the waters. All we can do is to start somewhere and then keep adjusting as we keep on going and learning.

Part (a large part) of the battle in security analysis is to form in one's own mind the categories in which to fit information about the security / business in question.

I haven't looked at ACGL (and don't even know what company it is), but here are some general comments:

1. It's not clear how the body of your discussion relates to the list of 5 categories you set out at the beginning of the post. I see the value (item 1), and I see the growth (item 4), but I'm not clear whether you meant the whole post just to be about value, and therefore we can expect the other four items to be posted shortly.

2. I haven't read all of the framework articles you mention. And I personally don't regularly use the ev/fcf multiple or the various versions of PEG you mention. In terms of a framework analysis, the discussion in Greenwald's (and others) Value Investing book is the best statement of how to combine, and to do, a valuation based on asset value and on earnings.

Marty Whitman uses a "cheap and safe" framework (see www.thirdavenuefunds.com; and read his quarterly and annual letters). For "safe" he emphasizes balance sheet strength. For "cheap" he uses either the balance sheet (eg, for undervalued assets), or a low multiple of recent peak earnings (eg, 6 times peak earnings).

Ben Graham's approach for categories was to look at various aspects of the balance sheet and income statement. You can get a sense of what he was after in Intelligent Investor; and a better sense in the various editions of Security Analysis. He talks about things like safety (usually look at debt ratios) and profitability (eg, the various kinds of margin, and returns on equity / assets / inv cap). Preparing one of his comparison sheets on a set of two or more companies is useful, I find. (The simple format is in the chapters where he compares one company to another. A more complex format is set out in Security Analysis.)

TMFKitKat's company analyses on this board are excellent, in terms of a possible framework. Horrendous amount of work, I'll bet.

3. As to growth: FWIW, this is my current thinking. Greenwald takes up Graham's point that, ideally, one shouldn't pay very much for growth. And that if one must pay for growth in order to buy the security in question, it's important to know that you are in fact paying for what Greenwald calls "growth within the franchise". It has to do with earning an reasonable return on incremental capital. Growth that doesn't earn that kind of return doesn't add value.

But your discussion was talking more about estimating growth rates. As you mentioned, the evidence is that analyst's projections aren't worth much (find old articles like "Higgledy Piggedly Growth"; and find the paper on persistence of growth at the Tweedy Browne website), particularly when they're dealing with more than one year out. It's for this reason that Buffett talks about 1) circle of competence and 2) unchanging, stable businesses.

I'll note analyst's projections. Most are smart and are likely to have far better knowledge of the individual company and industry than I'll be able to muster. In addition, if there are a large number of analysts behind the estimate, there may be a benefit of a group's guess being more accurate than the guess of only one or two people. You have to start somewhere.

I also pay attention to historically achieved growth, by running annual growth rates on revenue and earnings, ideally over 5 and 10 year periods. If you read the NAIC stock selection guide materials; they use this sort of approach.

There's a paper from about 2002 by a guy named Chan on persistence of earnings growth (don't have the link; a search might find it somewhere on the internet). His conclusions were 1) on the whole, it's impossible to predict earnings growth; and 2) there is some predictability to revenue growth. Because of conclusion (1), Chan's suggestion was that it makes the best sense simply to use an average of past growth when estimating future growth. Makes sense to me. In doing security analysis you want to be conservative, and so shouldn't predict higher growth than in the past unless there's a good reason to do so (ie, you've understand the business prospects).

And, regarding conclusion (2), consider adopting a [revenues x profit margin] approach when analyzing earnings. You can look at the last several years' worth of profit margins and find whether the company you're dealing with has stable margins or not, and based on Chan's research you increase the odds that your growth guess will be more accurate, because you're dealing with revenue.

More on growth: Find www.expectationsinvesting.com and the book by that title. They use an "expected value" analysis in their growth scenarios. This is a way of incorporating, explicitly, your guesses on growth into one number. You estimate the odds for each scenario and multiply by the growth estimate for that scenario. In your example, let's say that each scenario is equally likely (high, average past is average future, industry): (.333 x 20) + (.333 x 8.9) + (.333 x 10.95) = 13.27%.

