Prudential Financial: Own A Piece Of This 'Blue-Chip' Rock That Yields 7%

Jun. 20, 2020 7:00 AM ETPrudential Financial, Inc. (PRU)211 Comments

Summary

  • This is one of the best high-yield, blue-chip investments you can make right now.
  • Not only is the 7% yield generous and safe, but analysts expect it to grow about 9% CAGR over time.
  • From the best valuation in 12 years, approximately 36% undervalued, PRU is expected to deliver about 16% CAGR long-term total returns.
  • This idea was discussed in more depth with members of my private investing community, iREIT on Alpha. Get started today »

This article was coproduced with Dividend Sensei and edited by Brad Thomas.

Prudential Financial (NYSE:PRU) is a Fortune Global 500 company that was formed more than 140 years ago and today provides insurance, investment management, and other financial products throughout the U.S. and 40 other countries. In the U.S., "Prudential's iconic Rock symbol has stood for strength, stability, expertise and innovation for more than a century."

Source

As a child, I remember watching commercials on TV featuring Prudential, and the famous "get a piece of the rock" slogan. I found this interesting graphic below that illustrates the evolution of the "Rock of Gibraltar logo" that has become "more clean and simplistic."

Source

As you know, I'm always looking to diversify my retirement portfolio, beyond REITs, and this week, I reached out to Dividend Sensei to assist me with an article on Prudential.

The company was originally a recommendation from our fellow Dividend King co-founder, Chuck Carnevale, and now, a new Phoenix watchlist company (the latest addition to the DK Phoenix portfolio and also a recent purchase from both me and Dividend Sensei).

Dividend Sensei Real-Money Phoenix Portfolio Bucket

(Source: Morningstar) 27% cash/bond allocation not shown

Phoenix bought a starter position in PRU and intends to buy it each week for the next three weeks. If it were to suffer a large enough correction, we'd buy it every week for the next month.

Why are we so bullish on Prudential? Simply put, this is one of the best high-yield, blue-chip investments you can make right now.

Not only is the 7% yield generous and safe, but analysts expect it to grow about 9% CAGR over time.

What's more, from the best valuation in 12 years, approximately 36% undervalued, PRU is expected to deliver about 16% CAGR long-term total returns, a market-smashing 16X what the incredibly overvalued and low yielding S&P 500 is likely to deliver.

Prudential's 7% Yield Is One You Can Trust

Prudential was founded in 1875 and over 145 years has built itself into one of the biggest financial companies on earth.

(Source: investor presentation)

  • over 50 million customers in over 40 countries
  • $1.6 trillion in assets under management
  • $525 billion invested assets (mostly insurance float)
  • Among the 10 largest asset managers in the world

It also has a very safe dividend income investors can trust.

  • 2020 consensus payout ratio: 49% vs 50% safe for insurance companies
  • Debt/capital: 21% vs 20% safe
  • S&P credit rating: A stable outlook = 0.7% 30-year bankruptcy risk
  • Fitch credit rating: A stable outlook = 0.7% 30-year bankruptcy risk
  • Moody’s credit rating: A3 (A- equivalent) stable outlook = 2.5% 30-year bankruptcy risk
  • Dividend growth streak: 12 years, cut 50% in Great Recession (Fed requirement)
  • M-score: -2.72 vs -2.22 or less safe = low accounting fraud risk
  • Safety score: 5/5 very safe
  • Dividend cut risk in this recession: 2% to 3%
  • Dividend cut risk in a normal recessional: 0.5%

The main concern with any dividend's safety this year is how the business will be impacted by the pandemic.

PRU has stress-tested itself using the same assumptions as Moody's just used.

Even factoring such conservative assumptions as 50% loan losses on low-grade corporate bonds, PRU estimates three-year recession losses would total less than a year of free cash flow.

(Source: PRU investor presentation)

It also took into account the fact that Moody's expects 12.5% of Baa (BBB) bonds to be downgraded to junk status.

So, here's why we rate PRU 5/5 on safety (a recent upgrade), other than just its strong financial metrics.

The upgrade is courtesy of the credit rating reports about the company, which replace my own stress tests.

S&P reaffirmed its stable outlook twice this year when PRU sold two tranches of bonds to boost its liquidity and refinance its debt.

Even with this 2051 issuance, we expect leverage to remain within our expectation of 30%-35% and fixed-charge coverage around 8x-10x in 2019 and 2020." - S&P

Credit rating agencies want to see fixed-charge coverage ratios (industry equivalent of interest coverage ratios) of 8+ and PRU's slightly more debt-laden balance sheet is expected to average 9. As far as how the pandemic will affect it on May 18 Fitch reaffirmed the A stable rating saying:

Fitch's current assessment of the impact of the coronavirus pandemic, including its economic impact, is based on a set of rating assumptions described below. These assumptions were used by Fitch to develop pro forma financial metrics for PFI that Fitch compared to both rating guidelines defined in its criteria, and relative to previously established Rating Sensitivities for PFI...

