Sporting P/Es of 5.6 and 7.9 respectively, MetLife (MET) and Prudential Financial (PRU) have become chronically undervalued. Ten years ago, both companies traded at multiples comparable with the S&P 500 average: today, they trade at half that. Here's a three-year chart for Prudential (green) with MET (gray) for comparison:
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Share prices have gone up and down: however, a linear regression shows PRU flat-lined, while MET is trending downward. During this same three-year period, PRU increased Book Value excluding Accumulated Other Comprehensive Income (BV ex AOCI) by 7.93% annualized. The dividend was increased from 70 cents to $1.45, and currently yields 2.5%. Combining growth in BV ex AOCI and the dividend, shareholder returns have been 10% annually, but Mr. Market will not pay up for this performance. On the same basis, MET has been earning 6%, eliciting a negative response.
Cost of Capital
Aswath Damodaran finds an 11.43% cost of equity capital for the Life Insurance industry, which inverts to a P/E of 8.75. Because they are not meeting their cost of capital, both MET and PRU are trading under GAAP book value. While it is possible to argue that market perceptions exaggerate the risks associated with the business, the logical response (for management) is to either deploy excess capital at an ROE in excess of cost, or return it to shareholders, by dividends or buybacks.
MetLife CEO Steven Kandarian discussed the topic at the company's 2012 Investor Day (see transcript) :
So a part of what I talked about is increasing our return on equity, and I also talked in the beginning about creating shareholder value over the long term. And those 2 things come together, return on equity and also your cost of equity capital, come into play.
So if your cost of equity capital is going up, then that raises the bar for return on equity. And that differential is really how you create shareholder value. If your return on equity is above your cost of capital, you're really creating shareholder value. If your cost of capital is higher than return on equity, you're destroying shareholder value. Now we're trading at a discount to book. So market is saying to us, essentially, you have those numbers wrong. Your cost of capital is above your returns.
So to change that dynamic, we think, work on both increasing our return on equity and decreasing our costs of capital. And one of the key elements of decreasing your cost of capital is risk. The riskier your overall portfolio is perceived or is, either one, whether it's is or perceived, it still goes through your stock price, the higher your cost of equity capital.
I was unable to locate an equally explicit discussion of the topic from Prudential's John Strangfeld. However, the company has set an ROE goal of 13% to 14%, and has been deploying capital accordingly, while returning excess capital to shareholders by means of buybacks. As of June 2012, a $1.5 billion authorization from the prior year had been completed, and the board authorized an additional $1.0 billion, amounting to 3.7% of shares outstanding.
Using BV ex AOCI as the primary metric, I apply an estimated ROE to arrive at earnings, and multiply by a P/E of 8.75 (to reflect the 11.43% cost of capital).
Prudential is holding between $4.5 and $5 billion of excess capital, half of which is easily deployable. ROE for the most recent quarter, after removing special items, was in excess of 11%. Assuming half of the excess capital is deployed at 14%, an ROE of 12.85% emerges. BV ex AOCI is $60.77 per share. $60.77 X 12.85% = $7.81 X 8.75 = $68 per share.
For MET, using management's expected ROE in the 11% area for 2012: $48.60 X 11% = $5.35 X 8.75 = $47 per share.
Compared with recent share prices in the $59 area for PRU, and $37 for MET, there is considerable room for share-price appreciation. Low interest rates have been keeping a lid on share prices here, and if yields on the 10-year treasury continue to rise, these companies will benefit.
Questioning Perceived Risk
Life Insurance was not always considered a high-risk business. Here's a chart, showing the historical 60-month beta for MET and PRU since they demutualized and went public:
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Three important risks faced by these companies are interest rate, foreign exchange, and equity market fluctuations. These risks are hedged by means of derivatives, and judging by the resources devoted to the hedges, interest rate is the most important, and forex the least.
Equity market risk is created by guarantees provided with variable annuities. These liabilities are treated as embedded derivatives in the financial statements, and offset by derivative hedges. In effect, they sell put protection to their customers, and buy it on the markets. Since the companies' results reflect equity markets, to include the S&P 500, as hedged, it is difficult to see why beta would be greater than 1. Logically, hedging should reduce beta.