4. ROE / ROA: You're right to take note of any large difference between these two ratios. Differences can be an indication of leverage (debt) being employed or mis-employed. Doing a DuPont analysis on ROE can be useful in revealing what's changing in the business over time. (That's where you break down the ratio into three different components; there's articles on that here at the Fool.) Buffett, in his 1980 Chairman's letter (http://tinyurl.com/5oo5u), calls ROE the best single year gauge of management performance. He adds a caution that it's important to understand what goes into that number in terms of earnings policies, asset and depreciation policies, industry conditions and so on. And it's important to remember that a single year's figure doesn't tell you much. Someone did post the multi year figures. I notice that the most recent year is quite different than previous years, by a significant amount. I would want to investigate the reason for that large change. My fear would be that it wasn't going to be sustained.

jacko2

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Author: iceberg0 Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32809 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 8/25/2004 8:35 PM
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DCFNewbie -

Opinions…are needed and welcomed.

IMO you've picked a very difficult learning situation in ACGL which is an insurance operation. The ratios you've written about seem more suitable for evaluating a mfg. company. Here is the ACGL business description:

Arch Capital Group Ltd. ("ACGL"...) is a Bermuda public limited liability company with over $1.9 billion in capital and, through operations in Bermuda and the United States, writes insurance and reinsurance on a worldwide basis. While we are positioned to provide a full range of property and casualty insurance and reinsurance lines, we focus on writing specialty lines of insurance and reinsurance.

Some suggestions:

1) Start with a share count. Counting shares for ACGL gave me a quick headache and I gave up right here in the K:

As of December 31, 2003, there are 28,200,372 common shares outstanding and up to 44,599,812 common shares issuable upon exercise of options or warrants or conversion of convertible securities. Of the outstanding shares, 21,493,985 common shares are freely tradable and 45,551,052 common shares (including common shares issuable upon conversion of convertible preference shares) are subject to Rule 144 under the Securities Act. Of the shares subject to Rule 144 under the Securities Act, there are 11,989,347 common shares registered for resale by selling shareholders, including those registered pursuant to our existing registration statement. In addition, we have registered with the SEC up to $500,000,000 of new securities which may consist in part or entirely of common shares.

We have granted the Warburg Pincus funds and Hellman & Friedman funds demand registration rights and all of the investors in the November 2001 capital infusion certain "piggy-back" registration rights with respect to the common shares issuable to them upon conversion of the preference shares or exercise of the class A warrants. Certain other investors who purchased or acquired shares in unregistered transactions also have demand and piggy-back registration rights. They can exercise these rights at any time.



2) I would suggest an important ratio for an insurance operation which is not in your post is p/bv which is around 1.29 at the moment and looking for this series range at ACGL and competitors might help suggest whether the closing price $36.63/shr today is attractive to you (IF you can figure the share count.)


3) You'll want to read up on what Berkshire Hathaway's “present management” has to say about what's important for evaluating the economics of an insurance operation. Here's a couple of snips from the 1998 Chairman's letter, you'll want to read much more:

With the acquisition of General Re -- and with GEICO's business mushrooming -- it becomes more important than ever that you understand how to evaluate an insurance company. The key determinants are: (1) the amount of float that the business generates; (2) its cost; and (3) most important of all, the long-term outlook for both of these factors.

An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money.




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Author: DCFNewbie Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32811 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 8/26/2004 12:05 AM
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Jacko2,

Let me start out by thanking your support regarding this post.

1. It's not clear how the body of your discussion relates to the list of 5 categories you set out at the beginning of the post. I see the value (item 1), and I see the growth (item 4), but I'm not clear whether you meant the whole post just to be about value, and therefore we can expect the other four items to be posted shortly.

I wasn't clear enough. That was just relative to the first section "Valuation". I'm hoping for some more feedback before submiting posts related to the other 4 categories.

Marty Whitman uses a "cheap and safe" framework.
Ben Graham's approach for categories ...
TMFKitKat's company analyses on this board are excellent, in terms of a possible framework. Horrendous amount of work, I'll bet.

That's one of the problems. Since one of the objectives is to find a framework that is simultaneously complete and simple, some sort of compromise will have to be achieved. KitKat's aproach, although probably the most detailed, might be difficult for a beginner to grasp. Personnaly I would vote on a simple EV/FCF approach together with ROE, ROA and debt/eqity ratio (somehing I can easily and quickly calculate). I believe that others might also support something like that for newbies in general.