PFI's Stable Outlook reflects Fitch's view that while expected losses tied to the economic fallout of the coronavirus pandemic will pressure the company's earnings and capital, financial performance and balance sheet fundamentals are expected to remain largely in line with rating expectations.

PFI's expected losses are primarily driven by the company's exposure to asset risk and, to a lesser extent, mortality and variable annuity (VA) hedge breakage." - Fitch

Not surprisingly as a financial company, PRU is leveraged to asset prices and mortality rates, and the pandemic isn't going to help either.

Today's rating actions follow Fitch's recent action to revise the rating outlook on the U.S. life insurance industry to negative.

Fitch's primary concerns over the near term include the decline in interest rates and equity markets, increased credit losses, rating migration on fixed maturity investments, and elevated mortality.

Longer-term concerns include the potential for a prolonged, steep macroeconomic downturn, changes in policyholder behavior and low-interest rates that persist for multiple years." - Fitch

All the risk factors that have hurt the share price this year are factored in by Fitch, including in downgrading US life insurers as a whole, to a negative outlook. Guess whose rating wasn't downgraded? PRU. Here's why.

The ratings assigned to PFI continue to reflect the company's very strong business and financial profile, which remain in line with rating expectations.

The ratings also consider ongoing challenges due to low-interest rates and competitive market conditions, as well as business and investment exposure to the macroeconomic environment in Japan.

Fitch notes that continued business growth in recent years has improved the diversification of PFI's business risk profile. Mortality-based earnings and cash flow from Japan and other non-U.S. insurance markets provide an offset to the company's more capital market-sensitive businesses in the U.S. insurance market, including its large VA business, which is more vulnerable to adverse market conditions.

Within the U.S. insurance market, relative exposure to legacy VA business has declined due to faster growth in other business segments including retirement and group insurance." - Fitch

Again, Fitch is making no bones about PRU's risks, which it's well aware of and understands fully. Yet this is one of the strongest insurance companies on earth, and management has steadily worked to de-risk the balance sheet, including by ending variable annuities and long-term care policy underwriting.

Fitch views PFI's financial profile as very strong with key credit metrics remaining largely in line with rating expectations. Based on the application of Fitch's coronavirus pandemic rating case assumptions, the statutory capitalization of PFI's U.S. insurance market could potentially deteriorate below rating expectations, including a decline in Fitch's Prism capital model score below the 'Strong' level.

Over the past year, financial and total debt used throughout the organization increased. However, financial and total leverage metrics remain in line with rating sensitivities and are expected to trend down modestly over the near term.

Moreover, Fitch's view of PFI's financial profile benefits from the company's exceptionally strong financial flexibility due to highly diversified sources of funding, both on balance sheet and off-balance sheet, and demonstrated market access." - Fitch

Fitch and other rating agencies are under no allusions that this year is going to be a good year for PRU. The pandemic is going to hurt, but Prudential came into the recession with "an exceptionally strong" balance sheet and so it has a large safety buffer to right out this crisis.

PFI's earnings-based interest coverage metrics have been maintained in the 9x to 10x range in recent years and are in line with rating expectations.

The level and diversification of subsidiary cash flow to the holding company for debt service has improved materially in recent years, with meaningful dividends sourced from domestic insurance, international insurance, and asset management.

Fitch's view of PFI's debt service capabilities also considers the holding company's very strong liquidity profile, which benefits from cash and invested assets well in excess of cash uses. Over the past year, PFI has set a target for holding company liquid assets of $3 billion-$5 billion range." - Fitch

PRU's interest coverage has averaged 9.5X in recent years, well above the 8 level rating agencies consider safe.

Its global empire of financial assets has been paying rising dividends back to the parent company, and that's expected to continue in the long term.

PFI's ratings continue to reflect the company's strong statutory capitalization with regulatory capital ratios well in excess of regulatory minimums.

Statutory capital and risk-based capital ratios at the U.S. insurance subsidiaries have been in line with rating expectations but are expected to be pressured by the economic fallout from the coronavirus pandemic.

The U.S. insurance subsidiaries' capital adequacy based on Fitch's Prism capital model is scored at 'Strong', which is somewhat below rating expectations." - Fitch

Even with the 26% EPS hit expected this year, PRU's capital ratios, which the Fed monitors and stress-tests each year, came into the recession in great shape. This means there's little risk that the Fed will force another dividend cut as it did in the Great Recession.

What is Fitch basing its stress-tested PRU affirmation on?

Fitch used the following key assumptions, which are designed to identify areas of vulnerability, in support of the pro forma rating analysis cited above:

--Decline in key stock market indices by 35% relative to Jan. 1, 2020.

