Adjust The Portfolio

Peter Lynch is probably one of the most famous investors ever.

As the head of Magellan Fund for 13 years, he averaged returns of 29.2% annually. Assets under his management swelled from $18 million to $14 billion. Like a good athlete he left at the top - the size of the fund nearly too large to continue such incredible gains.

Lynch wrote several books on investing and I read a few. I won't say my investment prowess even came close to his.

Not even close.

Peter Lynch

Lack of trust, lack of research, lack of time ...

But the one maxim that Lynch repeated over and over in his writings was to buy what you know.

Lynch would watch the consuming habits of his wife, his kids, his friends - and ask about the products or services that were being purchased and why. Then he'd take a look at the sector, and the companies in that sector to determine whether a company was under valued based on his criteria.

It's really a simple evaluation. Basically, Lynch was interested in the early consumer adoption of a product to predict whether a company making that product would be successful.

The key, according to Lynch, is to buy what you already know and watch the cycles...

With that in mind, I'm intrigued by workers' compensation insurance at this point in time.

Work comp, as we know, is highly cyclical. While the rest of the economy cycles, work comp seems to have higher highs, and lower lows.

The mantra, of course: buy low, sell high.

The trick for investors is to spot the beginning of an up cycle, and it seems like we're entering that phase now.

NCCI, in its last state of the industry observation, noted that carriers for the first time in decades are posting combined ratios below 100. That means they're making underwriting profits - which is nearly unheard of in work comp.

That the business community is tolerating rates and premiums supporting an underwriting profit is unique; work comp carrier profits are typically the product of savvy investments. But investment returns lately have not been good because conservative products, e.g. bonds, have been suppressed by unprecedentedly low interest rates.

There are several trends emerging, though, that fare well for carriers.

In big states California and New York, the minimum wage will increase a third to $15/hour over the next several years. Quite simply, this just means more premium money into carrier coffers because policies are tied to payroll. The more payroll, the bigger the premium, the more money into the insurance company treasury.

In addition, the Department of Labor's recent change to exempt vs. non-exempt/overtime regulations means hundreds of thousands of individuals will see an increase in wages; again, more money in payroll means bigger premiums which means more money to the insurance companies.

The seventh or eighth largest (depending on who is measuring) economy in the world, California, is adding more jobs, faster, than any other state in the nation. The latest unemployment statistics put the state at 5.3% unemployment. More telling, employment in California increased 2.8% in the last twelve months, compared to 1.9% nationally. In addition, most of those jobs are in low risk sectors like IT, or professional services. And the most populous areas, the Bay Area, Los Angeles and Orange Counties, are seeing unemployment rates well below the national average...

Finally, interest rates are poised to head up. After seven years of near zero interest on Federal Treasury Bonds, the mainstay of the investment community, Wall Streeters are seeing signs that the Federal Reserve is getting ready to slowly raise rates as the global economy starts warming up - and there's no reason not to believe that it will since American consumers will, at least for a short period of time, have a bit more purchasing power due to the aforementioned increases in minimum wage and overtime.

So, lots of fresh money will be heading into insurance company treasuries.

But what about paying out that money in claims?

Here's what we know on a national basis: frequency continues to decline reflecting safety and the ongoing shift in the economy to office-type work; work comp medical inflation is at an historic low (unlike the general health sector); and severity is at an all time low.

So, the work comp line is going to be flush with cash for a few years until those high wage claims start hitting the books - which means that carriers will be investing more money into better instruments to make more money before it is needed to pay claims, thus greater dividends to investors which makes the stock prices go up.

Now, I could be a complete investing moron - certainly my track record does not speak to any Lynch-style wonderment.

And economists who watch the insurance industry, like the great Bob Hartwig, may disagree with my analysis.

But, if we follow Lynch's advise, this is something we know. Seems like a good time to adjust the portfolio...