Insurance companies are increasingly going out of favor of many growth-oriented investors as the growth prospects are perceived to be minimal for this industry. However, this shouldn’t stop income investors from investing in insurance companies, considering growth and income investors are at two ends of the spectrum.
The Travelers Companies, Inc. (NYSE:TRV) is a holding of Warren Buffett that provides a range of insurance solutions. The favorable interest rate environment helped Travelers report improved earnings over the last 3 years, and the share price has gained 19% in this period.
Even though growth would be limited in the future, shares are trading with a dividend yield of 2.4% at the market price of around $135 on Monday. More importantly, the shareholder distributions are safe from a cash flow perspective and the company will likely hike dividends per share in the future, as there is room to do this.
The Travelers Companies provide a range of personal and commercial insurance products and services in the United States and internationally. According to data from the 2018 annual report, the company earns 93.4% of its revenue domestically. The international segment is dominated by its business operations in Canada, which accounted for 4.5% of revenue in 2018.
The company operates under three segments.
Business insurance segment
Bond & specialty insurance segment
Personal insurance segment
Commercial automobile and property insurance
Management and professional liability
Personal accident covers
General liability insurance
Property and casual insurance products
Source: Company filings
As confirmed in the third-quarter earnings conference call, one of the primary business strategies of the company is to improve and sustain its competitive advantages to ensure the economic moat. In the long term, such advantages are expected to help Travelers generate economic profits.
Growing the book value per share of the company is also a strategic priority of the management. To this end, the company is focused on striking a balance between shareholder distributions and retained earnings. This strategy has been a success.
Book value per share
Insurance companies thrive when interest rates are on the rise, primarily because insurers realize a higher return on their investments under such a macro-economic environment. The hawkish stance of the Fed in the second half of 2018 prompted Deloitte to issue a favorable outlook report for insurance companies in 2019. However, tables have turned and the Federal Open Market Committee (OTCPK:FOMC) decided to cut the Fed funds rate 3 times so far this year. Even though Jerome Powell chose his words carefully over the last 6 months to give the impression that these rate cuts are indeed mid-cycle adjustments, investors are reading between the lines and are considering these cuts to be the beginning of the next rate-cutting cycle. Lower rates are not ideal for insurers.
On the bright side, the dot plot released by the FOMC in September points to rate hikes in 2020 and 2021. The Committee is projecting a revival of economic growth in the U.S. as trade war fears subside beyond 2019.
Source: Federal Reserve
While things from a policy rate perspective will remain challenging for insurance companies in the short term, the long-term outlook is positive.
The heightened risk for extreme weather conditions in the U.S. has led to many organizations opting to take cover against such events. As the below graph confirms, the average number of billion-dollar disaster events in the U.S. has increased over the last 3 decades.
The demand for property and casualty insurance products will rise along with this increasing average of high-fatality natural disasters that affect the United States. Even though this threat remains elevated, the 2019 Atlantic hurricane season, which ends November 30, has so far caused $13.9 billion in damages, well below the $50 billion of damages in 2018 and the $220 billion of damages in 2017. This is good news for the insurance industry.
S&P Global Intelligence, on the other hand, projects combined ratios of just below 100% for the next two years, based on benefits from continued strength in key business liens and improving underwritings.
Technological advances and Big Data would also be at the center of the insurance industry in the next few years. Many insurers are investing to improve their technological capabilities to understand clients better to deliver a more personalized service. In a report about the future of the insurance industry, PwC projects concepts such as automated underwriting to become common within the next couple of years. To implement such changes, the industry will invest billions of dollars, which would keep capital expenditures at elevated levels throughout the next 5 to 10 years.
Overall, there are short-term challenges for companies operating in the property and casualty insurance industry in the United States. However, the long-term outlook is promising, and the industry is on the verge of transforming to a more digitized one. Growth opportunities are there but insurers will likely grow at low to mid-single-digit rates.