--Increase in two-year cumulative high yield bond default rate to 16%, applied to current non-investment grade assets, as well as, 12% of 'BBB' assets.

--Both upward and downward pressure on interest rates, with spreads widening (including high yield by 400 basis points) coupled with notable declines in government rates.

--A COVID-19 infection rate of 5% and a mortality rate (as a percent of infected) of 1%.

--Capital market access is limited for issuer at senior debt levels of 'BBB' and below." - Fitch

The stock market did indeed decline by the amount Fitch expected, 34% to be precise, before bottoming.

Fitch is running its model on PRU's mortality costs using an estimated 16.6 million final confirmed US cases and 166K deaths.

That's stricter than what management is expecting as discussed in the risk section (100K) and yet even with those assumptions, Fitch still considers PRU to be one of the few US health insurers worthy of a "stable" A credit rating.

Moody's also affirmed its rating for PRU, at A3 stable (A- equivalent).

The coronavirus-driven ultra-low interest rates, bear market, and the restricted movement of the US population will stress most aspects of life insurers' financials, including those of Prudential Financial.

This includes sales and investment income, investments and reserves, and capital adequacy. Most life insurers, including Prudential, start with a healthy capital and asset quality to weather this storm over the near term, but these conditions will weaken their creditworthiness if they persist." - Moody's

Moody's is watching for the interest coverage ratio to rise above 10 for a potential upgrade (to A equivalent) or fall below 7 for a potential downgrade (to BBB+ equivalent).

Remember that S&P and Fitch expect the coverage ratio to remain about 9 but fall no lower than 8, and that's including their own stress tests of the company's balance sheet.

Here is what management had to say about the dividend during the Q1 conference call.

We're also highly confident about the quality of our investment portfolio, which Rob will cover in more detail shortly.

The strength of our financial position means our dividends to shareholders remain well covered by our income and free cash flow...

While the severity and duration of the pandemic and related economic impact remains unknown, we are confident about the strength of our company.

Prudential has survived pandemics, wars, recessions and the depression, among other events in its 145-year history. We are resilient, we are strong and we will continue to move forward to deliver sustainable value for all our stakeholders. - CEO, Q1 conference call

Why is management so confident that the dividend will remain safe?

We began 2020 with a strong capital and liquidity position, and our capital ended the quarter exceeding AA financial strength levels. As the pandemic unfolded and in light of the uncertainty in the global markets, we executed our playbook.

We successfully issued $1.5 billion of senior debt in early March, while spreads were still attractive. This included a $500 million green bond issuance, the first of its kind for a U.S. company in our sector.

These actions pre-funded our opportunities through the end of 2021 and enhance the liquidity of our businesses. As part of the playbook, we further enhanced the liquidity of our businesses and also paused share repurchases at the end of the first quarter to see how the economic environment develops." - CEO

PRU sold $1.5 billion in debt in March to refinance its maturing debt through the end of 2021. While the pandemic is expected to last until mid to late 2022, it faces no short-term refinancing risk.

And as we'll explain in the risk section, financial markets are incredibly liquid right now, with financial stress now at below-average levels.

Unless this changes significantly in the coming 18 months, PRU should have no trouble refinancing its maturing debt in 2022 or beyond.

(Source: investor presentation)

PRU's adjusted debt/capital (leverage ratio) is 25% and rating agencies say that as long as it remains at 30% or less, the company will retain its current rating.

The company also has $6.4 billion in additional recovering credit lines it can tap should the pandemic turn out worse than expected. Taking on that much debt would likely result in downgrades, which is why management is holding those facilities in reserve.

But they are there to help PRU through this crisis, which is expected to last a total of 24 to 30 months according to health experts (we're in month six).

Current liquid assets stand at $5.3 billion and the CEO told analysts at the CC that:

We're confident in our ability to successfully manage in this environment in large part due to the robust operational and financial risk framework that we put into place after the Great Recession of 2008.

This framework prepared us with a playbook to address multiple stress scenarios, including pandemics and economic conditions that are more severe than what we are currently experiencing." - CEO Charles Lowrey

The point is that PRU is a very strong financial juggernaut that's expected to easily weather even the worst recession in 75 years. All while maintaining and growing its dividend throughout the pandemic.

(Source: F.A.S.T Graphs, FactSet Research)

But that's just one reason to buy this 7% yielding blue chip.

The second is that PRU has a long growth runway, created by its diversified global businesses, which is expected to generate impressive long-term growth in earnings and dividends.

A Good Business Model With Strong Growth Prospects

Prudential's CEO, Charles Lowrey, took over in 2018 and before that ran the international business.

Management is above average from a conservative income investor perspective, as Morningstar explains,

On the positive side, while Prudential, like most life insurers, struggled during the financial crisis and was forced to raise capital, the damage was limited and the company's balance sheet recovered relatively quickly.

