Dear investors,
The ideal investment opportunity is to find a high-quality company trading at low prices in the market. This type of opportunity almost never appears when the economic scenario is favorable and the company is showing good results. So, if you want to buy really cheap shares on the stock market, be prepared to invest when the economic scenario is very bad, or when the company is showing bad results, or when both things are happening together.
It was in a context like this that we purchased our shares in Porto (PSSA3). The thesis is interesting because it is practically a textbook case, without major complications or twists, and it illustrates well some aspects of our investment philosophy. So, here we will tell the story of our investment, which is still ongoing. Currently, Porto is the second largest position in the Ártica Long Term FIA portfolio.
What Porto does
Porto is one of the main insurance companies in Brazil, with 13 thousand employees and 37 thousand independent brokers who currently serve 16 million customers across the country. The group is divided into 4 business verticals: Insurance, Health, Bank (financial services) and Services (general). The main one is the insurance unit, which currently represents ~65% of the company's total revenue. It was the activity with which the group began. The other verticals were created with the aim of selling additional products and services to customers who already contracted Porto insurance. The table below summarizes the company's current areas of activity.
In car insurance, Porto is the clear leader in Brazil and has maintained a market share of ~27% for more than a decade, while the second currently has around ~18% (after the acquisition of competitors) and the third ~13%. In the Southeast, the region in which it is most present, its market dominance is even greater. This segment is the most relevant for the company not only because it represents ~50% of the group's revenue, but because it is the best known and the gateway for new customers, to whom the rest of the product and service portfolio is offered in tow. Therefore, we will place more emphasis on this line of business.
The crucial point is to understand how Porto has been able to maintain its leadership position for so long. Stable market share typically indicates the existence of entry barriers and competitive advantages, as it is only with these impediments that competitors are unable to attract large numbers of customers. Sectors with these characteristics tend to have an orderly competitive dynamic, in which each company ends up dominating certain regions or product segments and does not make major offensives to try to take market share from its competitors. This configuration is very applicable to the auto insurance sector in Brazil, where the market share of the main insurers remains stable or changes very gradually over time. See how Porto's market share has evolved since 2000.
Market Share Porto vs other insurance companies
Source: Susep
In our view, there are three main competitive advantages that make Porto's leadership position very sustainable: the scale of its operations, the strength of its brand among end customers and the good reputation and relationship that the company maintains with the broker network independent. Let's explore each of them.
The importance of scale for the auto insurance segment is related to traditional economies of scale (eg: bargaining power in negotiating spare parts) and the need to maintain a service network ready to serve insured vehicles that, for example , get involved in traffic accidents.
This support structure needs to be scaled by the peaks of demand in each region served, that is, by the number of simultaneous services that each assistance unit needs to be able to carry out so that the level of service guaranteed to customers is satisfactory. For a small insurer, both geographic coverage and optimizing the use of the assistance network are problematic requirements.
The issue of geographic coverage is simple. Imagine a small insurance company that only has clients in the state of São Paulo. It is natural that there is a service structure in the region where your customers live, but how can you assist those who are involved in an accident while traveling to Minas Gerais? It is unpredictable where and when customers will travel, and maintaining coverage in all possible areas, to attend sporadic events, is economically unfeasible. The insurer with clients in both São Paulo and Minas Gerais ends up having an advantage. The ideal is to have operations throughout the national territory, as is the case with Porto.
Understanding the advantage of scale in optimizing the use of the assistance network requires some notion of statistics. A traffic accident is a random event with low probability and, therefore, it is impossible to predict whether a specific driver will have an accident on a specific day. However, it is easier to predict the number of accidents that a large group of drivers will suffer in a day, and the larger this group, the greater the predictability of the total number of accidents, as it will be closer to the probability of each isolated accident occurring. multiplied by the number of drivers in the group. This statistical principle is known as the Law of Large Numbers. Thus, the greater the number of customers within the operating radius of a given service unit, the more predictable and constant the number of accidents that this unit will have to deal with each day will be and the lower the total cost per service will be. In this matter, it is not only the total number of customers that matters, but how concentrated they are in a given region. Therefore, the insurer with the largest market share in a given geography will probably have the lowest logistical cost to attend events covered by the insurance. Again, this is the case with Porto in the main regions.
