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Tuesday, March 16, 2004

Over the past few years, we at Contra the Heard have tweaked our methodology to emphasize a corporation's margin of safety in the selection process and avoid the crash-and-burn stories. After all, sometimes out-of-favour stocks deserve to be neglected. They are, as described by our friend Norman Rothery, who edits and the Rothery Report, "cigarette-butt" stocks: cheap, easy to pick up, but only okay for a puff or two.

Nonetheless, we still get tempted to walk on the wild side occasionally. Such was the case with our purchase of the Pennsylvania-based health insurer Penn Treaty American Corp. (PTA-N) last December at $1.61 (U.S.), which closed yesterday at $1.83.

Like all Contra purchases, Penn has traded at far higher prices in the past, but the astonishing speed at which the company imploded is quite extraordinary. If one examines a 10-year price chart, the stock made a steady climb from the $6 level in 1994 to a high of $35 in 1997. After that, it seesawed in a downtrend for the next four years, settling at $17.40 on March 29, 2001. The annual report for the year 2000 came out; three days later the stock was trading at $2.60.

So what caused this implosion?

Insurance companies are particularly difficult for an investor to assess. Like all businesses, they grow by selling more product; in the case of Penn, that's more policies for disability and long-term health care to more people. But unlike with the vending of most goods and services, every new sale brings with it a long-term liability, i.e. the future claims that the customer may make under the policy. The cash flow coming in from premiums and invested capital is balanced with the money going out to satisfy current demands.

Computing the liability associated with future claims is the realm of actuarial science, which analyzes historical statistics to make predictions. Of course, the tricky bit is that assumptions change over time, sometimes causing claims to be much higher than expectations. That results in premium increases that make for unhappy consumers. Even worse, if the insurer becomes insolvent, policy holders may be out of luck.

These potentially dire effects on the population elevate the insurance business to a political issue. The industry is heavily regulated, premium increases frequently need to be approved by government bodies, and the insurance companies' levels of capital are carefully scrutinized.

So on one level, Penn's ability to sell lots of new policies to an American population terrified of being sick and broke in their old age made it a terrific success. In 2000, book value was up to $25.81 a share, with a profit of $3.17 a share. But to support that growth, the corporation needed to increase its capital base just as quickly, a feat it found much more troublesome.

The repulsive piece of news in that 2000 report was the auditor intoning that Penn might not have sufficient capital to cover its mandated "statutory surplus," casting doubt on whether the company could continue as a going concern. With that came a requirement for a "corrective action plan" from the Pennsylvania Insurance Department, and the ability to issue new policies was severely curtailed.

Since then, Penn has survived by balancing gingerly on a knife-edge. The auditors have removed the going-concern warning and convertible debentures have raised desperately needed capital, causing the number of outstanding shares to rise sharply, and further dilution is likely. The power to sell new policies has been regained in most jurisdictions, most recently in California, which traditionally represents about 15 per cent of revenue.

We only made a smallish bet on this stock, knowing full well that our investment could disappear into Chapter 11 like a puff of smoke. But if Penn can turn the corner to prosperity and reach our initial sell target of $12.24, we will enjoy one of Cuba's finest cigars.

Benj Gallander and Ben Stadelmann are co-editors of Contra the Heard Investment Letter. This column first appeared on

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