After a recent analysis on MetLife (NYSE:MET), showing MET to have an upside of 30% (higher, now that investors are panicking), I received the following request:
Kovnat is referring to the excess returns model, which is a superior alternative to the discounted cash flow model when applied to bank and insurance company stocks. The excess returns model, created by a professor of the Stern School of Business and written about here, here, and here, values a firm by adding the capital invested in the firm to the present value of the upcoming excess returns. For companies that make most of their money through investments, such as The Travelers Company (NYSE:TRV), this model allows an investor to compare the company's stock price to the true-market value of the capital and future value invested.
Applying the Model to TRV
Keep in mind that this model compares TRV to the market expectations. A higher excess returns model (ERM) price implies TRV to outperform other investments. And if the ERM price significantly differs from the stock price, the implication is a misvaluation of the stock:
- ERM price > stock price: TRV is undervalued
- ERM price < stock price: TRV is overvalued
Obviously, these results would have implications for the shareholders of TRV. An overvaluation, for example, should drive you to sell TRV, all things being equal. Of course, this valuation should only be one of your considerations in whether you buy, sell, or hold TRV, but nevertheless the ERM price gives an objective means of valuating the stock.
We should also look at the ERM trend. Specifically, we should look for three things:
- Is ERM moving upward or downward?
- Does ERM move in alignment with the stock?
- Do ERM movements precede stock price movements?
If the first result is upward, the investments of the TRV are improving.
If the second and third conditions are true, then we can likely use the ERM trend to predict TRV's stock price movement.
The results appear below:
We are in luck in that the ERM does seem to move in alignment with the stock price. As the returns and invested capital increase, the stock price does as well. Likewise, the drop in ERM we saw in early 2008 was followed by a drop in the stock price.
Of course, TRV would have dropped in 2008 regardless of the fundamentals. But so far, we have only seen two drops in ERM: one in 2008 and one in 2015. The more recent one is more concerning for the following reason.
Since 2007, TRV's ERM price seems to precede stock price movements. That is, ERM growth and decline are predicative of TRV's future growth and decline. The steady incline in ERM from 2007, when ERM and stock price were at the same point for nearly a year, has preceded growth in TRV's stock price.
Thus, the recent decline in ERM should predict a decline in the stock price, which we have not yet seen. In addition to that, the stock price has traveled far away from the ERM price. According to this valuation, TRV is 45% overvalued.
TRV has technically been overvalued since 2013. However, with increasingly strong investments, investors had more reason to invest. This effect snowballed to where we are now, standing $30 above the proper valuation.
Implications for Investors
Those currently holding TRV and considering selling might benefit from leveraging this analysis in doing so. Switching to a similar company with a mispricing between the ERM and stock price could pay off in the long run, especially in opportunity cost. TRV's dividend is not high enough to be an attractive buy or hold for a value stock, and its increasingly high price is making it harder to justify in a dollar cost averaging strategy.
Overall, the downside seems high. At 45% overvalued and with only a 2% dividend, TRV has more to lose than to gain. Those who have held it for the past few years lucked out.
Those thinking of buying TRV, however, would benefit from looking elsewhere. TRV's share buyback program has made the stock harder to buy, not only due to its higher price but also due to the reduced outstanding shares. TRV's outstanding shares are less than half what they were in 2006:
Those who have been holding TRV since 2006 have essentially seen a reverse split, only without having to give up their shares. This is the group who made a good investment. In the meantime, the stock price has spun out of control and is no longer in line with the fundamentals, buyback programs withstanding.
Effectively, earlier investors - those who bought before 2013 - received an increased dividend in the form of an increased price per share. Instead of buying back shares, TRV could have issued larger dividend increases, which would make the stock more attractive to investors today. But at present, only those holding the stock prior to 2013 are likely to profit from TRV in the long run, assuming they don't sell now.
TRV is overvalued. Its outstanding share reduction - instead of dividend increases - has kept investors from making their own choice as how to reinvest the excess returns of TRV. TRV is essentially forcing their long-time holders to continue holding the stock and will continue to do so as their share buyback program continues.
If you're holding TRV, have been since at least before 2014, and love the company, by all means keep holding. You're already ahead. But if you're new to TRV and considering investing, don't.
In fact, the only trades I would recommend on TRV are pair trades and shorts.
Pair trade on the insurance sector:
- Long American International Group (NYSE:AIG)
- Short TRV
- Outright short TRV and buy back when you've hit somewhere around $75 a share.
- Buy put options on TRV.
- Sell credit spreads on TRV.
Request a Study
If you're interested in seeing your strategy backtested, having a model run on a stock of your choice, or receiving a statistical analysis, just ask me in the comments section or via mail.
Disclosure: I am/we are long AIG.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.