Companies that provide insurance for long term care (LTC) are required to keep a ‘reserve’ available for claims. The requirement makes sense if you consider the vulnerability of policy holders when they need to make their claim. Imagine what would happen if your mother, father, or spouse needed insurance coverage but the company carrying the policy was unable to pay out.
All by itself, reserves are a normal cost of doing business. It’s not a bad thing to keep these assets available and the business model is fine. However, once in a while, a company doesn’t do a very good job preparing for this reserve requirement due to unexpected claims, or just poor management. This happens to companies with pension requirements, as well, from time to time, and the shortfall has to be made up and constitutes an “expense.”
Such is the problem that Genworth Financial Inc (NYSE:GNW) is dealing with right now. Its shortfall is clearly meaningful but it doesn’t know how material it will actually be. After initiating a review in July, 2014, the company has delayed revealing its position until after the New Year.
As you can see in the chart below, the long term care issues were disclosed in July, and the stock was downgraded by analysts (including a “junk” debt rating from S&P) in November. Since that time, analysts are still not sure what the final long term care review will look like but the stock has been consolidating in a triangle near $8.50 per share.
Genworth Financial, Inc. (GNW): Chart Courtesy of eSignal
From a technical perspective, the consolidation hasn’t broken out yet but we like the idea of a short position in Genworth if the lower trendline is broken. Entry orders at or under $7.50 per share may make sense. But this trade isn’t just about the problems that are unique to this long term care company. Inflation expectations (or the lack thereof) are driving bond yields lower. Unfortunately, this is a bad thing for most insurance companies who usually hold very conservative bond-based portfolios. Lower yields means lower income, which is a problem for any of the firms in the sector.
Sometimes choppy market conditions are referred to as a “stock picker’s market” because investors are more inclined to look for fundamental-value for new positions. Distressed firms, turnarounds, or growth problems are all a lot less attractive during these periods as investors reallocate from risky assets to safer investments across the board. We expect that this will put a great deal of pressure on GNW in the short term.
The CEO, Tom McInerney, told investors in December that the long term care review should be disclosed in the first quarter of 2015. That disclosure should line up with Genworth’s earnings report expected in the first week of February. Obviously, a surprise in the report could lead to a significant amount of volatility either direction. Analysts are actually a little split on the stock with JPMorgan (JPM) — among others — being very bearish while BTIG is looking for upside, and Raymond James upgraded the stock in November.
We agree with the JPMorgan analyst, Jimmy Bhullar, who has said, “Given the company’s limited disclosure on its in-force block, as well as significant management discretion in setting assumptions for reserve analysis, we consider projecting the charge with precision an exercise in futility.”
If it’s so uncertain, why do we like a downside position on the stock?
Because of the uncertainty, this looks like a very short-term opportunity to us with an exit time limit of the earnings report in February. This is basically the opposite of “buy the rumor, sell the news,” Right now, low interest rates are going to hurt GNW and there is a significant amount of uncertainty around the long term care issue.
We expect traders to continue selling into the earnings report and potentially buy the news once it has been released. Clearly, we can’t say for sure what will happen after the report, but that is a pattern that is repeated frequently enough — e.g., ITT Educational Services’ (NYSE:ESI) enrollment report in November — to suggest taking advantage of the pre-announcement selling.
John Jagerson and Wade Hansen are the editors of SlingShot Trader, helping investors capture options profits trading the news by using a proprietary 100% news-driven trading platform that turns event-driven pricing inefficiencies into fast profits. Get in on the next trade and get 1 free month today.
New to options and need more personal guidance? Try our online options course: Strategic Investing and receive your first two weeks free by clicking here.
