Thursday, June 4, 2009

P&C Insurers: A Sector Left Behind By the Rally

In my most recent article I discussed a conservative and proactive way to approach individual stocks even if the recent rally had made you wary of investing at the currently more elevated valuations. Another tactic that I will detail in this piece is to attempt to identify either specific stocks or entire sectors that have not participated meaningfully in this rally and are still trading at reasonable valuations. The most fascinating thing about the run up in the markets since the beginning of March is the extent to which it has been led by the sectors that had been the most beaten down: for example retailers, financials, REITs and early cyclicals. In contrast, even though just about everything is up from the early March levels, companies that people associate with stability such as consumer staples have actually trailed the market.

The S&P 500 hit a devilishly low level of 666 intraday on March 9th but as of the close on June 2nd had already increased 41.7% to 944. Talk about a bull market rally within a bear market. However, the overall market appreciation understates the dramatic increases we have seen in the shares of some of the stocks that saw the worst declines in the late 2008-early 2009 period. For example, since March 6th American Express (AXP) is up over 136%, Macy’s (M) is up 90% and SL Green (SLG) is up over 186%. Accordingly, anyone who was familiar with these companies and had the discipline and fortitude to buy when everyone else was engaged in panicked selling has enjoyed some substantial gains. In contrast to these startling increases, the returns of some of the more staid companies with enduring franchises and dominant market shares have been mediocre. Take Coca Cola (KO) and Proctor and Gamble (PG) for example. Since March 6th these two stocks are only up 25.2% and 17.1%, respectively, lagging the broader market by a substantial margin. While this is not too surprising since these stocks had not been under anywhere near as much pressure, it is indicative of the type of rally we have seen.

It was within this context that I began to look for sectors or companies that had seen some appreciation over the last 3 months but had not reached valuations that were out of line based on historical multiples and my realistic appraisal of the company fundamentals going forward. What I stumbled on was the not particularly exciting property and casualty insurance/re-insurance sector. This consists of a group of companies that write insurance and re-insurance for mostly property and casualty losses and have some specialty lines as well. Unlike their life insurance brethren, they do not have risky investment portfolios and don’t have exposure to dubious annuity contracts. As a result they by in large have not seen the extreme volatility that companies such as MetLife (MET) have (up 145% since May 6th but still 54% below the 52 week high). There is no question that P&C insurance companies’ stocks have bounced way off of their 52 week lows, but what struck me is that they continue to trade at multiples that are well below their historical averages.

Below is a chart that details the current tangible book value multiple and recent average multiple for 8 of the companies in the P&C insurance space that I am following:


Stock Price

Current P/TBV

2003-2008 AVG. P/TBV

































Group Average



* AWH average multiple only covers the years 2006-2008

-Source: Capital IQ and my calculations

As the above table indicates, despite the exuberance we have seen in the markets these companies still appear to be trading at attractive valuations. As a group they are currently trading at 95% of TBV in comparison to an average of 142%.

That is not to say that these companies have not faced significant headwinds over the past year. First off, despite not getting the press that Hurricane Katrina received, Hurricanes Ike and Gustav (apparently the national weather service let the guys who created South Park name the hurricanes) caused a severe amount of damage and led to significant losses for these companies. Furthermore, all of these companies have seen some losses in their usually conservative investment portfolios due to the dislocation in the markets. Insurance companies are often big buyers of the debt of financial institutions, securities that have obviously taken large hits as a result of the solvency concerns regarding many firms. Also, as the ABS and MBS markets got larger and more liquid, the managers of the investment portfolios bought these securities while relying on the ratings of the rating agencies. As a result, as the true value of the underlying collateral for these instruments has become more obvious, these companies have been forced to realize losses. Finally, even with the 41% increase in the S&P since early March, the index is down almost 35% from its peak in 2008. Accordingly, just about any equity portfolio has taken a beating.

However, most importantly, the pricing environment for P&C insurance and re-insurance has been relatively soft over the past year. At a recent meeting with Markel (MKL) CIO Tom Gayner, he indicated to the group of attending analysts that AIG’s continued presence in the market has absolutely distorted market-wide pricing. Specifically, Gayner believes that AIG is writing contracts at prices well below those of competitors and feels that these will eventually turn out to be extremely unprofitable. This practice has served to limit price increases that the other P&C insurers are willing to take and has kept the entire market depressed. As a result, smart companies are turning away business in order to retain pricing discipline. At this rate, according to Gayner, it is going to take a major catastrophe to help firm up pricing in the industry.

All of that being said, I believe all of these headwinds are more than reflected in the stock prices. In fact, a number of these companies had very good first quarters of 2009. Take Aspen Holdings (AHL) as an example. In Q1 2009 AHL earned $1.39 per share versus $.89 in all of 2008 and $1.40 on a trailing 12 month basis. If you annualize that number, the shares are trading at only about 4.4x forward EPS. Furthermore, the combined ratio (ratio of losses and expenses to net premiums earned) for Q1 was 84.5% and the company recognized $69.4M in underwriting profit in Q1. What those two items indicate is that AWL made money on its insurance operations and not just from its investment portfolio, In contrast, Fairfax Financial (FFH), which is run by famous value investor Prem Watsa, has traditionally had combined ratios at or near 100%, a fact that means that most of the company’s earnings have come from the investment portfolio. To me that sounds a little bit like a hedge fund operating with cheap capital and I personally would rather own a company that has a proven track record of profitable underwriting as well.

At the current price AHL sports a solid 2.5% dividend and is trading at 76% of tangible book, 42% below the 5 year average multiple of 1.32x. Also, with debt to equity of less than 9% and $663.6M of net cash on the balance sheet, it does not appear that AHL is going to be at the mercy of the capital markets any time soon. While the company does still have some non-agency MBS losses in the investment portfolio and is always at risk of being exposed to a major catastrophe, I think the valuation remains compelling even after the run the stock has had.

In conclusion, I think it makes sense for investors who are afraid to touch some of the stock that have led the rally to do more research on the P&C insurance/re-insurance space. Obviously these stocks were much more attractively priced in early March but that does not mean that there are not some bargains remaining for investors who have a long term time horizon.

Specifically, here are 10 attributes I would focus on when evaluating these companies:

  1. Conservative investment portfolio with minimal ABS and MBS exposure
  2. Historical combined ratios below 100% (except in major catastrophe years)
  3. Gross premiums written flat to slightly up year on year as an indication of pricing discipline
  4. Valuation on a price to book and price to tangible book well below recent historical multiples
  5. Consistent dividend policy
  6. Preferably strong insider ownership or recent share purchases
  7. Consistent gross redundancy when it comes to future loss estimates as a sign of a conservative loss projection policy
  8. Low debt to equity ratio and net cash on the balance sheet
  9. Company and subsidiary credit ratings of A (from the dreaded S&P and Moody’s) or better
  10. Long enough track record in the business so that investors can examine performance in soft markets, hard markets, and catastrophe years

(Picture courtesy of