Travelers reported disappointing results for the third quarter of 2019. According to data from company filings, core income declined 45% in comparison to the corresponding period last year. The total revenue of the company, on the other hand, has increased at low-single-digit rates in the last decade, except for a decline in 2015.
Source: Company filings
As explained in many annual letters to shareholders, earning a high return on equity (ROE) is a characteristic that Buffett has endorsed over many years in his investment career. Travelers has consistently earned a higher return than the U.S. domestic property and casualty industry.
Source: 2018 annual report
Travelers has maintained a higher return on equity than the industry primarily due to high-single-digit returns achieved from fixed-income investments.
The balance sheet of the company, on the other hand, remains strong. According to data from third-quarter filings, there are no debt maturities between 2021 and 2025, while only $500 million of debt reaches maturity in 2020. The company would not face any refinancing risk for at least another 6 years, and this places the company in a strong position to approach challenging macro-economic conditions. The debt-to-capital ratio was 22% at the end of the third quarter, and the management is confident of maintaining the debt level below its target range.
The declining interest rate environment will take its toll on Travelers Companies in 2020, and the management expects quarterly after-tax net interest income to be lower by about $10-15 million in each quarter of the next year. However, the increasing assets pile is expected to more than offset this negative impact and drive the earnings higher in fiscal 2020. The macro outlook will turn favorable along with the expected boost from successful trade talks between the U.S. and China as well. Travelers will likely grow at low single digits in the next few years.
Travelers has a long track record of distributing wealth to its shareholders, dating back to 1990. The company was previously a part of the Citi Group and was spun-off in 2004. The dividend per share has grown in each of the last 14 years, which is indicative of the success of the company in this period. Even during the financial crisis in 2008, the company raised its dividends.
According to data from GuruFocus, since 2001, the company has consistently covered its dividend distributions with free cash flow, which is a positive sign for income investors. Free cash flow per share, in fact, has grown at a much higher rate than the dividend per share in the last 5 years, which has left ample room for the company to increase distributions in the future.
The payout ratio is 34% at present and has declined in the last 5 years along with improving earnings.
Both from a cash flow and earnings perspective, Travelers pays a safe dividend. Shares yield 2.43% at the market price of $135.10 on Monday. The yield-to-cost will eventually increase along with the expected dividend hikes, which makes Travelers shares attractive to investors.
The company has been buying back its shares over the last few years as well, which has become another source of income for investors. In addition, these buybacks will improve per-share earnings figures of the company in the future.
Source: Company filings
The price-to-earnings ratio of Travelers does not provide any meaningful indication in comparison to its peers. However, as evident from the below graph, the earnings multiple has remained flat and failed to expand.
A dividend discount model was used to calculate an intrinsic value estimate for Travelers, under the assumption that the company would eventually payout its earnings to shareholders in the future.
The consensus analyst estimates indicate net income growth of 5.3% in 2019 and 13.2% in 2020, but much lower growth rates were used in my model to derive a more conservative intrinsic value that reflects the short-term challenges faced by the company and the industry.
Below are the major assumptions used in the model.
The implied intrinsic value based on these assumptions is $133, which is 2% below the market price of $135 on Monday. Shares are fairly valued.
Travelers Companies will grow at stable and steady rates in the next five years, creating room for dividend growth. The 14-year streak of dividend growth will likely expand in the next half a decade. Shares yield 2.4% at present and the yield-to-cost will grow along with the expected dividend hikes. The cash flow coverage of dividends is excellent, and the balance sheet of Travelers is strong, which are both indicators of a safe dividend. Travelers Companies is a buy for income-oriented investors.
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This article was written by
I am an investment analyst with 7 years of experience in financial markets. I specialize in U.S. equities and incorporate a top-down approach to identify developing macro-level trends and the companies that would benefit from such trends. I am a strong believer that the best investment opportunities could be found in under-covered equities. Please click the "Follow" button to get timely updates on new articles.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.