AFLAC (AFL) came up as clear winner in an aggressive quantitative computer filtering program as of 2012-11-23. Visual inspection of operations look good too, but the price is like a bucking bronco and owning this stock could feel like a rodeo ride.
WHAT IT DOES
Before we discuss our filter process, this is a short statement about what the company does.
This US domiciled life insurance company gets about 80% of its revenue from Japan where it is #1 in terms of individual life and health insurance policies in force (not necessarily the most premium in force, but the most policies). It sells both individual and group policies. Cancer policies are an historical lead product for the company in Japan.
The company gets about 20% of its revenue from the United States, where it is the #1 supplemental indemnity health insurance writer.
It is the company with a duck as its advertising mascot -- probably second only to the GEICO gecko in terms of brand identification among insurance companies using animals in their promotion.
Overall, it has more than 50 million policies in force worldwide sold through an agency force and the bank channel.
In Japan, its cancer policy premium is declining, while its medical premium is rising among its protection products; and the company is increasing its premium from savings and accumulation oriented products.
This chart from an extensive 2011 report to analysts shows the changing mix of premium in Japan:
OUR FILTER PROCESS
Step1: The first filter was of all stocks traded in the United States in the Reuters DataLink database for the rate of change of price to be at least as much as the S&P 500 proxy SPY over the last 10 days, 21 days, 63 days, 126 days and 252 days; and for the linear regression slope of the price to be positive over the past 63 days and 252 days.
Of 7,779 stocks in the Reuters database, 424 passed that filter.
Step 2: The 424 Step 1 survivors were subjected to a filter for mean reversion potential, requiring each of the trailing P/E, P/S and P/B to be lower than the 5-year and 7-year average of each multiple.
Mean reversion is one of the better predictors of future positive performance.
There were 13 stocks of the 424 that passed that filter.
Those stocks are:
|Barclays PLC (ADR)||BCS|
|Community Health Systems||CYH|
|Covanta Holding Corporation||CVA|
|Eaton Vance Corp||EV|
|EOG Resources, Inc.||EOG|
|L-3 Communications Holdings||LLL|
|Provident New York Bancorp||PBNY|
|Reed Elsevier plc (ADR)||RUK|
|Salisbury Bancorp, Inc.||SAL|
|Zimmer Holdings, Inc.||ZMH|
Step 3: We visually interpreted multi-year charts of sales, cash flow, free cash flow, earnings, dividends, and payout ratios to identify the most attractive of the 13 survivors of Step 2, with a strong bias toward consistent strong free cash flow.
There were 4 companies that survived that process. They were AFLAC, Eaton Vance, L3 Communications, and Medtronic. AFLAC, however, had the best looking "pictures" in that visual inspection.
Here are the mean reversion data, as well as yield data for the 4 Step 3 survivors in Figure 1. Although only P/E, P/B and P/S multiples were used in the filter, the yield data also shows mean reversion potential.
Higher current yield than historical yield suggests the possibility of reversion to the historical yields by price adjustment.
Collateral to Step 3, we looked into what other analysts think about the four stocks. AFLAC is clearly the favorite.
The Wright rating of 3 alpha and 1 numeric element are for, in order, trading liquidity, financial strength, profitability and earnings growth (0-20).
Here are the "pictures" for AFLAC in Figures 3-6.
We rely on pictures in the final stages, because there are pattern issues that the eye can pick up that typical computers and rules cannot see.
SOME RISK CONSIDERATIONS
AFLAC is not without its disadvantages. Its 10-k lists a number of business risks, mostly common to life and health insurance companies.
It is important to keep in mind that the company's primary revenue and profits source is in Yen, which fluctuates against the Dollar. To a certain degree it is a Dollar/Yen risk.
The slow growth of the Japanese economy and its population are not favorable trends for AFLAC's business, but its move into financial life company products with its higher premiums, and the bank channel, is an important compensation for declining cancer policy sales.
In the United States, Obamacare may reduce the utility of supplemental indemnity health insurance, putting a bit of lid on a key part of its US business.
On the other hand, we think the company will be clever enough to evolve complementary supplemental coverages of one sort or the other as markets evolve, but Obamacare is probably more of an event for it than a process of change in the United States.
The possible elimination or reduction of tax-free cash value build-up in life policies (includes endowments and annuities) in the United States, as part of the fiscal cliff resolution, would limit new product or channel development for those products in the US. Additionally, the vast array of savings and investment vehicles in the US takes away many of the arguments for cash value life products.
