Ace Limited (ACE) has been on a roll since June, racking up a 30% gain. Insurance company valuations have been depressed since the financial crisis, so it’s even more impressive that a company like Ace is hitting new highs while still trading at less than one times book. If they can return to historic valuation levels, shares have room to move much higher. I recently wrote a similar article about one of their competitors, HCC Insurance (HCC) (HCC Insurance: Historically Cheap), which is in a similar situation as Ace. They’re also a very well run insurer hitting new highs with a depressed P/B.
Ace is a global commercial property and casualty insurer. They have four segments: North American, Overseas General, Global Reinsurance, and Life. North American and Overseas General constitute more than 80% of their business.
Ace’s most recent bump up was because of outstanding results in the 4th quarter. They beat EPS estimates for the quarter by reporting $2.05 and $9.11 for the year. Looking ahead, they issued 2011 guidance of $6.10 to $6.50. On the negative side, their combined ratio increased slightly to 90.3%, although this is still much better than most of their competitors. For example, W.R. Berkley (WRB) has a combined ratio of 94.1%, and Travelers (TRV) is 93.2%. The Australian floods have been a big source of uncertainty for global insurers like Ace. On their conference call, CEO Evan Greenberg estimated that losses specific to Ace would be $75 to $90 million, although the situation is still fluid.
The best metric to measure insurance companies is price to book. Ace is particularly impressive, both as a company and as a stock, when you examine their book value. Current book value stands at $68.59. That’s 17% higher than where it was at one year ago and 58% higher than two years ago. 2008 was certainly at depressed levels, dropping 14% that year from the previous year, but if you look at them over a ten year period, you’ll see strong, consistent book value growth. Book value at the end of 2000 was $23.36.
That makes the company impressive, but looking at their historical P/B is what makes the stock attractive. In 2000 their P/B ratio stood at 1.8. In 2005 it stood at 1.5. Even in 2008 it stood at 1.2. Today? It's at .9. That is significantly lower than their history and doesn’t reflect their strong growth in the recent past and expected growth in the future. To come up with a price target, assume they return to 1.3 times book and book value grows at a 5% clip over the next year. That would give them a stock price of $93.63 at the beginning of 2012. At current prices, that is a significant increase with apparent downside protection.
Let’s briefly discuss why P/B values across the insurance space are depressed. First, prices are soft and there is little future visibility right now, although Ace has been able to increase their prices. Two, the low interest rate environment makes it difficult for insurance companies to make substantial gains on investments.
For those unaware of how insurance companies make money, only part is from proper premium pricing. The gains (or losses) from investing the float can have serious consequences on the earnings of the insurance company. Because preservation of capital is so important, a low interest rate environment limits the investment gains and depresses yields from bond investments. If we are, in fact, in a bond bubble right now, insurers will be disproportionately affected.
Finally, inflation is not the friend of the insurance industry. Because insurers collect premiums in today’s dollars and pay them out in future dollars, high inflation is very harmful to the business model. While we don’t officially have an inflation problem right now (But don’t tell that to companies dealing with rising commodity prices), valuations in the industry are depressed in anticipation of high future inflation. In my opinion, inflation is the biggest risk and the thing that most limits my investments in this sector despite the cheap valuations.
I earlier wrote an article highlighting four reinsurers that traded for less than .8 times book. Ace is a slightly different business model, but compared to their historical range, they would fit right in with those other companies. Ace is undeniably cheap, but your enthusiasm level will depend on your macro views.