I've been reading "John Neff on Investing" and came across a situation he encountered in the 80s with beaten-down property and casualty insurance companies. Wall Street predicted that asbestos-related problems were going to be a liability of approximately $500 billion. Wall Street overreacted and insurance stock prices moved downward significantly. Sounds familiar to me. Insurance stocks have been beaten down with many of the recent natural disasters in Japan and in the US, which have made for some real bargains.
Instead of focusing on the fate of the insurance industry if costs reached the predicted magnitude, we wondered about the impact once overreactions melted away. - Ness
Neff decided to buy Cigna (CI) at its lows with special consideration to the low P/E and well-managed business. After the market realized the predictions were overblown, Cigna's shares advanced 54% and property and casualty insurers advanced 45%. The S&P 500 gained 29%
One of my favorite stocks right now is Aflac. This stock has taken a beating over the last year, dropping 32% from its highs with concerns of the natural disaster in Japan and questions about investments made in European banks. Its investment portfolio is roughly $90 billion and most of that is outside the debt-laden Euro banks. Aflac is now selling off or already has sold off much of its exposure to the troubled European countries for a loss. This has scared investors and has created an overblown sell-off very similar to Neff’s situation in the 80s.
- Dividend: 3.5% (31% payout)
- 5 year Dividend Growth Rate: 17.99%
- Debt/Equity: 28.3
- Forward P/E: 5.4
- Price/Free cash flow: 2.0
Aflac is sitting on a 2-year low and sporting a P/E around 9. The 5 year P/E stands at 15.6. Price to book is at 1.35 with a 5-year price to book of 2.9. Besides the drop in 2009 due to the U.S. subprime meltdown, we are seeing some record low valuations.
Total Return Ratio
In honor of Neff I will use his Total Return Ratio (Annual Earnings Growth + Yield ÷ Trailing P/E Ratio). Analyst estimates have Aflac’s projected 5-year earnings at 12% growth. As with all analyst estimates, they are usually over-optimistic. I’ll play it conservative and cut Aflac’s growth rate to 6%.
6% + 3.3% = 9.3% total return
9.3 (total return) ÷ 9 (trailing P/E) = 1.032
Neff considered a total return ratio of .7 as a worthy investment for further research. Using the forward P/E of 5.4, we get a total return ratio of 1.722.
I also applied the Graham Number:
Square root of (22.5 * earnings per share * book value per share)
√ (22.5 * 3.81 * 25.37) = $46.64
I get $46.64, which has a Margin of Safety of 33.5%
Vitaliy Katsenelson’s Absolute P/E Model
This is a new favorite of mine. Generally, Vitaliy assigns expected earnings growth rates with a certain P/E. A no growth stock is a P/E of 8 (Jae June and myself use a P/E of 7 to be safe). Then you add the yield for the “basic P/E”. He assigns Business risk, Financial Risk and Earnings predictability with a premium or discount depending on the company (average is a 1). I’ll probably do the full breakdown in another post, but I won’t go into it here. The valuation is explained in greater detail by Jae Jun here.
This is the equation:
Fair Value P/E = Basic P/E x [1 + (1 - Business Risk)] x [1 + (1 - Financial Risk)] x [1 + (1 - Earnings Visibility)]
I assigned a 5% discount to business risk, financial and earnings visibility. I assigned earnings growth yet again with 6% opposed to analyst predictions of 12% growth.
Absolute P/E came out to: P/E: 12.7
Fair value: $46.39 Margin of safety: 35.1%
At 12% growth I get a fair value of $59.13
I think John Neff would love this stock. On a value basis, a contrarian basis and fundamental basis I believe Aflac is worth investing in. As is usually the case, the market has overreacted and they’re ignoring the prospects of this company. I will be waiting patiently with a 3.3% dividend for everyone else to recognize this as well.
Disclosure: I am long AFL.