The “Edge Effect” in Investing: Advantages of a Global Mindset
In ecology, “edge effect’’ describes the greater biodiversity that occurs at the edge of different ecosystems, such as where a savanna might border a forest. In such places, new lifeforms come into existence at a more rapid pace, forced to adapt faster to variations at the edge. To us, this concept evokes a powerful visual with parallels in the world of investing. Developing a deep understanding of business across geographies results in a richer perspective and long-term investment ideas. Each day, technology further shrinks distances and expands the opportunity set for many businesses from local to global. For investors, a global mindset is no longer just an edge, it has become table stakes for success.
Any investment edge is never neatly formulaic and is often hard to articulate. We are often asked what having a global mindset means to us in practice and how this has helped our portfolios. It is hard to isolate the impact of a global mindset on the investment process and, ultimately, on performance. What we can do is use real examples to illustrate how this mindset has helped us over the years. In this piece, we will examine one sector – insurance – and reflect on a few examples from there. First, a brief digression to underline three core observations.
Firstly, a global mindset is crucial to stay invested in great companies, many of whom are global in outlook. Where a company is listed and where it earns its revenue today often has little bearing on where its future opportunity set lies. Great management teams understand this and persist accordingly in thoughtful investments that often take them to different parts of the world. To invest and to stay invested in these businesses, we have to make the intellectual trip around the world to understand and value such investments. Secondly, a global mindset is an excellent antidote to short-termism. For companies listed in the developed world, the market has a tendency to undervalue international assets, especially when there is stress in the home business. When this occurs, using a global lens can help us identify great companies trading at a discount to intrinsic value. Finally, we believe there is increased urgency around global investing today. Across the developing world, technology is expanding the opportunity set for businesses at a pace we have never seen before. As investors, not understanding these effects would mean missing out on some of the best investment opportunities of the day.
To understand business at the edges, key hubs in the supply chain are often great places to track. For our first example, let us consider one such gateway – Lloyd’s of London, a global hub for insurance and reinsurance business. Knowing what happens here has helped us with investments listed in countries around the globe, such as Canada, Bermuda, the U.K., and the U.S.
Lloyd’s of London has a long and storied history. Its origins date back to a 17th century coffee house where mariners, ship owners, and merchants met to underwrite ships sailing on dangerous and uncertain voyages. More than 300 years later, a lot has changed. Lloyd’s is now a behemoth in the insurance world, headquartered in an iconic building in London’s Square Mile, with brokers bidding on insurance risks from over 70 countries.
What is interesting, however, is what has not changed. Lloyd’s is the only insurance marketplace in the world where brokers and underwriters sit in close physical proximity and debate the goings on in the world of risk. News and gossip, supply and demand, players and reputations are all debated, shared, and fed into the pricing of deals. Another fact that has remained the same is the difficulty of getting a seat at Lloyd’s. To build an underwriting operation, or syndicate, to scale at Lloyd’s takes years and is expensive due the structure of the marketplace. This makes the established syndicates valuable, a fact that is often overlooked by the market during periods of stress. Tracking the happenings in this hub, while appreciating the long-term value of a Lloyd’s syndicate, has helped us identify several investments over the years, such as Validus Holdings, XL Group, Fairfax Financial, Beazley, and Navigators Group.
Valuing Hidden Jewels
For our second example, let’s turn to the East. It is no secret that Asia now represents the largest contributor to global growth and many companies, irrespective of where they are domiciled, look to benefit from this opportunity set. However, what is striking is how rapidly this opportunity set has expanded just in the last few years through technology diffusion into these developing markets. Data and smartphone availability have brought billions of new customers onto the grid for products and services, ranging from mobile banking to telemedicine. As investors, staying on top of such explosive change at the edges can create investment opportunity. For example, consider the history of two Asian investments that were made by Fairfax, the Canadian insurer and current Diamond Hill holding.
In 2002, Fairfax invested $35 million to establish an insurance business in Singapore. Fifteen years later, with no additional capital, this business called First Capital has become the largest insurance company in Singapore. In 2017, Japanese mega-insurer Mitsui Sumitomo acquired the business for $1.7 billion, representing a 30% compound annual return on Fairfax’s initial investment. Similarly, in 2001 Fairfax partnered with ICICI Bank to establish ICICI Lombard, an Indian insurance company. Over the next 16 years, ICICI Lombard grew to become the largest private property and casualty insurer in India. When the company went public in 2017, Fairfax reduced their stake in the company from 35% to 9.9%, resulting in an after-tax gain of close to $1 billion.
Such international initiatives, despite their modest beginnings, often signal substantial future value. At many points in time over the last fifteen years, Fairfax’s stock price did not reflect the value in these investments. While the market was focused on the anomalies of the insurance pricing cycle, anyone who appreciated the rapid pace of value creation in these markets would have seen the hidden jewels that were in Fairfax Asia. Even today, the market is undervaluing the diverse portfolio of international assets that Fairfax owns including investments in India, a market where technology is leap frogging and the app economy is creating opportunity at a staggering pace.
Gaining from Translation
Operating at the edges can sometimes lead to serendipitous connections. Often what we learn about the dynamics of a business in one geography can be applied to a similar idea elsewhere. Our third and final example, SCOR Group, illustrates this idea. SCOR is a French reinsurer with about half of its earnings from life reinsurance, a relatively obscure business with only a handful of global players, of which only one is a pure-play company. This business allows for reasonable, but not excessive, margins and requires significant industry knowledge and relationships. Given these barriers to entry, it’s no wonder there are hardly any new entrants. Year after year, the same few players maintain their market shares in a pie that grows steadily. SCOR’s business is also remarkably long duration, with results best observed over long periods of time. Individual quarterly results in this business are impossible to predict accurately, even though long-term returns and market positions are relatively stable. This dynamic results in the market unduly penalizing SCOR in the occasional quarter when results are short of consensus expectations. Before investing in SCOR, we had seen this dynamic play out multiple times as investors in Reinsurance Group of America, a pure-play U.S. life reinsurance company. When we invested in SCOR, we believed that the market was not recognizing the value inherent in its life reinsurance business and our confidence in the SCOR thesis primarily came from our experience with Reinsurance Group in the U.S. market. Oftentimes, what we learn about a business in one market translates very well to other markets.
For the best companies, the world is now their oyster, and despite the recent trend toward populism, there is no denying the structural changes happening all around us. Every day, technology is reducing transaction costs and is allowing information to flow more freely, enabling business opportunity to transcend borders. It is imperative for businesses and investors alike to learn to operate comfortably at the edges. It would be egregious not to. Our ultimate goal, after all, is to benefit from economic activity wherever it occurs.
As of January 31, 2019, Diamond Hill owned shares of Beazley PLC, Fairfax Financial Holdings Ltd., The Navigators Group, Inc., Reinsurance Group of America, Inc. and SCOR SE.
Originally published on February 26, 2019.
The views expressed are those of the research analyst as of February 2019, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.