When I want a good buy on clothes, whether I am shopping for a suit or skivvies, my eye always turns to the clearance, buy-one get-one, sale, or discount items. I like to feel like I am getting a bargain. In fact, I often pick the store I plan on shopping based on my perceived understanding of its likelihood to be holding otherwise quality goods at some reasonable discount (from retail) price.
I admit it. I try to buy Polo branded clothes at Ross. Sometimes I can find them, and it usually requires work. But at least I've narrowed my search to a place known for helping one dress for less.
It stands to reason that when I am looking for an investment opportunity, I'd like to find a deal as well. A good place to start is to find industries and companies that are out of favor, perhaps by comparing to historical earnings multiples, sector or macroeconomic indicators.
Two such industries are the Property & Casualty and Accident and Health Insurance industries. Both contain opportunities to invest in solid companies holding collectively trillions of dollars in assets with many years of earnings and dividends.
Insurance is defined as the equitable transfer of risk of a loss from one entity to another in exchange for payment. The concept of transferring or distributing risk was practiced by early Mediterranean sailing merchants (circa 1750 B.C.) who would receive loans to fund shipments that had built-in premiums that would guarantee the lender would cancel the loan should the shipments be stolen or lost at sea.
Modern property insurance owes its origins to the 17th century "Great Fire of London" which destroyed more than 13,000 homes. Marine insurance (late 17th century), life insurance (18th century), and accident insurance (19th century) have been around for nearly as long.
In general, policy holders (or the insured) are willing to take a smaller, known loss (premium payments) in exchange for the insurer's promise to compensate the insured in the case of a (presumably) larger, unknown loss that may or may not ever occur.
Insurance companies profit when earned premiums (plus investment income) exceed incurred losses and underwriting expenses. Insurers don't leave the unknown losses to chance. They employ the actuarial science of rate-making (price-setting) which uses statistics, probability, and lots of history to determine the appropriate rates to set for agreeing to take on the risk of loss.
Maintaining adequate insurance is widely regarded as a cornerstone of sound financial planning, and in many cases is a legal requirement (think state-minimum auto coverage, federal unemployment insurance). For those that believe in an "invest in what you know or use" policy, publicly-traded insurance companies can offer interesting long-term plays.
As a student of Benjamin Graham, I typically start my universe of investment ideas with a relatively elite group of companies known as dividend aristocrats (companies that have a history of increasing dividends every year for at least 25 years). Despite only containing 51 constituents, the list of dividend aristocrats includes three insurance companies: Aflac (NYSE:AFL), Chubb Corp (NYSE:CB), and Cincinnati Financial (NASDAQ:CINF).
First, a little background.
Aflac profile: Aflac Incorporated, through its subsidiary, American Family Life Assurance Company of Columbus, provides supplemental health and life insurance products. It operates through two segments, Aflac Japan and Aflac U.S.
Chubb profile: The Chubb Corporation, through its subsidiaries, provides property and casualty insurance to businesses and individuals. The company distributes its products through independent insurance agents and brokers in the US, Canada, Europe, Australia, Latin America and Asia.
Cincinatti Financial profile: Cincinatti Financial Corporation is engaged in the property and casualty insurance business in the United States, operating in five segments: Commercial lines P&C, Personal lines P&C, Excess and Surplus lines P&C, Life insurance and investments. The company also offers commercial leasing and financing services.
We will evaluate each based on Graham's stock selection criteria for the defensive investor and determine if the business of insurance is right for your portfolio.
1. Adequate size of the enterprise
Graham cautioned that smaller, less established businesses (those with annual sales of less $100 million) are inherently more risky than larger companies. Adjusting for inflation, companies should have current annual revenues of approximately $536 million or more.
At $4.5 billion in annual revenue, even the smallest of these companies (Cincinnati Financial Corporation) clears the mark almost nine times over.
AFL Revenue (Annual) data by YCharts
Aflac, pass, 44.66x required minimum. Of note, nearly 75% of the company's premium income is derived from Japan. Prolonged dollar/yen exchange rate fluctuations can have a material impact on revenues (premium income) and net income.
Chubb, pass, 26.02x required minimum. Of note, Chubb derives approximately 75% of its premium income from the United States, with commercial insurance accounting for nearly 43% of net written premiums.
Cincinnati Financial, pass, 8.45x required minimum. Of note, over a quarter of the company's earned premiums are derived from just two Midwestern states: Ohio and Illinois. MRQ investment income accounted for approximately 11% of revenues.
Winner: Chubb. Its US heavy blend of premium mix can help this actuarial challenged guy sleep at night.
2. A sufficiently strong financial condition
Current assets should be at least twice current liabilities. The risk of near-term liquidity issues is significantly diminished when a company has $2 in current assets for every $1 in current liabilities.
None of the subject companies present classified balance sheets with total current assets and liabilities, but we will nonetheless assess current liability (unpaid policy claims + unearned premium) coverage by current assets (cash + receivables + short-term investments) as a proxy for current ratio.
We will supplement this criteria with each company's Fitch Ratings' "Issuer Default Rating" (a measure of an entity's relative vulnerability to default on financial obligations, "AAA" [Highest Credit Quality] to "D" [default]) and "Insurer Financial Strength Rating" (an assessment of the financial strength of an insurance organization, "AAA" [exceptionally strong] to "C" [distressed]).
|Date of Fitch Rating/Affirmation||Fitch Long-Term IDR||Fitch IFS||Current Ratio|
|Cincinnati Financial (6/14)||A-||A+||.3939:1**|
*Excludes future policy claims
**Excludes IBNR (incurred but not reported)
Cincinnati Financial, fail.
