Best value play of the next 12 months = Insurers (Non-Life):
lbcapital.ckt1.com
IT IS ALWAYS DARKEST BEFORE DAWN
And dawn is here! The highly-cyclical insurance industry has finally broken the shackles of 14 years of underwriting doldrums. Recent news of strong improvements in commercial lines pricing are the first sign that the industry's boom/bust cycle is finally turning up. This follows the worst year and worst quarter -FY1999 and Q1 2000, respectively – that insurance stocks have faced in a decade.
THE EVIDENCE
The tide started to turn in March, with news of double-digit rises in P&C commercial line renewal rates. This strength accelerated into May and June, culminating in a fabulous July. Industry sources are noting that January 2001 renewal rates will be even more impressive, as a lot of business needs to be renewed at that time. The overwhelming majority of companies in the industry are becoming wildly enthusiastic about a continued acceleration in rate increases.
The segment exhibiting the greatest strength has been reinsurance. Several bellweathers have boasted of 50% workers' comp and 100% retrocessional renewal rates, and that's not to say that other RE lines are not recording double-digit renewal increases as well. As of late, RE stocks have been rewarded accordingly. The Bermuda-based entities have done exceptionally well.
Virtually all P&C companies, from the insurers and the reinsurers to the brokers, are forecasting a continued 'hardening' in all lines, as renewal rate hikes continue (in every region no less). In addition to renewals, new business is starting to be written at increasingly favorable terms. While the upturn there is not of the same magnitude, it is indeed a highly encouraging sign. Strength begets strength.
Now, due in large part to cutthroat competition and excess capital within the industry, two key factors which caused premium rates to fall for so many consecutive years, industry officials believe that, at the current pace, it will take at least five years for rates to return to acceptable levels. We therefore believe that the upswing in the cycle will yield us a good trade or two for at least the next few years. All aboard!
WHY THINGS ARE CHANGING
Recent heavy reinsurance losses appear to have triggered the price turn, as reserves have finally begun to be consumed off of company balance sheets. Additionally, one can argue that the early Q2 slide in the equity markets did indeed contribute to recent premium hikes, as insurance company balance sheets are far more exposed to equities than at any other time in history. That period of equity market turmoil marks exactly when the premium hikes began. Insurance companies favored Growth & Income stocks, all of which got hammered. Thus, their reserve levels needed to be replenished! In our view, contrary to popular belief, the insurance industry has, for some time now, been reserve deficient, not only cash flow negative. Thus, P&C companies have decided to get their houses in order over the last six months. The slide in the equity markets and subsequent weakening in industry financial strength was the last straw.
So the cycle has turned, eh? Well, what else is industry data telling us? For P&C insurance, middle market commercial, as a component of revenues, is currently exhibiting the most strength. For the REs, the strength has been across the board. Furthermore, in every segment, retention rates are good. Globally, the international outlook has followed the U.S.'s lead. It is now the case that the very same turn in the non-life environment has began to be witnesses abroad. Bottomline - the fundamental backdrop is now in place for increased profitability in the industry, and recent data suggest that, compared to 1999, this year's results are beginning to look like nothing less than a seachange.
THE STOCKS ARE LOOKING ATTRACTIVE!
Many P&C stocks are up big this year, having bounced sharply off of the five-year lows of early March. The trigger was the famous 'cyclical rally' in the latter half of March 2000, when every sleeping value stock on the NYSE, from John Deere to CIT Group, was rudely awakened from their slumber by stunning events in the derivatives markets. Specifically, a very large institution had previously used the futures market to long the Nasdaq and short the S&P 500, a trade in which they are simply betting that the Naz outperforms the S&P. the trade was incredibly profitable for the first three months of 2000, so the institution decided to close it out – two days before a triple witching expiration. The effect on the market was enormous. The media, misinformed as always, ran stories trumpeting that 'investors' have soured on growth stocks and were now hunting only for value stocks. Needless to say, the lone stocks which have not gone back to their pre-insanity week levels are the insurers and other financials. Insurers have in fact been the stronger of the two.
P&C Insurers St. Paul (SPC) and Chubb (CB), Diversified Insurers American International Group (AIG) and Allstate (ALL), Reinsurers XL Capital (XL) and Partner Re (PRE), and Insurance Brokers Arthur J. Gallagher (AJG) and Aon Corporation (AOC), bellweathers of their sectors, are all up huge since that fateful week in March. Keep an eye on St. Paul - their captain, Douglas Leatherdale, stands to make a killing should the stock rise another $10 (part of an unusual performance-linked package granted upon the 1998 USF&G merger). St. Paul is already over 100% off of its March low. We have a feeling that after third quarter results, the stock will smash through the Leatherdale level an continue into the $60-range. Out top picks are SPC, XL, NY Marine and General Insurance Company (NYM) and Navigator's Group (NAVG). NYM and NAVG, smaller plays which are into marine and aviation insurance, are especially attractive at current levels. Rates are up handsomely in aviation, primarily due to recent catastrophes, and are sharply higher in marine, due primarily to strength in the shipping industry. While information is hard to come by with NYM, we also like the stock as a takeover target. In addition, we like Diversified Insurer CNA Financial (CNA) as a takeover target. Abroad, we like Zurich Re and ING.
IS PERSONAL AUTO NEXT?
It is interesting to note that the turn in P&C was not entirely a surprise – industry executives were talking about possible premium hikes over nine months ago. Now they have backed up their words with actions. So, what are they talking about now? Personal P&C premium hikes! Starting with Auto! We are looking for the hikes to start at year-end. The best play? Allstate, which is already well over 50% off of its March low. A higher risk play on a rebound in auto is Progressive (PGR). They have had their share of execution problems, and they are prone to disappointment, but the potential upside makes the stock attractive on a relative basis.
We will close this POV with this little tidbit, as if you need another reason to start buying the P&C group aggressively: You already know they are still relatively cheap, but did you know that the insurance group has an EXTREMELY low correlation with the Nasdaq? Were talking a dream beta! Now what better way to hedge your portfolio, already overstuffed with B2B garbage? |