We also like that Prudential has actively divested non-core businesses and been selective when it comes to acquisitions, though we acknowledge the jury is still out on AssuranceIQ.

We are generally pleased with the firm’s capital return policy. In 2019, Prudential returned over $4 billion to shareholders in the form of share repurchases and dividends.

We also believe the firm’s focus on expense management is prudent given the relatively commoditized nature of the life insurance business.

On the negative side, Prudential has faced hiccups in the past. In 2018, Prudential boosted reserves in the long-term care business. We view being appropriately conservative when it comes to reserves as a key element of stewardship for insurance companies.

That said, Prudential is not the only company to take a charge related to this line recently, and it hasn't written any new policies in quite some time." - Morningstar

Prudential has a benefits ratio (combined ratio) of 89% meaning it's earning 11% profits on its policies.

The company is adapting to the challenges it faces now, including to mitigate low-interest rates and other risks it faces.

(Source: investor presentation)

(Source: investor presentation)

10% return on equity is considered good for an insurance company. In 2019, PRU delivered 12%, and its five-year dividend growth record is impressive at 13% CAGR.

For those who just can't believe that insurance companies can grow in a low-rate environment, PRU proved you wrong by growing book value per share by 9% CAGR over the past half-decade.

PRU's Book Value Growth Among The Best In The Industry In A Low-Rate Environment

(Source: YCharts)

Prudential's book value growth over the last decade has been exceptional, far surpassing less diversified quality names like Travelers (TRV) and Chubb (CB).

We own all of these insurance companies in the DK Phoenix portfolio and the point is that low rates don't stop a quality management team from growing shareholder value or dividends.

PRU takes a long-term view of business, including ESG factors. Those aren't just for environmentalists, they are considered important by:

  • S&P
  • Fitch
  • Moody's
  • MSCI (indexing giant)
  • BlackRock (the world's biggest ETF manager)

(Source: Investor presentation)

Prudential claims it's leading the charge for a sustainable business model that focuses on "people, planet, profit," the so-called "triple bottom line."

MSCI rates more than 7,000 global companies by ESG criteria and considers PRU to be above-average compared to 45 other rated insurance companies.

(Source: MSCI)

PRU has steadily improved its ESG ratings over the years, showing that management isn't just talking the talk, but walking the walk when it comes to corporate responsibility.

All while steadily growing profits and dividends, and at one of the fastest rates in the industry.

(Source: investor presentation)

Management's priorities are exactly where they should be, with keeping the company solvent coming first, growing the business organically second, the safe and growing dividend third, M&A 4, and buybacks fifth, with whatever is left over.

(Source: investor presentation) For 2020 PRU hiked 10%

Since it was forced by the Fed to cut the dividend in 2008, PRU has grown the dividend at a torrid pace and is expected to continue steady growth even in this recession.

(Source: investor presentation)

While 87% of PRU's cash flow is from insurance businesses, 13% is from asset management, which is a thriving business courtesy of its funds outperforming their benchmarks over the long term.

95% of funds can't keep up with benchmarks over time, yet over the last decade, 94% of its funds have outperformed their benchmarks. This is why PRU has seen positive net inflows of assets in 16 of the last 17 years. That's good enough to rank No. 7 in fund flows among US asset managers.

40% of earnings are from the Japanese business and another 3% from its nascent emerging markets businesses, which are rapidly growing in hot growth markets like China, South East Asia, Africa, and Latin America, specifically Korea, Taiwan, Brazil, Argentina, Mexico, Chile, China, and Malaysia.

(Source: investor presentation)

While income investors might come for the generous, safe, and rapidly-growing dividend, they should stay for the potential growth catalysts represented by the asset management business.

That's because operating margins are 28% in the asset management business, far higher than the insurance operations.

(Source: Investor presentation)

PRU isn't just an asset manager running stock and bond mutual funds (in which it's one of the 10 biggest in managers on earth). It's also a top three asset manager in real estate, private equity and other alternative assets, including emerging market credit.

In Europe, PRU has been winning market share for a decade, and in China, AUM has been growing at 15% CAGR over the past decade.

(Source: investor presentation)

And the company continues to make smart partnerships and investments to achieve similar growth in other emerging markets.

(Source: investor presentation)

PRU is working, and hitting its targets, on achieving $500 million in annual savings that would represent a 10.5% increase in annual profits from 2019's levels.

We continue to make progress on achieving our goal of $500 million in cost savings, $140 million of which should be achieved this year. We realized $30 million in the first quarter through actions we completed before the start of 2020." - CEO

Basically, what's attractive about Prudential isn't just its conservative business model, competent and trustworthy management, and thus, a safe 7% yielding dividend, but its strong long-term growth prospects.

How strong? Let's take a look at the growth profile.