Out of curiosity, the average probability of a person driving in Brazil being involved in an accident is 1 time every 78.9 years, according to our estimates using 2023 data from the Ministry of Transport (neglects small accidents that do not are registered). Thus, an insurance company with 100,000 customers within a service radius of a given unit could expect to deal with around 4 accidents each day in that location. It illustrates how difficult it is for a small insurance company to maintain a support network that offers a high level of service and is not idle most of the time.
As the market leader with national coverage, Porto is in an excellent position to offer the best level of service to its customers and reinforces this advantage with a culture very focused on offering high quality services. Over decades of serving its customers well, it has built an excellent reputation that is very difficult to replicate. Today, the Porto Seguro brand is one of the most well-known and well-regarded in the country.
An insurance company's reputation is especially important because of the dynamics of its business. The customer pays the price of the insurance policy in advance and expects the insurer to honor its role, but he will only put his hope to the test on a bad day, when he is in the middle of the street with his wrecked car. So, it is natural that people seek to take out insurance from a company that has a good reputation and are willing to pay a price premium for the confidence that the insurer will be honest and helpful if called upon.
Porto's average annual car insurance value was R$ 2,600 in 2023, around R$ 220 per month. If a lesser-known insurer offered a lower 10% value, a relevant discount, would it make sense to save R$ 22 per month and not have the peace of mind that you will be well taken care of if you have problems? Most people think not and prefer to continue with Porto, especially because the additional fee is not an amount that will make much of a difference in their lives. This price premium, in relation to the sector average, directly contributes to the company's profitability.
The third competitive advantage is the strong relationship with the network of independent insurance brokers, which handles around 80% of sales of new auto insurance policies. What maintains this relationship with brokers is a set of factors: the commissions paid are attractive, compared to the market average; payments are always made punctually and quickly (up to 7 days), which makes a big difference for brokers, who do not always have such a solid financial situation; Porto's systems and internal team interact with brokers in an efficient and practical way; there are incentive programs to motivate the network, such as, for example, travel prizes or products for the best brokers of the year. This set of initiatives, combined with the strength of the Porto Seguro brand with end customers, means that Porto insurance is preferred by brokers, which increases the chance that it will be the most recommended for its end customers.
Acting together, these three major competitive advantages form a virtuous cycle that increasingly strengthens Porto and makes it very difficult for a competitor to take its leadership position. The scale helps to maintain broad coverage and a high level of services, which pleases customers and reinforces the strength of the brand, which allows it to charge price premiums and have more space to pay brokers well, which helps to attract more and more customers, expanding the scale even further.
Porto's advantage becomes clear when comparing its accident rate (cost of claims divided by the value of insurance premiums issued) with that of the rest of the market. Year after year it remains ahead of the competition (the lower the accident rate, the better).
Accident ratio Porto vs. other insurance companies (%)
Source: Susep
In this situation, Porto has been growing and generating excellent financial results for decades. In 25 years, its revenue has grown and its margins have remained healthy every year, even going through major crises, such as the subprime crisis in 2008, Dilma's impeachment in 2015 and COVID-19 in 2020. Very few companies have such a good track record . In businesses with these characteristics, it is very difficult to lose money investing. Even without any major movement that quickly increases the company's value, the compound effect of a long period of results is significant. Since its IPO in December 2004, Porto shares have generated an average annual return of 16.3%, multiplying its value by 18.3x.
Net Revenue (in R$ Billions)
History of Net Profit and Return on Equity
What created the opportunity
Porto is an old favorite in the market. The almost 20 years since the IPO and above-average profitability make it one of the great success stories of the Brazilian stock market. Historically, its shares outperform the Ibovespa in any 5-year window. Therefore, it is no secret that the group has high quality businesses. What caused its share prices to fall was a particular situation.
During the pandemic, the auto insurance sector suffered some shocks. The first was that the sale of new cars plummeted rapidly in 2020, also reducing the volume of insurance policies that are typically taken out when removing a new car from the dealership. Thus, Porto's revenue from auto insurance did not grow this year and, more impactful than that, the market reduced the growth expectations that its business would have in the years to come, bringing down the share price.
