Sunday, May 29, 2011

Betting on a Housing Recovery - Title Insurance

Transaction volume in the American housing market has been in a downward trend since 2007, likely driven by 2 factors:
  1. massive over-pricing caused by speculative demand prior to 2007 - prices are gradually dropping to more affordable price-to-income ratios.

  2. a generally sour employment situation and a weak income growth, caused by a slow economy since 2008.
At some point in the future,the number of transactions in the housing market will recover because America's underlying demographic trends point to continued growth in household formation over the next few decades. Prices are likely to continue coming down as the excess housing inventory continues to be brought to market (as banks gradually write-off their repossessed properties and make them available on the market at lower prices to stimulate buyers). As prices come down, transaction volumes are like to start trending upwards once housing prices revert to more affordable levels and the employment situations recovers

One way for investors to bet on this recovery is to invest in title insurance companies. Title insurance is unique to the American market. Unlike many other countries around the world, the United States does not have a centralized register of land records. Land records, claims and liens are filed with different authorities and recorded in many different registers, depending on the jurisdiction and the laws/practices at the time of a transaction. Title insurance companies help buyers manage the risk that a title has a competing claim recorded against it somewhere. Title insurance companies do this by establishing and maintaining a database of land records, and guaranteeing to a buyer that a particular title is free from defects or competing claims, and that the buyer is able to legally take ownership of the title. They more or less are taking on the role of a national land registry in the United States.

The economics of this business are:
  1. fundamentally low risk. Unlike typical insurance companies, title insurers behave more like the operator of a reference service or a fact-checking company that guarantees its results. Unlike Life and P&C insurance companies, title insurers generally do not assume much risk in their business. Their business model is to use their databases to screen out bad risks, and only insure those title transfers which the database indicates is free from competing claims. If executed correctly, this business is one whose profit characteristics are fairly stable.

  2. not-obsoleteable, and a non-discretionary item in real estate transactions. The product is an unavoidable expense, as mortgage lenders require that title insurance be a part of every real estate transaction. The flip side of this is that broad business volumes generally follows real estate market transaction volumes. The demand for title insurance is a derived demand - it is a second order demand, which derives from the first order demand for housing. As a derived demand, there is little that management can do to stimulate demand. In this sense, its characteristics are like those of common carriers shipping lines, where one of management's primary value-add is in being able to pre-emptively adapt company capacity and costs to changes in the industry primary demand trends.

  3. moderately scalable. Once a database is built and maintained, additional business signed primarily works to reduce the per-unit cost of maintaining the database. The additional variable costs primarily come from growing and running the sales and distribution network. In downturns, these companies have to adjust by cutting the sales and distribution infrastructure. As long as business does not drop below the database maintenance costs, the business should be able to survive.

  4. highly commoditized. Apart from economies of scale, there is little competitive advantage that a firm can build over a competitor. The title insurance business is a commoditized and highly transactional one. There is little to structurally differentiate one title insurer's product offering from another. 
In the United States today, the 4 largest players are:
  • 1 Fidelity National (FNF) - 38% market share
  • 2 First American (FAF) - 27% market share
  • 3 Stewart Information (STC) - 14% market share
  • 4 Old Republic (ORI) - 11% market share
Given the economics of this business, it is highly probable that the largest player within a jurisdiction can work towards having the lowest cost, and establish a structural competitive advantage as the lowest cost provider. Because of the commoditized nature of the product, getting to the lowest cost position is a matter of who has the best execution ability and cost-focus. In other words, until an 800-pound gorilla emerges with its attendant structural competitive advantage of being the lowest-cost player, it is a tactical dog-fight and good management becomes the source of a key competitive advantage for a title insurer.  Make no mistake, this is a competitive commodity business. The single digit margins that even the largest players have suggests that competition is brutal, and product differentiation minimal.

An investor who wishes to bet on the housing recovery can try investing in either FNF or FAF. A bet on either company is fundamentally a bet:
  1. that housing transactions will start trending upward at some point over the next 5 years, benefiting all title insurers (the "rising tide raises all boats" theory).

  2. the size of the company allowing it to build in a low-cost competitive advantage over smaller competitors.

  3. the management of the company being able to out-execute its competitors, and building it into the lowest-cost player
Khrom Capital has identified another title insurer (ITIC) which it believes is a good investment opportunity. Read about it here on Scribd: Khrom Capital on ITIC .  

What can go wrong for title insurance companies?
  1. Government regulation can become onerous and impose pricing controls on title insurance products.

  2. The United States could start implementing a system of land registration, which would obviate the need for title insurance.

  3. The United States banking industry is becoming more concentrated, with the top 5 lenders accounting for an ever growing share of mortgages in the market. It is potentially detrimental to a title insurance company/industry if they decide to come up with their own title insurance system, or boycott any of the title insurance companies.
  4. Title insurance is offered "in perpetuity" to a buyer, and there is typically no limit on when a claim may be filed. For example, a title insurance company is on the hook if there is a contest to a title even 15 years after the purchase of the property, as long as the buyer from that purchase still has a stake in the house. Any defects in the title records / title plants of the company today may not be known till many years down the road.
[ Update 29 Jan 2012: An excellent introduction to title insurance can be found at this website: ]