Today was the end of the road for browbeaten property and casualty insurer Reliance Group Holdings(NYSE: REL) , which finally put its poor shareholders out of two years of value-destruction misery and sold itself to diversified holding company Leucadia National Corp.(NYSE: LUK) . Under the terms of the deal, each Reliance share will be swapped for about 0.11 of a Leucadia share, which works out to $2.55 per share based on yesterday's closing prices. Why is that meaningful? After rising to sport a market capitalization as high as $2.3 billion in mid-1998, Reliance's equity ended up fetching a mere $300 million or so today.
The story of just how $2 billion in market value managed to evaporate into thin air in less than 24 months is a topic beyond the scope of a brief news story. In the hands of the right kind of writer, Reliance's rise and fall could probably be novelized into a best-selling business morality tale. Such a tale would touch on everything -- copious amounts of business daring, loads of colorful (and in same cases famous) major and minor characters, and tons of money sloshing around, all set amid the backdrop of one of the largest insurance-related scandals ever.
That scandal -- known throughout the insurance world by the singular, sinister word "Unicover" -- will end up tainting the Reliance name forever, much like history will forever associate Benedict Arnold with the single word "traitor." However, there are deeper lessons that equity investors can take away from the Reliance experience.
For investors, the major lesson that can be gleaned from Reliance's fall involves the dangers of putting money in companies not averse to employing tons of financial leverage to generate profits. In its pre-Unicover heyday of 1998, Reliance was able to show more than $300 million in net earnings on its income statement. The only thing was, the company had to lug around more than $12.6 billion in total assets on its balance sheet in order to do it. Given that shareholders' equity was $1.3 billion in 1998, it was plain to everyone paying attention that Reliance was leveraged to the hilt.
That wasn't so much of a big deal in 1998 when things were going well for the company. However, when Reliance found itself holding a huge liability bag as a result of its involvement with insurance middleman Unicover last year (chronicled well by Forbes in an article earlier this year), the curtain came crashing down. As one insurance industry observer has put it, "Leverage is a magnifier: it makes good results better and bad results worse."
It's for that reason that valuing Reliance post-Unicover using traditional valuation gauges was like trying to value quicksand. Investors might be stunned to see Reliance's equity fetching only $2.55 per share today given the fact that the firm's book value as of the most recent quarter was a much higher $9.56 per share. While that may seem like an enormous margin of safety for Leucadia, which is considered by some as a scaled-down version of capital fortress Berkshire Hathaway(NYSE: BRK.A) , keep in mind what Leucadia is also taking on in return.
According to the most recent 10-Q, Reliance has $735 million in outstanding debt, with $529 million of that total set to come due before the end of the year. There is also the issue of the more than $8 billion in unpaid claims and related expenses that are taking up space on Reliance's balance sheet, and who knows if those liabilities have been estimated correctly by the company.
Using book value may have its place in an investor's toolbox, as last night's Rule Maker Portfolio column illustrated. However, equity investors need to understand that valuing companies based on book value alone is asking for trouble. A thorough understanding of a firm's asset and liability accounts is also required, especially when you are dealing with financial creatures such as insurance companies, where leverage can often be a big part of the game. If you are not willing to invest the time it takes to understand these issues, then there is but one simple solution: Look elsewhere for your investment opportunities.
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