VARIOUS METRICS ABOUT AFLAC
Over the past year, analysts have lowered their price targets, but AFLAC is closing in on them now, as shown in Figure 7.
Even though AFLAC has been performing well on a relative basis over the past year, it has left numerous "bear tracks," as Figure 8 shows.
In this figure, we plotted the price of AFLAC from the pre-2008 highs through today. By our measure (price falling more than 20% below the trailing 1-year high price), AFLAC has been in bear territory 6 times since 2007 -- the big one in 2008 and 2009, where the stock when down far more than the S&P 500.
Its worst 12-month period ending in March 2009 was down 73.24%. Conversely , its best 12 months followed immediately with a 202.95% rise.
AFLAC has been in bear territory and deeply so, and should be considered a difficult ride -- not the kind of stock that a conservative dividend investor, or retiree with capital stability goals would want to own. However, that same volatility with steep moves, probably makes it an interesting tactical instrument.
The gold line is the 200-day average. The red line is a plot of values 20% below the 12-month trailing high price. The blue rectangles show periods where the price is below the level that is 20% below the 12-month trailing high price (individual stock "bear" conditions).
The earnings have been much less volatile than the price, which may help make tactical purchases easier to trust when the price seems to overshoot. And, the well covered dividend has been in a steady rise, while the earnings swing and the price gyrates, as shown in Figure 9 (price, earnings and dividends for the last 5 years). Figure 4 shows a current payout ratio of about 22%
Figure 10 plots the last 12 months relative to the S&P 500. The stock which has a 3-year Beta of 1.63 took a deeper dive than the S&P 500 this year, but is now higher on a relative basis.
The S&P 500 is shown in red (left scale) and AFLAC is in black (right scale). The AFLAC 200-day moving average is in green
The tendency to overshoot the S&P 500 in both directions at times is shown in Figure 11, which provides the upside capture ratio, downside capture ratio and capture ratio spread for AFLAC versus SPY (the S&P 500 proxy) using monthly intervals to determine whether SPY price movements were up or down.
Figure 12 further illustrates the high volatility. It shows the standard deviation, mean total return, and Sharpe Ratio for 3 years, 5 years and 10 years for AFLAC and for the S&P 500 (called "benchmark" in the table).
It is really over the 10-year holding period that AFLAC has outperformed, in addition to its current 1-year outperformance. Much patience, a long-time horizon and a strong stomach are required to take a core holding approach with this stock. However, in an actively rebalanced portfolio, this stock may be useful.
Figure 13 shows the total return of AFLAC less the total return of the S&P 500 for the last 40 quarters. Even without the massive moves down and then up in the 2009-2009 period, these differences are substantial.
Figure 14 shows the nice growth pattern over the past 10 years for revenue, cash flow from operations, and free cash flow. Tangible book value took a temporary dip in the 2008 crash, but has recovered fully, it would appear.
Cash flow from operations and free cash flow are essentially the same number, resulting in the plots on top of each other.
Figure 15 shows the P/E valuation coming steadily down over 10 years, which may negate a good deal of the mean reversion idea, but at some point it will be a bottom value. The current 8.5x multiple is low, we think, for a company with such strong operations -- so long as the risk factors listed above don't rain down upon the company.
Price to tangible book multiple and the price to sales multiples are also down, but that is easier to see in the table in Figure 1.
Figure 16 shows the steady rise in the dividend over the past 10 years. The dividend plot in 2006 could be called a decrease, which is not good, but alternatively, the spike could be viewed as a bonus. The post-spike is greater than the pre-spike dividend .
The yield, of course, spiked hugely during the crash, but otherwise has mostly been on the rise until this year, when the price has done very well.
On a dividend payback basis, we think something like a 39% to 46% purchase price recovery could reasonably be projected over 10 years, based on the 1-year, 3-year, and 5-year historical dividend increase rates; versus something more like 30% to 33% for the S&P 500.
AFLAC is perhaps an interesting way to invest in Japan in a company with a dominant brand in the financial sector, with an attractive dividend growth story; but only if very high volatility is either tolerable or desirable.
Right now it is on a winning streak.
If the company can find a way to replicate its success in Japan in other parts of Asia, AFLAC could become an impressive growth stock.
Disclosure: QVM has positions in AFL in some managed accounts as of the creation date of this article (November 26, 2012). We certify that except as cited herein, this is our work product. We received no compensation or other inducement from any party to produce this article, but are compensated retroactively by Seeking Alpha based on readership of this specific article.
General Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions. This article is presented subject to our full disclaimer found on the QVM site available here.