Your views on growth seems to be ideal in the context of this post since extrapolation of growth is probably the greatest enemy in valuation. Being scheptical on growth will allow for a greater safety margin while cuting down on valuation errors.

And, regarding conclusion (2), consider adopting a [revenues x profit margin] approach when analyzing earnings

Yes, I fill confortable with that. The problem is that in the end we're just breaking the same problem in to two. First, understanding the industry and past growth as to forecast changes in revenue, and second, to understand the company as to forecast changes in the profit margin. Still it at least structures the task (and that's half the difficulty).

They use an "expected value" analysis in their growth scenarios.
You estimate the odds for each scenario and multiply by the growth estimate for that scenario.

Right, that seems a very reasonable technique. You're essentially averaging growth expectations. Still I think a more complete formula would be: ((.333 x 20)*A)/ABC + (((.333 x 8.9)*B)/ABC + ((.333 x 10.95)*C)/ABC. The advantage being that it allows the placing of different weights on the degree of certainty for the various number of scenarios (A, B and C are for instants 4, 2 and 1, being A twice more likely than B that is twice more likely than C). Still it might just be a little anti-KISS.

You're right to take note of any large difference between these two ratios

Since it's the first time I've commented on the issue I'm glad my intitial instinct has been proven correct.

Someone did post the multi year figures. I notice that the most recent year is quite different than previous years, by a significant amount. I would want to investigate the reason for that large change. My fear would be that it wasn't going to be sustained.

ACGL is only 5 years old. The rapidly increasing ROE is compatible with the rapid increase in every single other valuation metric. I could be catastrophically wrong, but I haven't seen any red flags yet.

This takes me to iceberg0 's post:

IMO you've picked a very difficult learning situation in ACGL which is an insurance operation. The ratios you've written about seem more suitable for evaluating a mfg. company.

I'm glad someone spotted the elephant in the room. I must admit I'm actually being very self-servant with that choice for an analysis. Why? Because it allows me to post the following question to the elders on this board:

How does the operational nature of a company affect the way that value is interpreted?

Let me develop this a little more. Do value metrics like FCF, Growth, ROE and ROA have different meanings across different industries and/or sectors? Does the way we perceive a security's ability to generate cash change if you are talking about manufacturing, retail, insurance or mortgage financing?

One thing is the group of operational effectiveness metrics like payout ratio or price/book ratio, but that's just a way to analyse the business efficiency of the company and therefore allow for a better forecasting in growth and risk. That doesn't affect the way we interpert FCF cash generation, right?

Insights on this are very welcomed.

1) Start with a share count. Counting shares for ACGL gave me a quick headache and I gave up right here in the K:

Further down you'll spot a table that states:

Diluted average shares outstanding = 73,500,041

They have had the good habit of summing up all their highly dense texts in easy reading tables.

2) I would suggest an important ratio for an insurance operation which is not in your post is p/bv which is around 1.29 at the moment and looking for this series range at ACGL and competitors might help suggest whether the closing price $36.63/shr today is attractive to you (IF you can figure the share count.)

Here's a couple of snips from the 1998 Chairman's letter, you'll want to read much more:

"With the acquisition of General Re -- and with GEICO's business mushrooming -- it becomes more important than ever that you understand how to evaluate an insurance company. The key determinants are: (1) the amount of float that the business generates; (2) its cost; and (3) most important of all, the long-term outlook for both of these factors.

An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money. "

Ok, back to the previous question, although the importance of book value in the insurance industry is evident, isn't that and the items that Buffett mentioned just ways to ensure future FCF generation is protected?

Regards,

DCFNewbie





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Author: DCFNewbie Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32812 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 8/26/2004 12:42 AM
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A missplaced tag makes my previous post hard to read, sorry about that (mental note: Always preview posts).

Regards,

DCFNewbie

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Author: DCFNewbie Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32813 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 8/26/2004 5:01 AM
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Also, it isn't payout ratio it's combined ratio (two completly different things).

