The financial crisis of FY08 which initiated in the financial services sector of U.S. had detrimental impacts across the global economy. Virtually all industries were adversely affected worldwide. At the same time, investors with stakes in financial services companies suffered substantial losses as the prices of their investments hit the floor. The effects of this financial meltdown are being realized to this day. The economy may have demonstrated a substantial recovery and the global equity indices may be hitting their all time highs, but the investors still remains reluctant in terms of allocating their funds towards the financial services industry. These investors have become more aware of financial risks associated with these businesses and require a stronger premium in order to induce investment.
However, the environment is changing primarily because the financial services industry is efficient in terms of producing profitable growth. Specifically the insurance industry's outlook appears to be robust. The insurance segments are equally sensitive to economic and financial shocks which is why an appropriate proportion of premium requirement is understandable. In my opinion, there are a few insurance companies which are capable of producing such a premium for their investors. Ernst & Young states that the outlook for insurance companies is bright. This is because almost all companies have suffered from the macroeconomic factors such as the financial shocks and the post-crisis low interest rate environment but the insurance segments have considerable potential as the demand for their products remains strong.
CNA Financial Corp. (NYSE:CNA) is an insurance holding company operating primarily in property and casualty insurance. The company's core business operations are further divided into three segments which include CNA Specialty, CNA Commercial and Hardy.
From an investor's standpoint, there is a need to identify the companies which will outperform the industry in an upswing. CNA appears to be an attractive opportunity as the company's credit rating has improved substantially and the company has shown a remarkable recovery over the post-crisis period in terms of revenue growth. CNA has done well in maintaining a net margin above 6.5% in the past three years. The company has posted earnings of $0.93 per diluted share.
The above chart shows the performance of CNA Financial Corp. and two of its competitors, Travelers Companies Inc. (NYSE:TRV) and W.R. Berkley Corp. (NYSE:WRB), since the beginning of FY13. The chart shows that CNA has outperformed its competitors in terms of stock price appreciation and the subsequent sections will show that despite this outperformance, CNA remains relatively undervalued.
In order to determine the valuation of the company and estimate the extent of potential, a comparative valuation has been conducted using a few important valuation indicators.
Data Source: Morningstar
The above chart illustrates a comparative analysis of key valuation metrics between the three insurance companies and the industry averages. The P/E ratio for WR Berkley seems to be more attractive than the other insurance companies but across all other price ratios, CNA demonstrates significant undervaluation allowing for a substantial upside potential. Most importantly, the P/B ratio of CNA for three years up till FY07 averaged at 1. As with the improvement in the insurance industry's outlook, we expect investor confidence to recover towards pre-crisis levels and therefore the price metrics are also likely to reach similar positions. Therefore, the P/B of 0.7 is on its own a strong indicator of sizable upside potential. The P/E multiple on its own does not support this notion but going forward, CNA's PEG Ratio of 0.6 suggests substantial undervaluation considering the growth potential of the company's earnings. Lastly, the company is also offering a decent dividend yield of 2% which is higher than the industry average. The dividend yield helps in compensating for a high amount of risk.
As we consider the earnings yield of the company, we see that CNA is offering a stronger percentage as compared to the S&P 500 as shown in the figure above. This suggests a premium for the high-risk nature of the company as it operates in the financial services industry.
The above chart illustrates the earnings yield of the three insurance companies since the beginning of FY10. We can clearly see that the company has been offering a stronger earnings yield as compared to its competitors in the post crisis period and this undervaluation will prove CNA to be the most lucrative stock as soon as the industry begins to recognize its vast potential.
The insurance industry's performance is recovering because of robust demand for its products. The only factor for investors to consider is their risk appetite and the corresponding upside potential of the company. CNA appears to be offering a substantial upside potential and the company is simultaneously decreasing its risks as well. Moody's has improved its stance on CNA's credit standing as a report by the rating agency suggests that all market signals for CNA have improved over the last year. Considering the strong upside potential coupled with mitigated financial risk, I recommend a buy stance.