On a daily basis the analysts at Wanger are presented with unique investment opportunities, many of which tell a good story, but lack the “special sauce” that makes the story worth repeating. From a fundamental standpoint, we have seen an increase in the number of companies that appear to be cheap when valued on a P/E or Enterprise Value multiple; however, we have not experienced an equivalent increase in the number of companies in which we would like to invest. This begs the question: How can investors distinguish between a “value trap” and a stock that adds alpha? We believe that a recent addition to our portfolio—Zenith National Insurance Corp. (ZNT) — exemplifies a value play with the right amount of dislocation.

Zenith sells workers compensation insurance to small and medium-sized businesses, primarily in California and Florida. While many of their larger competitors have an appetite for a broad range of underwriting, we were attracted to Zenith’s focus on industry specialization and customer service. In contrast to life insurance, where actuarial tables are more straightforward, the assessment of workers compensation risk requires industry specialization. We believe Zenith’s focus on the agriculture and manufacturing industries is intelligent, but also necessary, given the higher risks associated with jobs in each respective industry.

Higher workers compensation risk translates into higher premiums, but Zenith does not compete on price. On the front end, a business will pay more for workers compensation coverage with Zenith than with its competitors; however, the business will reduce its overall costs in the long-run. How is this possible? After underwriting policies for a customer, Zenith will visit the client with the aim of educating and training employees and management. Over time, Zenith’s goal is to reduce the risk profile of its customers, which translates into less risk, reduced premiums, and lower total costs.

Independent insurance brokers (that we spoke with while conducting channel checks) who sell Zenith’s policies know them as a company that scrutinizes each customer carefully—rejecting the majority of applicants. We are also encouraged by the ongoing service that Zenith provides, which is another important differentiating factor for high

risk employers. For example, California’s state workers compensation plan is one of only a few insurers willing to underwrite high risk policies; however, a worker who gets his hand caught in a machine would prefer to avoid a customer service experience akin to the department of motor vehicles.

On the surface, Zenith appears to have struggled over the last few years, with revenues down roughly 32% since 2007. Currently, the less favorable pricing environment and a volatile investment backdrop create additional challenges for the company. Based on 2009 estimates, Zenith is trading at a P/E ratio of approximately 80. But before you ask me if I wear a bicycle helmet, please try to think of Zenith as one part insurance company and one part investment company. Behind the premium revenue is a substantial reserve account that has been put in place to pay claims as they become due. If, on average, it takes three to four years for Zenith to start receiving claim requests, they will have ample time to invest and create additional shareholder wealth. Similar to their underwriting style, Zenith’s reserve account has been managed conservatively, generating income for the common shareholder to the tune of an 8% dividend yield. Additionally, the company trades at a 12.5% discount to book value, which is composed mostly of the reserve account (and a small, manageable amount of debt). We believe their dividend is sustainable and are satisfied with the outcome of our dividend discount model valuation.

Zenith’s revenue decline in recent years can be explained in part by macroeconomic pressures and in part by management. To the extent that management is responsible for the decline, we believe the downturn was intentional. In a downward pricing pressure environment some companies make compromises on their underwriting standards, aware that their loss ratio will increase, but in the spirit of achieving greater investment returns on their reserve account—a disaster waiting to happen. Zenith is focused on long-term sustainability and their declining revenues speak more to a disciplined business plan than a short-term vision.

As a cyclical play, we believe Zenith will survive and is well-poised for growth during a macro recovery. Furthermore, premium pricing and book values are cyclical in the workers compensation industry. Zenith’s peers are currently trading at an average of 0.9x book value, but have a long-term historical average of 1.4x book. At 0.875x book, we believe Zenith has limited downside. Additionally, we have already seen early signs of premium price increases in California. Significantly higher combined ratios across the industry signal that further price increases are on the way—leading to higher profitability. Price increases and multiple expansion should provide healthy tailwinds as the company regains momentum in a recovery. Until then, weare content spending time with the strong dividend yield and excellent management team.

Lee Wolf is a Securities Analyst for Wanger Investment Management, Inc.