Regards,

DCFNewbie

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Author: Jacko2 Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32820 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 8/26/2004 2:15 PM
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In terms of insurance companies, I agree with the various comments. I highlight a few points:

1. You can go cross-eyed reading the material about valuing Berkshire. It's worthwhile if you can find it. There's stuff over on the Berkshire board from perhaps a year ago; very good on float. If you join, there's a Berkshire community at the MSN boards (find Parsad here at the Fool, and ask him), which has a copy of the Alice Schroeder Berkshire report from a couple of years ago. There is also some useful info reading the Fairfax chairman's letters (www.fairfax.ca).

2. Book value and return on equity are two key metrics for assessing insurance companies and financial companies generally. Because it's their business to manage assets and liabilities, I'm not sure that the EV / FCF ratio tells quite as much for those sorts of companies as for industrials.

3. One approach to valuing insurance companies is set out in the J. B. William's Theory of Investment Value book, from 1938 (there is a newer reprint available). The father of DCF. You can read the chapter on his valuation of an insurance company. It stands suitably well on its own; though there is material of interest in other chapters. Essentially, he splits the operation into two (shades of Berkshire): the contribution that the investments make (which you have to be cautious about because they're uneven, and not a business); and the contribution that the insurance business itself makes.

In terms of getting started, it's not a bad exercise to choose companies known for their excellent business characteristics. Examples include the "inevitables" that Buffett holds, Microsoft, the large pharmas (such as Pfizer or JNJ), and some of the banks. Might as well know what excellence looks like before venturing into other businesses.

jacko2

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Author: iceberg0 Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32825 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 8/26/2004 8:10 PM
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DCFNewbie –

Further down you'll spot a table…

True, the actual diluted share count is right on the ACGL I/S. What makes my head swim is that the difference between basic & dil share count you see here is material. About 1/2 of the dil shares out are “preference” shares convertible to tradable common 1/1 at any time. These “preference” shares don't publicly trade AFAIK and may have a different value since they do have a different & senior claim on equity than the shares you own.

Weighted Average Shares Outstanding
Basic 32,023,865
Diluted 73,500,041

From the recent K:

In the case of equity financings, dilution to our shareholders could result, and, in any case, such (preference) securities may have rights, preferences and privileges that are senior to those of our outstanding securities.

……..we have agreed not to declare any dividend or make any other distribution on our common shares, and not to repurchase any common shares, until we have repurchased ...preference shares having an aggregate value of $250.0 million, at a per share price acceptable to these shareholders…….the holders of preference shares ….are able to strongly influence or effectively control actions to be taken by us, or our shareholders.


In trying to calculate an EPS thus P/E or DCF, I bet many analysts use different share count assumptions. What would you use for ACGL? Just gives me a headache. The various websites probably have different numbers – you mentioned Yahoo had the wrong market cap.

Do value metrics like FCF, Growth, ROE and ROA have different meanings…

No. The raw metrics & ratios do have different importance weightings though in some industries. If I have a cash dividend and/or cap. gain in AIG and MMM over the last 10 years that I cash out – it spends or donates the same (i.e. has the same utility) no matter what type of operation it came from.

However, if I want to evaluate the economics of the next 10 years or until judgment day for AIG or MMM, I would dig into different metrics to try and identify the key economic variables in the business and industry. I'd want to know to what extent their products might have a sustainable competitive advantage to fairly estimate the rate at which the cash & value will pile up for the owner's account; I'll use your first name - a discount rate - to find it's future utility to me today.

Here, for example, is a formula you will need to calculate ACGL's insurance “float” to evaluate it's growth over each of the last few years from the same 1998 Chairman's letter I snipped from before (Hint: you wouldn't do this while evaluating MMM economics where maintenance capex, margins and ROE might be important economic variables):

...add net loss reserves, loss adjustment reserves, funds held under reinsurance assumed and unearned premium reserves, and then subtracting agents balances, prepaid acquisition costs, prepaid taxes and deferred charges applicable to assumed reinsurance. (Got that?)

Plus as you mention, the combined ratio would be important for evaluating ACGL and competitors as there is a huge demand for under priced insurance:

The combined ratio represents total insurance costs (losses incurred plus expenses) compared to revenue from premiums: A ratio below 100 indicates an underwriting profit, and one above 100 indicates a loss. The higher the ratio, the worse the year.

