Want one tough challenge? Try the one that faces income investors. Pure dividend payers are getting sold in bulk.
Will traders keep throwing these stocks away?
At this time, income investors know the negative driving the sale -- the Fed. That part is easy. However, before moving a dividend stock into the "sell" box, balance each investment’s relationship to improving GDP growth against rising rates driven by Fed tapering. It can be fruitful.
One strategy is to study a sweet spot inside Finance. The current macro ‘teeter-totter’ analysis, weighing positives against the negatives, looks rich to many inside this industry. Finance ‘quants’ can apply seasoned tactics to shifts in a macro climate. The most profitable Finance business models can hint at macro levers inside other cash-rich sectors of the economy too, like Info Tech, Health Care and Telcos.
Let’s begin by covering the rates waterfront.
Rates Are Rising
This fact most investors know. Ten-year U.S. Treasury rates went up 85 basis points from May 11 (the yield was 1.9%). If futures markets prove accurate, the 10-year ends 2013 just under 3.0%.
Rising risk-free rates mean Finance stocks need a dividend growth component. Though the reality is, strong earnings growth is not a replacement for yield growth. But it helps make the case for a stock, its management and a company’s business model.
Further into the income investor problem, what about waning demand for high yield bonds?
That is a question which has faced less market focus.
Credit Spreads Are Widening
High yield credit spreads have widened 110 basis points or more since the Fed announcement.
As a result, yield comparisons on dividend stocks to fixed income face the double pressure of rising risk-free rates and credit spread widening. In a widening spread environment, a company’s ability to manage operating and financial risk grows more important. And investors can pick up higher yields on high yield, substituting away from dividend stocks even more.
With “yield for yield’s sake” at risk, analysts turn away from companies with high dividends; unless underlying businesses can grow dividends by offering greater free cash flow down the road. That insight led us to the property/casualty (P&C) insurers.
As results below show, P&C companies can grow cash flow in an improving macro environment.
In Q1, P&C Insurers’ Overall Results Improved
A report published by ISO, a company in New Jersey compiling private P&C insurer data, announced U.S. P&C insurers' net income after taxes increased to $14.4B in Q1-13 from $10.2 billion in Q1-12. The increase in net income was primarily driven by net gains on underwriting, which swung to a $4.6B gain in Q1-13 from a $0.1B loss in Q1-12.
Analysts look to the next four quarters to build on these results.
Underwriting Turned Profitable... For the First Time in Years
In Q1-13, net gains on underwriting were a function of (1) premium growth, (2) increases in reserve releases, and (3) a decline in weather-related catastrophe losses.
The $4.6B net gain amounted to a +4.1% y/y increase in net premiums written (NPW), from $117.1B compared with $112.5B in Q1-12.
Net loss and loss adjustment expenses (LLAE) decreased -1.9% in y/y terms. The reduction was from $74.2B in Q1-13 from $75.6B in Q1-12. The decline in LLAE reflected both favorable reserve development and a decline in catastrophe losses. The combined ratio improved by +4.1% (y/y) to 94.8% in Q1-13 compared with 99% Q1-12.
Other underwriting expenses increased by +4.5% in y/y terms, partially offsetting the decline in LLAE. Other underwriting expenses totaled $33.5B in Q1-13 compared with $32.0B in Q1-12.
That may sound complex. But these three facts boil down to one insight: Find businesses that can grow upside faster than the economy’s +4% nominal growth target, and shrink down expenses in the process. As shown by the facts above, P&C is one such industry. It has seen these cycles before, time and again.
The next section shows how rising interest rates play out for P&C companies. This answer may surprise you.
‘It ain’t all roses,’ as most people think.
Rising Rates Are a Double-Edged Sword
I pulled this comment from a P&C insurance analyst:
“Slowly rising interest rates may be construed as positive for the industry, as maturing securities can be rolled into higher yielding investments, helping to boost net investment income. Such higher net investment income can then be used to offset catastrophe losses. In addition, rising interest rates may indicate an improving economy, which can spur GDP growth and thus premium growth.
"However, since insurance firms are large investors in fixed income securities, the values of which decline with rising interest rates, the asset valuations and thus book values of insurers tend to drop with rising interest rates. Since insurance stock prices tend to move with book values, higher interest rates are therefore also a negative factor for the stocks. Furthermore, rising interest rates typically indicate inflation, and higher claims costs are a negative.
"The key to determining whether interest rates will have a net positive or negative impact on the sector is magnitude and speed of directional change. A slow change is generally positive, a rapid change is negative, as then claims costs may rise and book values fall faster than rollover funds can be reinvested.” - Gloria Vogel CFA, Drexel Hamilton
Here are the Price to Book Ratios and Price to Earnings ratios for various types of insurers:
Insurance Brokerage: P/B 2.4, P/E 14.9
Bermuda Property/Casualty: Average Price to Book: 0.9, Average P/E: 10.3
Bond Insurers: P/B 0.8, P/E 9.1
Diversified: P/B 0.8, P/E 11.2
Life Traditional: P/B 0.8, P/E 12.1
P&C Builds Up Cash
Gather up all the facts and you can see this:
P&C cash flow over the last four quarters increased in a material way.
It reflected better paid loss ratios and higher premium growth. With modest growth in the economy raising premium volume further, and commercial insurers achieving mid-single-digit rate increases, cash flow should increase for P&C insurers over the next year too.
What about the headwinds?
The insurance rate environment in the P&C space is expected to soften somewhat in the next 12 months. Going forward, losses can diverge for different insurers. Exposure to catastrophic events always lurks in the P&C background, much like airlines and oil price shocks. Specific factors can make loss trends and rates different by line of P&C business.
However, this much should be clear to you. GDP growth raises P&C earnings and lowers macro risks. Bullish analysts add in a continued ‘normalization’ of catastrophes, couple it to high-single-digit rate increases and note a pricing dislocation in many individual insurance markets.
This is a medley of broad and specific factors. They can allow P&C insurers to grow cash flow at greater levels than those seen in softer markets. In early July, to no surprise, the P&C focused insurance industry is a Zacks Industry Rank of #41 out of 259 industries. Multi-line insurers are #27.
P&C insurers expected to see strong cash flow growth: AmTrust (AFSI - Snapshot Report) a Zacks Rank #2 with an Outperform Rating and a dividend yield of 1.4%, Markel (MKL - Snapshot Report) a Zacks Rank #3 with an Outperform rating, and Travelers (TRV - Analyst Report) a Zacks Rank #3 with an Outperform rating and a dividend yield of 2.5%.
Note I chose Outperform ratings over the current Zacks Rank. Most income investors are longer-term investors, meaning six months or more.
What comments sum it up for the besieged income investor?
Broaden your target. Don’t aim solely at high dividend yields. Focus on the underlying business case for building and sharing cash flow in an improving macro environment.