PRU Growth Profile

  • FactSet long-term growth consensus (2 analysts): 9.0% CAGR
  • FactSet growth consensus through 2022: 6.0% CAGR
  • YCharts long-term growth consensus: 8.3% CAGR
  • Reuters' five-year growth consensus (12 analysts): 9.0% CAGR
  • 20-year historical growth rates: 0% to 14% CAGR

Even when facing the prospects of record low-interest rates for the foreseeable future, the 12 analysts who cover Prudential, and collectively know it better than anyone but management, expect strong earnings and decent dividend growth (4.5% CAGR through 2022 despite the recession).

How accurate are analysts at forecasting growth for this company?

Other than the Financial Crisis of 2009, analyst two-year forecasts have managed to be within a reasonable 20% margin of error over the past decade.

  • Analyst growth consensus range (with historical margins of error): 6% to 11% CAGR
  • FactSet S&P 500 long-term growth consensus: 8.5% CAGR
  • Probability-weighted long-term S&P 500 growth expected: 6.4% CAGR

According to FactSet's John Butters, over the last 20 years, the average analyst overestimates for S&P 500 EPS growth has been 1.8% in non-recessionary years, and 3.8% in recessionary years.

Using the historical 86% probability of economic growth, we can estimate a probability-weighted long-term EPS growth rate, by applying the historical analyst margins of error, of 6.4% CAGR.

(Source: F.A.S.T Graphs, FactSet Research)

Which is in line with the modern era's 6% to 8% CAGR typical growth range.

Which means that PRU is offering not just a very generous and safe yield, but one that's likely to grow faster than the broader market, including its future dividends.

The bottom line is that this safe 7% yielding above-average quality company (and future 9/11 quality blue-chip) represents potentially one of the best high-yield investments you can make in this dangerously overvalued market.

Valuation/Return Profile Is Extremely Very Attractive

The way we value a company is by applying the historical multiples real investors, risking real money have paid for its fundamentals during periods of similar growth and fundamentals.

PRU Valuation Matrix

Metric

Historical Fair Value (6 yr timeframe)

2020

2021

2022

5-Year Average Yield

3.61%

$122

$128

$133

Earnings

9.3

$84

$106

$121

EBITDA

7.3

$103

$127

$131

EBIT

7.3

$92

$106

$110

Average

$100

$117

$124

There's an 80% probability that PRU's intrinsic value is between $84 and $122, but the $100 average historical fair value represents a reasonable estimate of its fundamental worth this year.

We then apply the following standards for margins of safety to determine a DK rating on a company.

Quality Score

Meaning

Margin Of Safety Requirement To Be A Potentially Good Buy

Margin Of Safety Requirement To Be A Potentially Strong Buy

Margin Of Safety Requirement To Be A Potentially Very Strong Buy

Margin Of Safety Requirement To Be A Potentially Ultra-Value Buy

3

Very High Bankruptcy Risk

NA (avoid)

NA (avoid)

NA (avoid)

NA (avoid)

4

Very Poor

NA (avoid)

NA (avoid)

NA (avoid)

NA (avoid)

5

Poor

NA (avoid)

NA (avoid)

NA (avoid)

NA (avoid)

6

Below-Average (speculative)

35%

45%

55%

65%

7

Average

25% to 30%

35% to 40%

45% to 50%

55% to 60%

8

Above-Average

20% to 25%

30% to 35%

40% to 45%

50% to 55%

9

Blue-Chip

15% to 20%

25% to 30%

35% to 40%

45% to 50%

10

SWAN (a higher caliber of Blue-Chip)

10% to 15%

20% to 25%

30% to 35%

40% to 45%

11

Super SWAN (as close to perfect companies as exist)

5% to 10%

15% to 20%

25% to 30%

35% to 40%

Which means that PRU's rating matrix looks like this.

PRU Rating Matrix

Rating

Margin Of Safety For 9/11 Blue-Chip Quality Companies

2020 Price

2021 Price

Potentially Reasonable Buy

0%

$100

$117

Potentially Good Buy

15%

$85

$99

Potentially Strong Buy

25%

$75

$88

Potentially Very Strong Buy

35%

$65

$76

Potentially Ultra-Value Buy

45%

$55

$64

Currently

36%

$63.82

$63.82

At $64, Prudential is about 36% undervalued and a potentially very strong buy.

PRU 2025 Consensus Return Potential

(Source: F.A.S.T. Graphs, FactSet Research)

2022 Consensus Return Potential

(Source: F.A.S.T. Graphs, FactSet Research)

Its consensus return potential, which assumes it grows as expected and returns to historical fair value, is exceptional, 34% CAGR over the next 2.5 years, and 21% CAGR over the next five.

S&P 500 2022 Consensus Return Potential

(Source: F.A.S.T. Graphs, FactSet Research)

S&P 500 2025 Consensus Return Potential

(Source: F.A.S.T. Graphs, FactSet Research)

In contrast, the broader market yields 1.9% and offers essentially little capital gains potential and flat total return potential entirely from dividends.

