When I think of life and general insurance company Aviva (LSE: AV) (NYSE: AV.US) , two factors jump out at me as the firm’s greatest weaknesses and top the list of what makes the company less attractive as an investment proposition.
1. Cyclicality
Looking back, it’s easy to see that the best time to purchase shares in Aviva recently was sometime early in 2013. Since then the shares risen 70% from a low of around 300p.
Anyone studying the numbers through a value lens could have been wrong-footed by Aviva’s move to trim the dividend immediately before the share price took off. In fact, a dividend cut could have prompted some shareholders to sell their Aviva shares.
Such is the danger of myopic thinking around shares in general, but even more so with cyclical shares such as Aviva. Buying and selling shares based purely on numbers, without thinking through a company’s business prospects and other qualitative factors, seems like folly. Simplifying investment decisions to the extent of only considering such things as dividend yields or current valuations seems dangerous. If we are buying individual shares, we need to put some work into it. If unwilling, we should perhaps buy a tracker, or some other passive vehicle.
In the case of Aviva, selling on the yield-cut would only have resulted in missing the gain from 300p. So often, badly timing an investment can lead to actual capital loss, as share prices ‘unexpectedly’ plummet after purchase.
Sometimes a little more research can lead to a superior investment outcome. With hindsight, we can see that Aviva has actually behaved as a cyclical share ‘should’ behave. According to master investor Peter Lynch, the best time to buy a cyclical share is when the P/E is high and the dividend yield is low. Back in 2013, the historical P/E was high, but it took a dividend cut to make the dividend yield lower, thus signalling an opportunity to buy for Aviva’s cyclical recovery.
I admit that it’s difficult to see with such clarity as things are actually happening. But my point is that an investor looking at Aviva through the lens of its status as a cyclical share, thinking about forward prospects for the industry and the company, and focusing in on qualitative factors and management cues, might be better able to forecast forward share price growth on cyclical up legs, than an investor just focusing on numbers like dividend yields. In the example of Aviva, such a broad approach could perhaps have helped prevent investors from misinterpreting the signal sent by the firm’s yield cut.
Cyclicality tends to overrule other factors and turn traditional valuation methods upside down. That makes timing an investment in a cyclical company like Aviva difficult. Whichever way you look at it, cyclicality means Aviva is definitely not one to buy and forget.
2. Debt
Aviva is turning around its fortunes by focusing on debt reduction and what it calls ‘cash flow plus growth’. The fact that the firm has pinned down debt as a target suggests the level of borrowing is high.
The firm is right to get its finances in order whilst the sun shines, because at some point there’ll be another down leg in the economy and, ideally, we want cyclical companies to go into such austere times with heaving positive bank balances, not sagging negative ones.
Progress on cash flow and debt looks like this:
| Year to December | 2009 | 2010 | 2011 | 2012 | 2013 |
|---|---|---|---|---|---|
| Net cash from operations (£m) | 2685 | 1807 | (342) | 1807 | 2685 |
| External borrowings (£m) | 15,000 | 14,949 | 8,450 | 8,179 | 7,819 |
What now?
At a share price of 503p, Aviva has a forward P/E rating of 9.7 for 2015, with city analysts forecasting 11% earnings’ growth that year. The forward dividend yield is running at 3.8% with forward earnings expected to cover the payout around 2.7 times.