I recall a quote from BRK's last AGM was similar to “Gophers will find you at 4:00AM in mid-Atlantic on a raft if you will write under priced insurance for them.” This might make EPS & P/E look good in an accounting period but suffer in the future.

Have fun! Fill us in on ACGL's insurance "float" & it's growth and combined ratio if you dig them out.


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Author: educatedidiot Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32827 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 8/26/2004 9:59 PM
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True, the actual diluted share count is right on the ACGL I/S. What makes my head swim is that the difference between basic & dil share count you see here is material. About 1/2 of the dil shares out are “preference” shares convertible to tradable common 1/1 at any time. These “preference” shares don't publicly trade AFAIK and may have a different value since they do have a different & senior claim on equity than the shares you own.

Weighted Average Shares Outstanding Basic 32,023,865 Diluted 73,500,041


The difference is indeed substantial. P/E's are calculated with both sharecounts here, and you can see what a big impact it has:

http://www.anumati.com/DynamicReport.aspx?id=ACGL&report=VAL-A&dates=31/12/2003;31/12/2002;31/12/2001;31/12/2000;31/12/1999

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Author: DCFNewbie Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32829 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 8/27/2004 12:32 AM
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Jacko2,

Thanks for the tips, I'll get right on it.

I might also post something at the BRK board asking for some additional help.

Regarding BV, it seems to be in line with other Bermuda reinsurers but i'll have to get a bigger universe for comparison.

In terms of getting started, it's not a bad exercise to choose companies known for their excellent business characteristics.

For now I'll pass on switching to an analysis on a more conventional company (I was leaned on PKZ, FDP or NTE). Just for two reason, there has already been enough feedback from other posters to make it worthwhile to investigate ACGL, also I'm afraid that although I will certainly find excellence, I'm not sure I will find value.

iceberg0,

The reasons regarding the big chunk of preferred is related to the specific circunstances in which ACGL was founded.

http://www.insurancejournal.com/magazines/midwest/2004/06/07/features/43082.htm

Arch Capital, which lured Paul Ingrey out of retirement to head its new Bermuda-based reinsurance operation, Arch Reinsurance Ltd., in Jan. 2002. A group of investors led by Warburg Pincus and Hellman & Friedman invested an aggregate of $750 million in the venture, which has since been increased. Arch Capital, which is also headquartered in Bermuda, reported net income of $87.5 million for the first quarter of the year, compared to $ 52.5 million in the same period of 2003.

Those are the guys with the preferred shares. Insiders seem to own about 30% of the total shares. I do not know of which kind but maybe some diligence through ownership filings will give me some insight.

In trying to calculate an EPS thus P/E or DCF, I bet many analysts use different share count assumptions. What would you use for ACGL? Just gives me a headache.

It's not that hard because, like I mentioned before, management makes a good job in placing it all in neat, clean tables on their reports, the only problem is that those reports are really, really long.

Net income (P/S):

Three Months Ended Six Months Ended
June 30, June 30,
-----------------------------------------------
2004 2003 2004 2003
----------- ----------- ----------- -----------
$1.42 $0.91 $2.69 $1.7

No. The raw metrics & ratios do have different importance weightings though in some industries.

...

I'd want to know to what extent their products might have a sustainable competitive advantage to fairly estimate the rate at which the cash & value will pile up for the owner's account.


Allright, then I assume that my initial notion that anything besides FCF, float and dilution is only important to factor in growth and risk (which will give us the final DCF value). Am I right about this?

Regarding the metrics you mentioned. Once again ACGL makes a nice job in spreading it out in tables.

Combined ratio:

Three Months Ended | Six Months Ended
June 30, | June 30,
----------------------------------------------
2004 2003 | 2004 2003
----------------------------------------------
87.8% 90.7% | 88.4% 90.7%
----------------------------------------------

So it seems to be decreasing. And that has happened year after year (I'll post the values for 8 or 12 quarters when I sum up valuation in a future post).