Winner: Chubb. Its slightly lower modified current ratio is more than offset by its stronger Fitch ratings, which are a more thorough and appropriate assessment of financial strength.
3. Earnings stability
A business should be in the business of making profits, at least according to Graham. His third criteria for the defensive investor is that the company posted some earnings for the common stock in each of the past ten years.
AFL Pre-Tax Income (Annual) data by YCharts
Aflac, pass, some earnings for the common stock for 10+ years. 10-year average EPS growth 16.09
Chubb, pass, some earnings for the common stock for 10+ years. 10-year average EPS growth 15.02
Cincinnati, pass, some earnings for the common stock for 10+ years. 10-year average EPS growth 4.06
Winner: Aflac. All of these companies have an impressing earnings streak, Aflac's size and international presence give it an opportunity for growth, but investors should be aware that gains in home country GAAP earnings can be wiped out by foreign currency translation.
4. Dividend Record
From 1926-2012, stocks have returned approximately 9.8% annually. Dividends have accounted for 42% of that return. It's no wonder that Graham saw the value in an uninterrupted dividend record for at least the last 20 years.
AFL Dividend (Annual) data by YCharts
Aflac, pass, increased annual dividend for 30 consecutive years, most recently 5.7% to $.37/quarter.
Cincinnati, pass, increased annual dividend for 53 years, most recently 4.76% to $.44/quarter.
Winner: Chubb. Its most recent dividend increase was impressive, and its conservative payout ratio of 22% (tied with Aflac), along with significantly less foreign currency risk makes this one a no-brainer.
5. A Earnings Growth
Graham was concerned not just about a company's ability to generate earnings, but also to grow them.
His criteria for earnings growth was a minimum increase of at least one-third in per-share earnings in the past ten years using three-year averages at the beginning and end.
|2011-2013 Average EPS||2001-2003 Average EPS||Growth|
Cincinnati Financial, pass.
Winner: Chubb. Aflac has an impressive record of EPS growth as well, but I like the focus Chubb has placed on its US operations.
6. Moderate Price/Earnings Ratio
A stock represents an ownership in a business. If you invest in a great business, but pay too much for it, you expose yourself to financial risk.
Graham believed that current price should not be more than 15 times average earnings of the past three years.
|Trailing 3 years EPS||Price||Price/Trailing 3 year EPS|
Aflac, pass. Note, current P/E as of close on 7/28 9.85, below Accident & Health Insurance Industry average of 12.90.
Chubb, pass. Note, current P/E as of close on 7/28 10.63, below Property and Casualty Insurance Industry average of 18.90.
Cincinnati, fail. Note, current P/E as of close on 7/28 17.54, below Property and Casualty Insurance Industry average of 18.90.
Winner: Tie. Aflac and Chubb both appear reasonably priced at less than 15 times trailing 3-year earnings, and also relative to their composite peers.
7. Moderate Ratio of Price to Assets (price to book)
Graham summed up his investing thesis quite simply as "margin of safety". He was as concerned with paying too much for an earnings stream as he was an asset base. His final stock selection criteria for the defensive investor was two part, both based on a book value multiple.
Current price should not be more than 1.5 times the book value last reported. However, he acknowledged that he was willing to exchange some of his margin of safety in paying for the fair value of assets if he was paying a correspondingly lower multiple of earnings.
Graham suggested that the product of the price to book and price earnings multiples should not exceed 22.5. This latter refinement results in what is known as the Graham Number, or the square root of (22.5 * Earnings Per share * Book value per share). The Graham number is a notion of a stock's intrinsic value and represents the maximum an investor should be willing to pay).
|Book Value Per Share||TTM EPS||Graham number||7/28 closing price|
*Above table based on finance.yahoo.com as of 7/28/14
Aflac, pass, price to book*price to earnings less than 22.5
Chubb, pass, price to book*price to earnings less than 22.5
Cincinnati Financial, pass, price to book*price to earnings less than 22.5
Winner: Tie. Aflac and Chubb. Both companies are below Graham's maximum price/book and price/earnings product and both are priced at less than 90% of their Graham number.
Summary and final verdict:
Aflac: Passes all criteria except adequate financial condition.
Good for your portfolio if: You want significant exposure to Japan, don't mind earnings swings based on exchange rates, want to go with a large multi-national A&H provider.
Chubb: Passes all criteria except adequate financial condition.
Good for your portfolio if: You value dividend growth, want a multi-national P&C provider with significant exposure to United States.
Cincinnati Financial: Passes all criteria except adequate financial condition, moderate price/earnings ratio.
Good for your portfolio if: You can stomach the risk of having a US P&C provider with the majority of its revenues being derived from just a handful of Midwestern United States.
And the winner is...
Chubb Corp.: Its attractive price relative to its Graham number and its Sector, and strong historical and continued recent dividend growth make it a perfect investment consideration. Kind of like a fine pair of slacks, marked down 25%.
A word of caution:
First and foremost, take the time to read Graham's original text of The Intelligent Investor, then find one with updated commentary to put Graham's thresholds, analyses, and lingo into context today (I like Jason Zweig's version).
Next: Graham laid out these as minimum criteria to be considered for investment for the defensive investor. Strict application thereof suggests if a company fails any part of the analysis, it is not investment grade for a defensive investor.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.