Intuitively, the risk of interest rate fluctuations on bonds is less than that of equity market fluctuations. Empirically, the life industry has been exposed to an unprecedented shock on interest rates. The Fed has steered long-term interest rates into uncharted waters. Yet these companies continue to earn respectable profits. MET in particular has been very effectively hedged. So, if bonds are less risky than equities, and the interest rate risks are hedged by means of derivatives, why should the operation be more risky than bond investments?
Forex is not a major item. Japan is Mecca for life insurance companies, and there is a ready market betting for and against the yen.
The insurance holding company structure incorporates well-known risks. The debt is held at the holding company, which relies on dividends or returns of capital from the subsidiaries in order to service the debt. The financial statements include a discussion of the amounts that the subsidiaries can pay as dividends without prior regulatory approval. Management presentations discuss liquidity at the holding company level. A review of these considerations does not show any problems, and the bond markets view the risk with equanimity.
As the financial crisis recedes into the rear-view mirror, and falls off the back of a 60-month computation, life insurance company beta may start to trend back toward values that prevailed prior to 2009. Comparing 36- and 60-month beta, the trend for insurance companies is developing favorably, while for banks the progress is uneven. Here's a table comparing big banks and high beta insurance companies:
What Drives Beta?
At the risk of oversimplification, or restating the obvious, financial stress is the primary driver of financial institution share price volatility, and consequently, of beta. According to the STLFSI (Saint Louis Fed Financial Stress Index), stress has been falling rapidly.
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Implications for Investment Strategy
Life insurers, being high beta, outperform in up markets, and underperform in down markets. Investors who have a good sense of timing can conduct themselves accordingly. MET and PRU have been acting like 2X S&P 500 ETFs. They pay a dividend and don't have the same funky behavior when held long term.
MET has shown a strong inverse correlation with iShares Barclays 20+ Year Treasury Bond (TLT), consistent with market perceptions of interest rate risk. If treasury yields continue to increase, life insurers will outperform.
When a company consistently increases a metric such as book value, and continues to vacillate around the unchanged mark, compression results. The situation can't continue indefinitely, and eventually a breakout of share price or a breakdown of performance will ensue. In this instance, I'm looking for a breakout.
Using a 2- to 5-year time frame, increasing interest rates and decreasing beta should result in increased multiples for MET and PRU. I'm investing on the basis that share price appreciation will be in low double digits over the next 5 years.
Thoughts on Value Investing
I've been investing in MET and PRU since September 2009, with respectable profits on PRU, and a modest loss on MET. Neither company has met my expectations. As a rule of thumb, if a value candidate doesn't pan out within two years, the investor should look elsewhere.
In this instance, I'm still holding and looking for share price appreciation. The Fed's repetitious QE programs created considerable concern about insurance company profitability. Those concerns have been alleviated, at least with respect to quality P&C insurance companies such as Chubb (CB) and Travelers (TRV).
Revised accounting rules on DAC (Deferred Acquisition Expenses), together with non-intuitive accounting for hedging gains and losses, as well as fluctuations based on an absurd rule calling for mark to market on the companies' own debt, have operated to obscure actual results when presenting financial statements.
The Fed's restrictive regulation of MET as a bank holding company has pressured the share price. PRU and MET are widely expected to be designated as SIFIs, causing anxiety about regulatory capital requirements.
As heavy users of derivatives, these insurance companies get labeled with the same "complex financial" criticism that applies to the big banks. The distinction is, the insurance companies are legitimately hedging their exposures in the real economy, while the big banks and their hedge fund clients are using derivatives for speculative purposes, intent on replicating losses and passing off risk on the unwary. Heavy-handed solvency regulation of the banks has one benefit: it will make them into reliable counterparties, so that the insurance company hedges will function as intended.
The point is, that with so much noise in the environment, additional patience may be required before the underlying performance of MET and PRU is reflected in their share prices.