Annualized operating ROE:

Three Months Ended | Six Months Ended
June 30, | June 30,
---------------------------------------------
2004 2003 | 2004 2003
---------------------------------------------
21.1% 15.6% | 20.7% 14.6%
----------------------------------------------

Regarding book value per share, the preferred count makes things a bit more complex, but they layout all the calculations:


Calculation of Book Value Per Share

The following book value per share calculations are based on shareholders' equity of $2.04 billion and $1.71 billion at June 30, 2004 and December 31, 2003, respectively. The shares and per share numbers set forth below exclude the effects of stock options and Class B warrants.

(Unaudited)
June 30, 2004 December 31, 2003
------------------------- -------------------------


Cumulative Cumulative
Outstanding Book Value Outstanding Book Value
Shares Per Share Shares Per Share
------------ ------------ ------------ ------------
Common shares (1) 33,548,012 $36.72 28,200,372 $31.74
Series A
convertible
preference shares 38,364,972 38,844,665
------------ ------------
Total 71,912,984 $28.33 67,045,037 $25.52
============ ============


(1) Book value per common share at June 30, 2004 and December 31, 2003
was determined by dividing (i) the difference between total
shareholders' equity and the aggregate liquidation preference of
the Series A convertible preference shares of $805.7 million and
$815.7 million, respectively, by (ii) the number of common shares
outstanding. Restricted common shares are included in the number
of common shares outstanding as if such shares were issued on the
date of grant.


So book value is increasing, which is good. I'll try and dig up past values for the 2001 and 2002 years.

I would also like to mention dilution:


Diluted weighted average shares outstanding, which is used in the calculation of operating income and net income per share, increased by 5.8 million shares, or 8.5%, from the 2003 second quarter to the 2004 second quarter. Most of the increase in diluted weighted average shares outstanding was due to the full weighting of 4.7 million shares issued in our March 2004 stock offering.


In any other scenario 8.5% anual dilution would be unthinkable. However only 1.1 million or 1.5% were due to stock options, the rest was for all purposes added to net worth.

Have fun!

Challenging ... maybe, but fun?
People who like reading through fillings ... [Insert mandatory RotJob sentence] <g>

Fill us in on ACGL's insurance "float" & it's growth and combined ratio if you dig them out.

...add net loss reserves, loss adjustment reserves, funds held under reinsurance assumed and unearned premium reserves, and then subtracting agents balances, prepaid acquisition costs, prepaid taxes and deferred charges applicable to assumed reinsurance. (Got that?)

Suprisingly enough (or maybe not), that exact formula is laid down right there in the filling:


Cash 188,121 56,899
Accrued investment income 42,219 30,316
Premiums receivable 602,862 477,032
Funds held by reinsureds 206,796 211,944
Unpaid losses and loss adjustment expenses
recoverable 506,715 409,451
Paid losses and loss adjustment expenses
recoverable 23,183 18,549
Prepaid reinsurance premiums 232,329 236,061
Goodwill and intangible assets 31,423 35,882
Deferred income tax assets, net 53,875 33,979
Deferred acquisition costs, net 302,069 275,696
Other assets 157,144 139,264
------------ ------------
Total Assets $6,916,133 $5,585,321
============ ============

Liabilities
Reserve for losses and loss adjustment
expenses $2,702,358 $1,951,967
Unearned premiums 1,529,275 1,402,998
Reinsurance balances payable 104,382 117,916
Senior notes 300,000 --
Revolving credit agreement borrowings -- 200,000
Deposit accounting liabilities 41,495 25,762
Other liabilities 201,119 175,949
------------ ------------
Total Liabilities 4,878,629 3,874,592
------------ ------------

Commitments and Contingencies

Shareholders' Equity
Preference shares ($0.01 par value,
50,000,000 shares authorized, issued: 2004,
38,364,972; 2003, 38,844,665) 384 388
Common shares ($0.01 par value, 200,000,000
shares authorized, issued: 2004, 33,548,012;
2003, 28,200,372) 335 282
Additional paid-in capital 1,548,442 1,361,267
Deferred compensation under share award plan (11,792) (15,004)
Retained earnings 519,700 327,963
Accumulated other comprehensive (loss)
income, net of deferred income tax (19,565) 35,833
------------ ------------
Total Shareholders' Equity 2,037,504 1,710,729
------------ ------------
Total Liabilities and Shareholders' Equity $6,916,133 $5,585,321


I think insurance "float" is equal to Sharehoders' Equity ($2,037,504 in June 30 2004 and $1,710,729 in june 30 2003), since we are talking about Assets - Liabilities. But I need someones confirmation on that.

educatedidiot said "The difference is indeed substantial. P/E's are calculated with both sharecounts here, and you can see what a big impact it has:"

But the values at Yahoo regarding everything but Market cap, book value and enterprise value seem to be correct , including EPS and cash flow information.

