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I enjoy analysing complex multinational businesses like Old Mutual, as with so many moving parts it's more likely to reward one with pricing opportunities. For instance, whilst most of Old Mutual's value rests in South Africa, there is also a chunk in the US, Europe, the UK and Sweden - these values are moving with exchange rates all the time. Of course I haven't gone as far as I could go down the valuations rabbit-hole, so it's possible that others are outanalysing me & arbitraging against me (which is why I demand a margin of safety before I invest)! In the case of Old Mutual, I'll only invest if there's a 40% or more discount to embedded value.

I put a lot of emphasis on embedded value/share when wondering about what a life assurer's true share value is. For a life assurer, earnings merely represents the unwind rate of its embedded value (which is actually true of all companies, although most don't calculate embedded values as they don't have long-term liabilities). To understand this take the extreme case where a life assurer had one policy left which matured in the last financial year, and had a net charge of R10,000 in the fnal year - then the earnings for the year was R10,000 and the embedded value of the assurer at year end was 0 - clearly the embedded value gives a better idea of the value of the business, as there are no policies left and therefore zero value (of course you could counterargue that the R10,000 earnings is a better indication, as the staff of the business will write another policy which will start to accrue earnings, but my argument is that the embedded value gives a better idea of the value of the current book of business, and it is also possible for embedded value to take account of new business written).

Life assurers' competitive moat

What I like about life assurers is that they aren't completely dependent on selling new stuff, like a business which sell cars, for example, as there is already a lot of value consisting of existing business on their books - this is a strong competitive moat. Banks are similar, where many people would rather chop their little toe off than go through the inconvenience of changing banks.

Historic discounts to EV of Old Mutual

Old Mutual has traded at an average discount to EV of 15% on the year-ends since it listed. However, some say that part of the discount is as a result of the increased complexity of the business. So, when did Old Mutual start becoming complex? I would argue, since its purchase of Skandia in January 2006. Despite the purchase of Skandia in 2006, Mr Market valued Old Mutual at a surplus to embedded value at the end of 2006 and at only a 3% discount at the end of 2007. So the average discount to embedded value since the purchase of Skandia is 27%. Also, Old Mutual is now attempting to simplify the business, as is evidenced by reading their 2011 interim results: "We have continued to rationalise our business and reduce its complexity. On 7 April 2011 we announced the completion of the sale of US Life to Harbinger Group inc for $350 million. We have announced that we are closing our Swiss operation to new business. We will maintain our strict
value criteria for deciding which businesses remain within the Group."

Mergers of large businesses take a lot longer than people usually anticipate, and my view is that Old Mutual is only at the very early stages of realising operational synergies: "We continue to look at ways of improving synergies across our businesses and have recently agreed to outsource the South African IT, voice and data infrastructure network services of Old Mutual, Nedbank and Mutual & Federal to Dimension Data. The agreement is expected to generate significant local savings for the operating businesses involved over the next five years."

As these positive steps of simplifying the business and realising operational synergies are realised, I expect the market's confidence in Old Mutual to grow, and the discount to embedded value to narrow.

Expected return

Cost of capital in EV calc + change in discount rate

My sale price

Old Mutual isn't what I rate as a quality company. While an argument could be made for holding out for a smaller discount, I am also keen on exiting as I feel SA Equity is overvalued and their share price will be knocked by any fall in the SA Equity market (I'd rather be holding cash, and using the cash to increase an arbitrage strategy I have going). So my strategy is as follows:

• Sell 1/5th at a 30% discount 1594.6c

• Sell 1/5th at a 25% discount 1708.5c

• Sell 1/5th at a 20% discount 1822.4c

• Sell 1/5th at a 15% discount 1936.3c

• Sell everything remaining at a 10% discount 2050.2c

Purchase price

Old Mutual is an interesting investment when its discount to embedded value hits 40%.

Information

21 October 2011

30 June 2011

31 Dec 2010

31 Dec 2009

31 Dec 2008

31 Dec 2007

31 Dec 2006

31 Dec 2005

31 Dec 2004

31 Dec 2003

31 Dec 2002

31 Dec 2001

31 Dec 2000

31 Dec 1999

Allan Gray

In the 2nd quarter of 2011 the Allan Gray optimal fund built up a 1% exposure in OMLs.

In their Q12010 report, Allan Gray demonstrated how Sanlam's new business margin indicates their pricing discipline (they had a chart up to 2008, I've extracted the actual numbers from Sanlam's annual reports, and added on the latest). Interesting that the new business margin decreased in the years following the chart Allan Gray set up, and has never again attained the hights of 2008.

In their Q12007 report Allan Gray concludes that "Despite growing their policy liabilities at 17%, Sanlam and Liberty's embedded value have only grown at 9% p.a. and 11% p.a. respectively - implying a greater conservatism in the calculation of the embedded value." This is one of those rare occasions that I disagree with Allan Gray - my view is that this might merely reflect a change in the mix of business at Sanlam, from high margin smoothed bonus business to market-linked business.

RE:CM

On the 15th January 2011 RE:CM reported that they had both sold and purchased Old Mutual - the average sale price was R15.25 and their average purchase price was R13.86. The sale was done mid-2010 "against a signifant overweight overexposure relative to what our process justifies, whilst the purchase was done against inflows from new investors into the fund late in the year"..."Following the announcement that HSBC's proposed bid for subsidiary Nedbank had been withdrawn, Old Mutual's share price suffered a marked decline, which once again increased the margin of safety and therefore the investment appeal of the share. We have bought shares accordingly." At 31 Dec 2010 Old Mutual Plc was the 6th biggest holding in the RE:CM Flexible Equity Fund, with 3.6% exposure; and the 7th biggest holding in the RE:CM Global Flexible Fund with 2.5% exposure.

In their April 2009 Investment Insights:

"[Old Mutual's] market value at the time of listing ten years ago was R36.8bn. Since then it made acquisitions valued at R70bn. Currently its market value is about R26bn. Taking into consideration that it has distributed dividends of close to R25bn, Old Mutual has destroyed value for shareholders in the region of R50bn over the last ten years. Truly a case of the institutional imperative gone horribly wrong! Recently however, the risk return relationship appeared to have become skewed and we looked at the investment case anew. Buying Old Mutual at the current share price of R5 is equivalent to paying only for the South African Life Insurance business and getting the SA Asset Management, US Asset Management, Skandia and Old Mutual's 55% stake in Nedbank and 77% stake in Mutual & Federal for free."

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