In my previous article for Torchmark (NYSE:TMK), less than two years ago, I recommended purchasing its shares for various reasons. Since then, the stock has appreciated 65% while S&P (NYSEARCA:SPY) has advanced 39%. As the stock market hovers around its all-time highs, it is only natural that investors are looking for safety and hence I would like to emphasize the safety feature of Torchmark with a deeper analysis.
The bond market currently offers very low yields so the best choice for investors is to find stocks that will achieve a high return, which will be as predictable as possible in order to minimize the potential risk. In my opinion, Torchmark offers as predictable growth as it gets.
To be sure, in the last 4 quarters, the analysts predicted precisely the earnings of the company. More specifically, in the two quarters, the earnings came out completely in line with the expectations, while in the other two quarters, they differed by just $0.01, which was less than 1% error.
The main reason for the predictability of the earnings of Torchmark is the policy of the company to invest its available funds in long-dated bonds, with a lifetime of about 20 years, and hold them to maturity. In this way, the current yield of bonds hardly has any visible effect on the yield of the company's investment portfolio. To be sure, due to the record-low interest rates, the company invested its underwriting income of Q2-2014 ($167 M) on bonds with an average yield 4.7%. However, the annual yield of the total investment portfolio remained essentially the same as in last year's Q2 at almost 6% (5.92% in Q2-2014 vs. 5.95% in Q2-2013). The stability in the investment income is also attributed to the fact that the underwriting annual income (about $700 M this year) that is added every year into the investment portfolio ($13.2 B as of Q2-2014) is only about 5% of the latter and hence the underwriting annual income hardly affects the yield of the investment portfolio.
Therefore, the investment income of the company will certainly yield approximately 6% in the next few years. Moreover, as the underwriting income is about 5% of the total investment portfolio, the investment income will keep growing about 5% every year. If one adds the consistent 5% annual share repurchases of the company, one concludes that the investment income per share of the company will grow at a 10% rate in the next few years. At this point, it is critical to realize that the investment income of the company comprises 27% of its total net income. Therefore, the 27% portion of the company's earnings per share (EPS) will grow approximately 10% per year in the next few years. Even if a deep recession showed up, that part of the company's income would not decline (though it would grow at a slightly lower rate).
The remaining 73% of the net income of the company is the insurance underwriting income, i.e., the income from selling life and health insurance. Torchmark sells these two types of insurance at a ratio of 70/30. This is of course the less predictable portion of the income but Torchmark has exhibited a very consistent record of growing this part of its income by approximately 5% per year. If one adds the 5% share repurchases per year, one concludes that the insurance underwriting earnings per share have grown historically at about 10% per year and are expected to keep growing at that rate. Therefore, the total EPS of the company are expected to grow about 10% per year in the next few years. Even in a stress scenario, in which the insurance underwriting income does not grow at all, the EPS will grow 8% thanks to the predictable portion of the earnings and the share buybacks.
It is really important for investors to realize the value of the predictability of the future earnings. The reason that stocks always have higher dividend yields on average than bonds is because the former have the risk of their unknown future earnings attached to them. However, in the case of Torchmark, whose future earnings are fairly predictable, this risk is minimal and hence the stock should be trading at a high P/E ratio. Fortunately for investors, reality has shown the opposite, with the stock currently trading at a P/E=13, much lower than the P/E of the market (17). While this is a rare gift for investors, they should pick up their gift at some point because the market has started to appreciate the consistent growth of the company in the last few years, raising its P/E from about 10 a few years ago to 13 today.
At today's record-low interest rates, an important question when reviewing any stock is how it will be affected by the inevitable rise of the interest rates. This rise will have two effects on Torchmark. First of all, it will increase the yield of its investment portfolio, which has an average yield of almost 6% at the moment as mentioned above. However, as shown above, due to the long lifetime of the bonds of its investment portfolio, the effect of the rising interest rates will take some years (at least five) to produce a meaningful effect on the company's results.
The second effect of the rising interest rates will be the temporary decline in the value of the already existent bonds of the investment portfolio. This is what the value of bonds incurs when the interest rates rise. However, as Torchmark holds almost all its bonds to their maturity, this decrease in value will never be realized. Therefore, to sum up the effect of the rising interest rates: a beneficial effect on the company's income, which however will take some years to produce a significant boost; and a detrimental effect in the mark-to-market value of its portfolio, which will never be realized. Consequently, the company is 100% ready to deal with rising interest rates.
A note on this: thanks to the record-low interest rates, Torchmark is now facing the opposite side of unrealized losses in its portfolio. Its portfolio has unrealized gains of $1.4 B (almost 3 times its annual net income!) but the company does not include these gains in its net income, as it holds almost all securities till they expire.
From the above, it is evident that the shareholders of Torchmark are set for a consistent, predictable growth of about 10% per year. The only risk could be a serious deterioration in the underwriting policy, which could cause its underwriting income to decline. However, the management has an excellent record of about 3 decades and has proven that it does not sacrifice the underwriting margin in favor of selling more insurance policies. I expect the management to continue to be equally prudent and conservative in the future.
Disclosure: The author is long TMK.
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.