Along with house builders and traditional banks, Insurance companies have felt the full force of the ‘Leave’ vote The biggest firms in the sector, like Aviva, Prudential and Legal & General, have all seen there stock prices tumble in recent weeks. To most, a share price decline is a terrible event, but to me, share price declines are opportunities to buy more shares in the companies I like at discounted prices.
Since starting my dividend portfolio over a year ago, I have wanted to diversify my holdings in order to get exposure to some financial services related stocks. Banks to me have always been out of the question as they are terrible businesses and have more of a wealth destroying as opposed to a wealth creating effect from an investors point of view. The natural choice would then by a Technology company that acts as a financial proxy (such as Paypal, Visa or Sage) or an insurance company. As the majority of robust financial technology companies are listed on US indexes and priced in USD ($), there purchase is out of the question at the moment with the weaker GBP (£). Thus, the natural choice is for me to invest in the insurance industry where the UK has some very strong companies.
Legal and General has been the company to catch my eye in recent weeks. This is partly due to the tremendous value it offers now due to its share price decimation in the wake of the brexit vote and also to do with the strategy the company has taken in recent years.
Future of Insurance Industry – self driving cars and negative interest rates
Insurers have always been wonderful businesses as seen by a previous post I wrote on the merits of the industry. Companies in the sector have produced outsized returns for many years due to things such as the insurance float and the ability to delay taxes.
But in recent years, insurance has become a much more tough industry to be in and this has squeezed shareholder returns. WarrenBuffet, whose mammoth Berkshire Hathaway conglomerate was essentially built around the insurance industry, has recently stated that insurance is no more as attractive as it once was. The industry is concerned that it faces a future of lower premiums due to technological changes and at the forefront of this is self driving cars. In a world where there will be more self driving cars on the road, it would be easy to extrapolate that the number of accidents will greatly reduce and thus there will be no need for insurance.
Another cause for concern for the insurance industry as a whole will be negative interest rates. Whilst this was a non-issue several years ago, the possibility of negative interest rates hitting the UK is becoming a real possibility. We’ve already seen negatives rates in Europe and in Japan and there is talk that it will come to the UK with the BOE governor, Mark carney, keen to starve of a recession.
Negative interest rates has the effect of reducing an insurance companies cash flows and returns as bond yields will be lower. A negative rate also creates problems on the balance sheet as it increase the cost of long-term liabilities. The math is similar as for bonds: When yields fall, the value today of a future obligation rises. And bigger liabilities mean less capital. In addition to these two events, a persistent environment of negative rates could change consumer behaviour; whether or how they will save at all. As guarantee rates fall, insurance products become less and less attractive. Writing new business could be tough. This could prove an opportunity for the bigger insurance firms as they will be more resilient to a negative interest rate environment as compared to smaller firms who could well be put out of business.
How Legal & General is positioned for the future
Legal & General has been one of the first companies to recognise that the insurance industry will not be as attractive as it once was and thus it has changed its strategy and grown its assets management arm. The company has grown assets under management by 182% over the past 6 years which is a tremendous achievement. Furthermore, the company is taking a greater interest in pensions management and is aggressively moving into this sector by winning contracts from leading FTSE 100 such as National Grid . In addition to this, the company will benefit from the recently introduced work placed pension scheme initiative by the UK government. Under this initiate, companies are obligated by law to enrol their employees into a pension scheme if they are between the age of 22 and state pension age, earn over £10,000 a year and work in the UK. This new regulation will only enhance Legal and General business prospects and the company is in a great position to capitalise from this.
Furthermore, the diversified business model of Legal & General holds it in great steed for the future. 33% of the firm’s operating profit coming from UK insurance, 23% from retirement products, 23% from investment management, 13% from investing its own capital and 7% from the company’s American operations
Is Legal and General undervalued?
When buying Insurance stocks, the method used by Shelby Davies is a good way to go. Shelby Davies was an investor who turned $50,000 into $900,000,000 and generated annual returns of 23.2% by investing in insurance stocks. So he is definitely a person worth listening to. His method has 4 criteria in relation to insurance companies:
- Invest in high quality companies.
- Invest in undervalued companies
- Invest with cheap leverage
- Invest for the long-run
For me and my situations, Legal and General hits all but one of the above criteria. I do believe that Legal and General is a high quality company, it is undervalued (as seen below) and I aim to hold on to it for the long term. The only criteria that is missing is the use of leverage. Leverage can be good or bad, depending on the type you use. For an average investor like myself, the only type of leverage I can use is the one offered by my brokerage firm and this is the bad type of leverage as it is not very cheap and I can be forced to sell securities purchased on leverage.
On the undervalued or cheapness front, I like to use the P/E ratio.
Having bought the shares at a price of 167p, the Price to Earnings (P/E) ratio is in the single figures at close to 9. So in essence, I am paying £1 for every £9 in profits Legal and General makes. To me, this is a fair trade off for a company of.
Historically, LGEN has traded in the low single digit P/E figures – akin to most insurance companies. So bagging a single digit P/E is definitely worth it from my perspective for a company of LGENs quality.
The reasons LGEN has dropped in price and thus is being traded at this low P/E ratio is two fold, the company has significant exposures to the UK property market and the mainland European market. Both these are seen to be a worry for investors in the wake of Brexit. LGEN could in essence be a Value Trap.
But for me, this is a risk worth taking. At the right price, LGEN offers tremendous value with a built in margin of safety. In terms of the businesses financial performance, LGEN has done exceptionally well over the past 5 years. It has grown Earnings per share from 12.42 to 18.16 and grown the dividend from 6.40 to 13.40. Furthermore, Legal and General has ownership stakes in some of the largest FTSE companies which have been gaining in price recently. For example LGEN owns over 3% of RDSA and RDSB (Royal Dutch Shell) so you would expect it to receive a larger dividend in the coming year due to the devaluation of the Pound against the Dollar. Big ownership positions such as these should counteract risks specific to the UK market.
As mentioned above, I bought 347 shares of LGEN at a stock price of 167p (£1.67). I expect to get an annual dividend of £46.32 thus my yield on cost is currently 8% The great aspect about buying dividend growth stocks such as this is that I expect that the dividend the company pays me to grow over time. Any dividend growth investors dream is to get back in dividends what you initially paid for your stock – after that whatever you get in dividend payment is pure profit!
I bought Legal and General in my high yield non-isa portfolio. That portfolio currently contains 49 shares on Royal Dutch Shell (RDSB) and 564 shares in UIL Ltd (the old Utilico Investment Ltd). In total, I have put £1943.71 into this portfolio (including the purchase of LGEN) and my current annual dividend is expected to be just above £150. This gives me a very hefty dividend yield of 7.7% and the portfolio is up by 40% in just under a year since inception. Incidentally, my dividend yield on RDSB stock in this portfolio is close to 10% as I bought it during the February low of 1270p. If only I had bought more! This just goes to show that if you are patient and wait for the right price, you can buy a stock with both juicy levels and capital appreciation ability.