Putting It All Together: A Potential A+ High-Yield Investing Decision

We judge every potential investment on the three priorities, in this specific order, compared to the S&P 500, most people's default alternative.

Points

Meaning

Preservation Of Capital

Return Of Capital

Return On Capital

1

Poor

Bankruptcy risk 52+% (C-rated company equivalent)

Zero dividend capital return over five years

Probability-Weighted Return is zero or negative

2

Below-Average

Bankruptcy risk 13% to 52% (BB-rated company equivalent)

0.1 to 0.5X S&P dividend capital return over 5-years

Probability-Weighted Return is 0.1 to 0.5X S&P PWR

3

Average

Bankruptcy Risk 7.5% to 10% (BBB- or BBB rated company equivalent)

0.6 to 1.9X S&P dividend capital return over 5-years

Probability-Weighted Return is 0.6 to 1.9X S&P PWR

4

Above-Average

Bankruptcy Risk 5% (BBB+ rated company equivalent)

2.0 to 2.9X S&P dividend capital return over 5-years

Probability-Weighted Return is 2.0 to 2.9X S&P PWR

5

Excellent

Bankruptcy Risk 2.5% or less (A-rated company equivalent)

3+X S&P dividend capital return over 5-years

Probability-Weighted Return is 3+X S&P PWR

So, let's use the new Dividend Kings Investment Decision Tool to see why we consider Prudential a potentially A+ exceptional investment right now.

An A stable credit rating from both S&P and Fitch, and an A3 stable rating from Moody's earns it a 5/5 on preservation of capital.

Basically, the rating agencies are saying there is a very low risk (0.7% to 2.5%) that PRU will go bankrupt in the next 30 years.

Credit Rating

30-Year Bankruptcy Probability

AAA

0.07%

AA+

0.29%

AA

0.51%

AA-

0.55%

A+

0.60%

A

0.66%

A-

2.5%

BBB+

5%

BBB

7.5%

BBB-

11%

BB+

14%

BB

17%

BB-

21%

B+

25%

B

37%

B-

45%

CCC+

52%

CCC

59%

CCC-

65%

CC

70%

C

80%

D

100%

(Sources: S&P, The University Of St. Petersburg)

PRU Dividend Return Matrix

5-Year Estimated Dividend Return (% of your investment)

PRU

Current Yield

6.9%

Long-Term Analyst Growth Consensus (Column AH in valuation tool, also in Research Terminal Lists)

9.0%

Yield On Cost in 5-Years

10.6%

Average 5-Year Consensus Yield

8.8%

5-Year Estimated Dividend Return

44%

S&P 500

11%

(Source: Dividend Kings Investment Decision Tool)

Prudential is expected to generate about 4X as much dividend income as the S&P 500.

PRU Expected Return Matrix

Mid-Range Probability-Weighted Return Potential

PRU

5-Year Consensus Annualized Total Return Potential

21.3%

Conservative Margin Of Error Adjusted Annualized Total Return Potential

10.9%

Bullish Margin Of Error Adjusted Annualized Total Return Potential

32.2%

Conservative Probability-Weighted Expected Annualized Total Return

6.5%

Bullish Probability-Weighted Expected Annualized Total Return

25.7%

Mid-Range Probability-Weighted Expected Annualized Total Return Potential

16%

S&P 500

1%

(Source: Dividend Kings Investment Decision Tool)

PRU is expected to generate 16X the total returns of the broader market. That's courtesy of the lowest valuation in 12 years.

(Source: F.A.S.T Graphs, FactSet Research)

PRU Decision Matrix

Goal

PRU

Why

Score (Out of 5)

Preservation Of Capital

Excellent

0.7% long-term bankruptcy risk (A credit rating)

5

Return Of Capital

Excellent

44% of capital returned over the next 5 year via dividends vs 12% S&P 500

5

Return On Capital

Excellent

16% PWR vs 1% S&P 500

5

Relative Investment Score

100%

Letter Grade

A+ (exceptional)

S&P

73/100 = C

(Source: Dividend Kings Investment Decision Tool)

This means that PRU scores a perfect 5/5 across the board earning an A+ exceptional rating.

But just because PRU is one of the best potential investments on Wall Street today doesn't mean it doesn't have a risk profile potential investors need to understand and be comfortable with.

Risks To Consider

The biggest short-term fundamental risk to PRU is with the economy and thus its investment portfolio.

However, the portfolio is primarily focused on high-quality assets and thus its risks are manageable, as the credit rating agencies have all concluded.

The vast majority of Prudential’s corporate debt is investment-grade and is well diversified across various industries such as financial, consumer non-cyclical, and utilities. - Morningstar

Morningstar also agrees that there isn't a major risk of corporate defaults impacting its bond portfolio.