But anumati.com seems to have wrong data regarding cashflow activity in last quarters. At least it's very different from what's in the cash flow fillings.

Well that's it for now, I'm gonna try and bait some reinsurance wizs from the BRK board over here to help us, wish me luck.

One final note. There is a good reason why everything you (iceberg0) pointed out as being important to evaluate a insurance company (according to WEB) was present at the ACGL's filling. Constantine Iordanou the CEO was president of Berkshire Hathaway Group's commercial casualty division. So I guess he learned with the best.

Regards,

DCFNewbie

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Author: owekrj Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32833 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 8/27/2004 9:58 AM
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"Absolutely agree. The first couple of times I started to talk to non-investing people about stock-investing, I found out that this was their assumption. And I've noticed that many newbies here on the boards seem to want to get a start in investing by investing in penny stocks. They just want to dip a toe in the water and they think that's the place to start. I've been trying to think of a good analogy that would express the wrongheadedness of this idea, and my latest thought is that starting with penny stocks is a bit like thinking that it is safer or more conservative to try out travel by water in a rowboat than in an ocean liner. (Admittedly, that's not a perfect analogy. I'm hoping someone here can give me a better one!)"
-------------------------------------------------------------------
It's analogous to thinking that by paying $1 for an eighth of an $8 pizza you're getting a better deal.


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Author: owekrj Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32834 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 8/27/2004 10:10 AM
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"3. As to growth: FWIW, this is my current thinking. Greenwald takes up Graham's point that, ideally, one shouldn't pay very much for growth. And that if one must pay for growth in order to buy the security in question, it's important to know that you are in fact paying for what Greenwald calls "growth within the franchise". It has to do with earning an reasonable return on incremental capital. Growth that doesn't earn that kind of return doesn't add value."
-------------------------------------------------------------------

I think that having a firm grasp on the concept that growth--in and of itself--means NOTHING to an investor is critical. And I think that most investors, including professionals, totally miss this point...to their own detriment.

As "Jacko2" and Greenwald point out, growth virtually always requires the input of capital to produce that growth. And what matters to the investor is what return that investment produces. For the Average company in a free, capitalistic society, investment for growth produces a minimal return, as all excess profits eventually get destroyed by competition. Sometimes, the return is even less than the investment, in which case growth robs you of value. For the most part, growth is only really attractive for those rare companies that have sustainable competitive advantages or barriers to entry in their business.

This, as well as a few other CRITICAL concepts to investing are presented very well in Greenwald's book: "Value Investing: From Graham to Buffett and Beyond". I would highly, highly recommend that everyone committing hard-earned cash to equities read and thoroughly digest this book. It will absolutely set you out on the right path.

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Author: owekrj Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32835 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 8/27/2004 10:13 AM
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"In doing security analysis you want to be conservative, and so shouldn't predict higher growth than in the past unless there's a good reason to do so (ie, you've understand the business prospects)."

If you don't "understand the business prospects", you really shouln't be picking stocks in the first place. Either learn to understand them (and stick ONLY to those businesses you can understand)...or put your money in an index fund.



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Author: PaulEngr Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32860 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 8/28/2004 2:52 PM
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What you are essentially saying here is that you don't like debt in a company's capital structure or that they should be holding cash, cash equivalents & investments that exceed debt levels.

I second that. There are certain companies, especially utilities, that are extremely capital-intensive. That is, they have a huge amount of assets relative to their cash generating capability.

As a result, they also usually have a lot of debt. The debt is tied up in the acquisition and maintenance of all of those assets (cable, wire, buildings, etc.).

The end result is that you'll miss out on whole markets if you look for low-debt companies in some cases.

Those same examples are also usually really good at managing their debts (not that they have a choice in the matter).

On the other hand, a smaller operation with a huge debt load and not a lot of assets should be throwing up red flags.


