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In the October 31 edition of  Value Investor Insight, Ed Maran of Thornburg Investment Management described why he sees unrecognized value in Allstate (NYSE:ALL). Key excerpts follow:

Turning to some specific ideas, describe the investment case for Allstate.

EM: Allstate is a personal-lines property/casualty insurer with large market shares in both home and automobile insurance. It’s the second-largest auto insurer, a business we believe has high barriers to entry and large economies of scale, both of which should allow the leading players to increase their market shares over time. Such companies have more underwriting experience and better models, so they should be able to price their policies more effectively and profitably. For Allstate, that has translated into a lower-than-average combined ratio [insurance losses and expenses, divided by earned premiums], averaging 93% over the past five years.

Home insurance is riskier than automobile insurance because of potential losses from natural disasters, but Allstate is well diversified by product and geography and has a culture of conservative underwriting focused on profits over growth – even if it means not writing business in higher-risk markets. All that should be obvious, but historically the best way to lose money in this business has been to underprice policies in the name of growth.

The investment case here is relatively straightforward. We consider personal-lines insurance to be a stable, recession-resistant business that has tended to grow over time as the number and value of automobiles and houses increases, and we expect Allstate to capture greater market share as it takes advantage of its size. Given that, we think the sharp fall-off in the shares has resulted in an unusually attractive valuation relative to projected earnings, book value and its peers.

How comfortable are you with the company’s investment portfolio?

EM: We actually think it is fairly transparent and indicates the company has been prudent with its investments and owns mostly high-quality fixed-income securities that don’t pose significant risk of permanent loss. That’s not to say the market isn’t concerned about it, but that’s a big reason the shares are so cheap.

How are you valuing the shares, which at a recent $24.70 have fallen 45% just in October?

EM: Assuming a normalized combined ratio of 93%, we estimate earnings per share for 2010 of around $6.50, which is somewhat higher than Wall Street’s consensus estimate of $6.05. So on our normalized earnings estimate, the stock is trading at a less than 4x multiple.

Looking at it another way, for a company that we expect to earn a 14% return on equity over time, we think the stock should trade for 1.5x book value. That’s not at all aggressive for a relatively stable, low-risk business with a mid-teens ROE. But the stock today trades at only 80% of book value. Just getting to 1.5x book would imply a nearly 90% gain in the shares, and we believe book value will continue to grow as earnings are reinvested in the company.

How big is the risk Allstate will need to raise capital?

EM: That’s obviously something to look at very closely in this environment. We don’t expect them to need additional capital, but even if they do – as a result of some shock to the investment portfolio or a big natural disaster of some kind – we don't expect any dilution to be high enough to derail the investment thesis.

One risk in auto insurance would appear to be share erosion from direct-sales competitors like Geico and Progressive. How is Allstate responding to that?

EM: Online auto insurance sales are growing faster than the overall market, so the company is investing in its Internet platform and has gotten smarter about competing with Geico and Progressive. If Allstate stumbles on that front, that could be a risk. Overall, though, we believe the agent relationship is highly valued by customers who choose to buy that way, and that relationship gives Allstate a leg up as it looks to sell other related products.

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Source: The Long Case for Allstate