(Source: investor presentation)

83% of PRU's invested assets are in its float portfolio which is both well diversified and prudently managed for risk.

(Source: investor presentation)

For example, it has 3% exposure to energy bonds during the worst oil crisis in history. It has lower than average exposure to BBB rated corporate bonds, and its mortgage-backed securities have an average down payment of 44%.

Those are literally Canadian level downpayment on mortgages showing just how conservative PRU's investment portfolio is being run.

90% of its corporate bonds are investment grade, which is precisely the kind of conservative approach to risk-management that income investors want to see from a blue chip.

(Source: investor presentation)

The increased mortality from the virus is another risk since we don't know how big the second wave expected to start in September will be.

PRU is estimating $430 million in total costs in 2020 from the pandemic, but that assumes 100K US deaths and 40K in Japan.

  • 119,952 US fatalities as of June 18
  • 931 Japanese Fatalities as of June 18

So far, PRU's assumptions have remained valid, but the potential for a second wave in the fall must be considered before buying this company.

(Source: IHME)

A short-term risk to the dividend is due to the fact that the Fed could potentially impose a dividend cut on it since it's $525 billion in invested assets put its payouts under the CCAR regulatory approval of the Fed.

Financial Stress Now Below Average = No Financial Crisis Brewing

(Source: YCharts)

However, there are no signs of a pending Financial Crisis, and in fact, financial stress has fallen back to below-average levels relative to 1993.

  • 0 = average financial stress since 1993
  • +1 = historical norm for recessions and mini-financial crises
  • +5.7 March high
  • +9.3 2008 peak

Prudential also faces some key long-term risks.

  • Legacy long-term care policies for which it had to increase reserves in 2018
  • Should long-term interest rates keep falling this would reduce the profitability of its bond focused portfolio

Bond Market Inflation Expectations Recovering Off March Lows

(Source: YCharts)

The bond market, via its inflation breakeven rates, is the best proxy we have for long-term inflation rates.

Currently, inflation is expected to run 1% to 1.5% over the next five to 30 years.

The recent uptick, due to economic reopenings, indicates little risk that long-term rates keep falling.

That's unless the Fed's bond-buying and possible yield-curve control measures result in a permanent cap on long-term rates.

The Fed is considering temporary yield-curve control but, fortunately, for the fundamentals of the economy, it's in no hurry to take control of the bond market.

Federal Reserve Chairman Jerome Powell said the central bank’s announced move this week to buy corporate bonds fulfills a pledge it had made earlier but is not an effort to take over the market.

“It’s out of an excess of caution to preserve these gains for market function by following through,” Powell said Tuesday during his semiannual testimony before Congress. “I don’t see us wanting to run through the bond market like an elephant snuffing out price signals, things like that...

“It’s really going to depend on the level of market function. If the market function continues to improve, then we are happy to slow or even stop the purchases,” Powell said. “If it goes the other way, we will increase.” - CNBC (emphasis added)

Powell is talking about corporate bonds here, not Treasuries. But it's clear that the Fed is only interested in doing as much QE (which yield-curve control would mean) as is necessary to maintain liquidity in the credit markets.

In other words, as long as the financial markets remain well lubricated with credit, and risks of another financial crisis are low, the Fed will not undertake yield curve control.

Think about it like this. Financial companies make money on the yield curve, which affects their investment spreads. If the Fed artificially lowers the yield curve too much with QE, then financial companies will not be able to generate strong profits, which would harm the very financial system the Fed is bending over backward to protect.

This is the same reason the Fed has said numerous times it has no plans for negative interest rates, except in the direst of emergency conditions.

Negative rates would pressure banks to lend recklessly to avoid losing money on reserves held at the Fed. While that would be somewhat stimulatory to the economy, higher loan losses would threaten the solvency of the entire banking system, potentially triggering the very financial crisis the Fed and all global bankers have spent the last 11 years working to avoid.

Valuation risk is very low, given that in the modern regulatory era of low-interest rates the market has priced PRU at 9 to 9.5X earnings.

(Source: F.A.S.T Graphs, FactSet Research)

Paying 6X earnings for PRU is definitely getting a quality financial giant at a discount.

But volatility risk is something that all companies have, even 9/11 quality blue chips that are highly undervalued.

PRU Is A Very Volatile Stock

(Source: YCharts)

PRU Is Far More Volatile Than Other Phoenix Portfolio Insurance Companies

(Source: YCharts)

Most insurance companies tend to be low volatility companies most of the time. PRU is a stark exception that creates wild swings during bear markets.

We don't mind volatility because it's what puts such great companies on sale. However, potential investors, when considering how to size PRU in their portfolios, (our recommendation is 7% or less) should consider its historical volatility.