We made our first purchases at the beginning of 2021, still with a timid capital allocation, to monitor the case. Our interpretation was that the insurance sector has been quite resilient throughout history and would probably continue to be so, as private cars would hardly cease to be an important mode of transport.
The first half of 2021 still saw typical growth, but Porto already grew again in the second half. Even so, the company's shares fell amid the beginning of the interest rate hike announced as a measure to combat inflation. We took advantage of this fall to make our first purchases in significant volume at the end of 2021. A little early, in retrospect.
In 2022, another shock affected the industry. During the period of social isolation, the circulation of cars had greatly reduced, also reducing the number of accidents (loss rates) that insurance companies had to pay for. Initially, this impact was positive, but the competitive dynamics of the industry meant that the prices of new policies adjusted to the expectation of lower claims rates. Shortly afterwards, two unforeseen movements negatively affected the profitability of insurance companies: the return of urban traffic to post-pandemic normality was faster than expected and, in parallel, there was a strong upward movement in the prices of cars and spare parts. , increasing the unit cost of claims. As a result, some insurance policy seasons have become much less profitable than usual, compressing the sector's profits. The weaker results and all the unrest in the macroeconomic scenario, due to high interest rates and discussions surrounding the presidential elections, meant that Porto's share price remained low throughout the year.
We keep buying. One factor that gave us a lot of confidence in this is that we saw the company significantly adjust the prices of its car insurance (increase of 43% in the price of policies issued in 2Q22 vs. 2Q21) without this causing a reduction in its customer base, as all insurance companies followed this adjustment. With the adjustment made, it was only a matter of time before profitability was recovered, as unprofitable policies would have to be renewed at the new prices when they completed 1 year from issuance.
It is rare to have so much visibility into the factor that will cause a company to return to its historical profitability and so much clarity about the timeline in which this will happen. To this day we wonder why this investment opportunity existed for so long in such a well-known and liquid stock. Our best guess is that many funds were experiencing redemptions, so many managers were unable to act on the opportunity or were looking for something that offered the hope of faster returns, to try to assuage their investors' dissatisfaction. In any case, we spent 2022 buying Porto shares at attractive prices, until we tripled the capital allocation we had at the end of 2021, making this thesis the main one in our portfolio at the time.
where are we today
Fortunately, the auto insurance unit recovered its profitability and returned to growth throughout 2023, as we had predicted. Growth was even stronger than we initially expected. In the last two years, auto insurance revenue increased by 44%. The rest of the business segments in which the company operates, although not our focus here, also contributed greatly to growth, with non-auto revenues expanding by 57% in the last two years, so that the group's consolidated revenue grew 50% in the period. Note that we are talking about an already large company, with net revenue of R$ 21.3 billion in 2021, which reached R$ 31.9 billion in 2023.
As a consequence of these excellent results, the share price rose again, but more timidly than one might expect. Today, Porto's value is 37% above the market cap calculated with the 2021 closing price, which may seem like a large price adjustment, but the share was already cheap at that time and the business has evolved to a clearly different level in recent years. last two years, which is easily observable by comparing recent financial results.
Another fact that points towards the company still being undervalued is that Porto's current P/E multiple is 8.1x, compared to a historical average of 10.9x over the last 10 years.
One of the arguments that could explain the market's reticence with the action is the expectation that insurance companies will have weaker results in a lower interest rate environment, as part of their revenue comes from the application of amounts received in advance from customers in insurance policies. However, this hypothesis is not verifiable in Porto's results history. The company maintained a similar level of profitability through different economic scenarios with very different interest rates. In short, this happens because the insurance industry in Brazil is very professional and prices its policies already considering the interest curve projected by the market, so that the expected drop in interest rates is already embedded in the prices currently charged.
Porto's Return on Equity vs. SELIC rate (% per year)
In the absence of any good explanation as to why the share would be undervalued, it seems to us that it simply remains cheap, amidst the reluctance of several Brazilian investors towards the stock market. Therefore, we continue with Porto being one of the main theses in our portfolio and optimistic about the results it should bring us in the years to come.
Check out the comments from Ivan Barboza, manager of Ártica Long Term FIA, about this month's letter in YouTube or in Spotify.