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Author: DCFNewbie Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32863 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 8/29/2004 9:44 PM
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ATTENTION: This thread continues here:

http://boards.fool.com/Message.asp?mid=21234279

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Author: educatedidiot Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32888 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 8/30/2004 8:13 PM
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But anumati.com seems to have wrong data regarding cashflow activity in last quarters. At least it's very different from what's in the cash flow fillings.

I believe there was a glitch in the quarterly cash flow statement that has since been fixed:

http://www.anumati.com/DynamicReport.aspx?id=ACGL&report=CF-Q&dates=30/06/2004;31/03/2004;31/12/2003;30/09/2003;30/06/2003;31/03/2003;31/12/2002

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Author: DCFNewbie Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32896 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 8/31/2004 5:59 AM
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That's more like it. Smooth cash flow....

DCFNewbie

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Author: hmcnamee Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 36340 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 2/16/2005 2:22 AM
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Sorry for the 2nd message on ACGL. I was wondering how you determined that Yahoo's MC number was wrong when you did this analysis? Also, is there an easy way to re-check Yahoo's numbers for MC, EV, and for FCF? I have wondered about some of the FCF numbers I have been seeing on Yahoo. Thanks.

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Author: DCFNewbie Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 36384 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 2/17/2005 7:46 PM
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"Sorry for the 2nd message on ACGL."

Let me try and answer both of your questions.

1) The reason why Yahoo has wrong numbers regarding the market cap and share count is because about half of the shares outstanding for ACGL are special preferred shares in the possession of ACGL's founding entities (two funds I believe). However ACGL is very explicit about it in their 10-Ks and 10-Qs. All other metrics in Yahoo (except EV) are correct (P/E, debt, ROE, CF, ...). I advise you to check ACGL on www.anumati.com. It gives some extra ratios (although the number for outstanding shares is still erroneous). Also read their latest annual report from top to bottom twice. It's very long but extremely helpful in understanding the insurance industry. Finally, my analysis on ACGL has essentially everything I have to say about the company. Read all four parts, cross reference it with their annual report and, most importantly, draw your own conclusions.

2) Another interesting Bermuda (re)insurance company might be MRH. I haven't invested in it because it doesn't quite give me the same confidence. Use yahoo stock screener (http://screen.finance.yahoo.com/newscreen.html) and search for stocks with high ROE and low EV/FCF. You'll find lots of extremely profitable insurance companies.

Hope this helps. Regards,

DCFNewbie

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Author: educatedidiot Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 36389 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 2/17/2005 9:32 PM
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I advise you to check ACGL on www.anumati.com. It gives some extra ratios (although the number for outstanding shares is still erroneous).

The share count on Anumati is 34.7 M as of September.
http://www.anumati.com/Report.aspx?id=ACGL&report=BS-Q&dates=30/09/2004;30/06/2004;31/03/2004;31/12/2003;30/09/2003;30/06/2003;31/03/2003;31/12/2002

The company filings have the sharecount at 34.9 M, but that is as of December. Anumati hasn't added the most recent report yet. I think you might be getting confused between outstanding shares and "diluted" outstanding shares. The number of OS listed on Anumati is correct.

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Author: DCFNewbie Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 36393 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 2/18/2005 5:01 AM
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The number of OS listed on Anumati is correct.

The number of outstanding common shares is correct. The total number of shares isn't. There are 37,348,150 extra Series A convertible preference shares. Those are not included in any financial service's number.

Check the very end of the annual report. There is a table explaining everything:
http://biz.yahoo.com/bw/050214/146258_1.html

DCFNewbie


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Author: educatedidiot Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 36394 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 2/18/2005 7:32 AM
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That report listed common shares.

As you can see, in the diluted EPS calculations, the convertibles are accounted for:
http://www.anumati.com/Report.aspx?id=ACGL&report=IS-Q&dates=30/09/2004;30/06/2004;31/03/2004;31/12/2003;30/09/2003;30/06/2003;31/03/2003;31/12/2002

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Author: DCFNewbie Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 36416 of 46847
Subject: Re: ACGL : A case study on security analysis Date: 2/18/2005 5:00 PM
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As you can see, in the diluted EPS calculations, the convertibles are accounted for:

You are correct.

DCFNewbie


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