Prudential Has Suffered Large Declines In The Past

(Source: Portfolio Visualiser)

Even ignoring the Financial Crisis, which isn't likely to be repeated due to a much stronger balance sheet and more conservative investment policies, PRU was cut in half during a bear market from 2018 to 2020.

That was partially a result of legacy LTC policy costs, that are now basically behind it. But this is where prudent risk management comes into play when considering buying Prudential.

As a 9/11 quality blue-chip, Prudential has a 7% max portfolio risk cap recommendation.

So, here's an example of a well-diversified and prudently risk-managed balanced PRU focused income portfolio.

(Source: Portfolio Visualiser)

This portfolio, which is rebalanced annually, is 70% dividend growth stocks, 15% cash (t-bills), and 15% long-duration US Treasuries.

We chose these particular ETFs because it allows us to back test to January 2008, the start of the Great Recession, during which PRU fell 85%.

Balanced PRU Portfolio Since January 2008

(Source: Portfolio Visualiser)

Despite falling 82% at its peak, this balanced PRU portfolio still managed to beat a 60/40 stock/bond portfolio, with nearly identical volatility and slightly better long-term returns.

Balanced PRU Portfolio Assets Since January 2008

(Source: Portfolio Visualiser)

Thanks to bear markets bookending this time period, PRU investors who bought in January 2008 are still slightly underwater.

Yet thanks to 93% of the portfolio being invested in other income-producing assets, prudent income investors still did well over the past decade.

(Source: Portfolio Visualiser)

Despite being 7% in a stock that fell 82%, the balanced PRU portfolio actually fell 1% less than a 60/40 portfolio, just 30%, and far less than the S&P 500's 57% crash.

In the recent bear market, this portfolio fell 11.4% vs 12.4% for a 60/40 portfolio.

Outside of bear markets, this balanced PRU portfolio hasn't suffered a correction in a decade.

THIS is the nature of SWAN investing, and the kind of portfolio that any of our recommendations should be a part of.

Prudential is a very volatile company, but for no fundamental reasons inherent to the high-quality assets, solid management team, or safety of its balance sheet.

So, harness the volatility to your benefit by buying this high-yield, blue-chip at the best valuations in a decade, but in a bunker portfolio that can withstand virtually anything the economy/market can throw at it.

Bottom Line: Prudential Is One Of The Smartest Potential High-Yield Investments You Can Make In This Dangerous Market

We are not market timers, just fundamentals/valuation/risk-management focused analysts.

Some people might not like PRU's extreme historical volatility. Rest assured that its wild price swings are not justified by its good management quality, sound long-term business practices, or a balance sheet that's one of the strongest in the industry.

The 7% yield is not just safe but expected to grow at one of the fastest rates of any insurance company over the long term.

When combined with its best valuation in 12 years, a mouthwatering 6X earnings, Prudential represents one of the best 7% yielding blue-chips on Wall Street.

It's a 100%, A+ rated investment idea that, as part of a well-diversified and prudently risk-managed portfolio, is likely to deliver strong preservation of capital, immense future income, and some of the strongest total returns of any high-yield company you can buy today.

Prudential is a potentially very strong buy that the Dividend Kings look forward to buying many more times in the coming weeks and months.

Author's note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.

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This article was written by

Brad Thomas profile picture
104.86K Followers
Author of iREIT on Alpha
The #1 Service For Safe and Reliable REIT Income

Brad Thomas is the CEO of Wide Moat Research ("WMR"), a subscription-based publisher of financial information, serving over 6,000 investors around the world. WMR has a team of experienced multi-disciplined analysts covering all dividend categories, including REITs, MLPs, BDCs, and traditional C-Corps.

The WMR brands include: (1) The Intelligent REIT Investor (newsletter), (2) The Intelligent Dividend Investor (newsletter), (3) iREIT on Alpha (Seeking Alpha), and (4) The Dividend Kings (Seeking Alpha). Thomas is also the editor of The Forbes Real Estate Investor and the Property Chronicle North America.

Thomas has also been featured in Forbes Magazine, Kiplinger’s, US News & World Report, Money, NPR, Institutional Investor, GlobeStreet, CNN, Newsmax, and Fox. He is the #1 contributing analyst on Seeking Alpha in 2014, 2015, 2016, 2017, 2018, and 2019 (based on page views) and has over 102,000 followers (on Seeking Alpha). Thomas is also the author of The Intelligent REIT Investor Guide (Wiley). 

Thomas received a Bachelor of Science degree in Business/Economics from Presbyterian College and he is married with 5 wonderful kids. He has over 30 years of real estate investing experience and is one of the most prolific writers on Seeking Alpha (2,800+ articles since 2010). To learn more about Brad visit HERE.

Disclosure: I am/we are long PRU. 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.

Additional disclosure: Dividend Sensei is also Long PRU. The Dividend Kings Phoenix Portfolio holds TRV and CB.

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