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Do they offer a margin of safety?
On Wednesday, we put Independent Insurance to the test by having them jump through the Qualiport criteria hoops. Because insurance companies are different from your average company, and make money in a different way, it was not surprising that they failed a few of the tests.
Qualiport tradition says that we first decide we are looking at a quality company before looking at its valuation. There is absolutely no reason to waste time and effort looking at a company's valuation if you are never going to buy shares in it. To my mind, even if a poor company is trading at a significant discount to its net asset value, it is not a buy. Fools have a long-term investment time frame, and over an extended period of time, a poor company with poor economics trading in a commodity industry will never provide shareholders with a market-beating return, virtually regardless of the buy point. A case in mind is RJB Mining, which trades at a significant discount to its net asset value. Would you buy shares in that company, given the long-term economics of coal mining?
It is in this aspect that Warren Buffett differs from the traditional Ben Graham value approach to investing. The turning point for Buffett was his investment in the textiles company called Berkshire Hathaway. Buffett thought it was a bargain when he assumed control of the company, yet over the years, the textiles business required significant capital expenditure just to keep it going, let alone grow profits. Eventually, Buffett closed down the textiles business, having learnt a harsh investment lesson.
The question therefore becomes, do we think Independent Insurance is a quality company?
Plus points:
Minus points:
Having done my research, and knowing a bit about the insurance industry and how it works, I'm going give Independent Insurance the Qualiport thumbs up. As usual, I know the risks, and for Independent Insurance they are perhaps greater than they would be for a "normal" company. However, I feel the plus points outweigh the minus points. This is a personal decision, and not one all Fools will necessarily agree with.
Valuation
We briefly touched on valuation in Wednesday's report, where we said that investment companies, which is what Independent Insurance basically is, usually trade on a multiple of net asset value.
An insurance company should be valued at net asset value if it regularly breaks even on its insurance underwriting business. Breakeven is known as having a combined ratio (the ratio of an insurance company's claims and expenses to its premiums) of 100.
However, as we have seen, Independent Insurance is a profitable underwriter of insurance. In 1997, on net premiums of £444m, they booked an underwriting profit of £21m. That means they had a combined ratio of 95 (1 minus 21.3/444), which is pretty good, as insurance companies go.
The fact that Independent are raising new investment capital at zero cost instantly means that they should trade at a premium to net asset value. The fact that they have consistently achieved this feat, and that they won't write new business that is too high a risk, means that they deserve a premium valuation.
Let's break down the numbers, from Independent's 1997 annual report.
Pre tax insurance profit -- £21.3m, after a £6m deduction for potential future losses. After tax of 31%, that gives net insurance profit of £14.7m. Capitalise that at, say, 15 times, which is less than the current market average price to earnings ratio (P/E), and we get £221m
Net realised investment income -- £43.8m less tax equals £30.2m. Let's give them a high capitalisation rate of 15%. Investment returns can vary form year to year, and as they say in the advertisements, "past performance is not necessarily a guide to the future." That gives us a capitalisation of £201m.
Unrealised investment gains -- £24.1m less tax provision of £6.7m equals £17.4m. Again, capitalise this at 15% and that leaves us with £116m.
Add the three together and we get a possible valuation for Independent Insurance of £538m. Some of the above assumptions may be a little conservative. If we capitalised net insurance profits before the provision for potential loses at 18 times, and lowered the investment return capitalisation rate to 12%, the possible valuation increases to £736m. What's a £200m difference between friends?
Independent Insurance's net asset value at June 1998 was £252m. As we've determined above, they deserve to trade on a premium to that ranging from a low point of £538m to a high point of £736m. At a current share price of around 270p, they are capitalised at about £635m, in the middle of our range.
Stated earnings per share (EPS) for insurance companies do not take into account unrealised investment gains, as they are not added to reported profits. Here's a breakdown of results:
£m
Underwriting profit 21.3
Investment income 32.3
Realised investment gain 12.8
Investment expenses (1.3)
Tax charge (19.4)
Net profit 45.7
This is the amount on which stated EPS is calculated. However, to get the full story, we need to add on the unrealised investment gains, which do not go through the company's profit and loss account.
Investment appreciation 24.1 Deferred tax (6.7) Unrealised investment gains 17.4 Total profits 63.1
Shares in issue, including unexercised share options, were 242.6m, giving an adjusted EPS of 26p. Compare that to a share price of 270p and the shares trade on an adjusted trailing P/E of just 10.4.
Independent Insurance's total return on average equity (ROE) is an impressive 31.7%. If you assume that they can maintain an average ROE of 25% for the next 10 years whilst paying out 18% of their total earnings as dividends, they could generate 2008 total profits of £1,448m. Capitalise that at a conservative 10 times, add dividends of £341m, and you get a total potential valuation of £3,963m. Compared with a current market capitalisation of £635m, that's total appreciation of 524%, or a compounded annual growth rate (CAGR) of 20.1%. Compare that to an investment in the building society!
Doing my usual high/low tests:
ROE 18%, dividend payout 20%, 2008 P/E 8 = CAGR 8.5%
ROE 20%, dividend payout 20%, 2008 P/E 10 = CAGR 13.3%
ROE 30%, dividend payout 18%, 2008 P/E 15 = CAGR 31.2% (wow!)
Summing Up
We've (I've) decided that Independent Insurance is a quality company and would be a worthy new member of the real money portfolio.
Their current market capitalisation is £635m and their net asset value is £252m, meaning they trade on a price to book value of 2.5 times. We've demonstrated why and how they deserve to trade at a premium to book value and calculated a conservative valuation of £538m and a not so conservative £736m. The current valuation puts them bang in the middle of those two numbers, indicating they may be trading at a fair value.
However, when we look at a company trading at a trailing P/E of 10 that is achieving a return on equity of over 30%, it looks an altogether more attractive option. A CAGR of over 20% is very impressive. On this basis, the current Independent Insurance valuation appears to allow a substantial margin of safety.
We will be running a Qualiport special on Monday in which we will announce some swingeing changes to the real money portfolio. It will be an action packed week in Qualiport land! Stay tuned, Fools.
Please post all thoughts about Independent Insurance on its individual web message board. What do you think of the company and its valuation?
Have a good weekend, Fools.
Bruce Jackson (TMF Googly)
Qualiport Numbers
16/10/98 Close
Company Change Bid
EMA 0.31 9.25
MKS 0.01 4.34
RTO 0.07 3.49
ULVR -0.10 5.56
Qualiport Stocks
Last Rec'd Total # Company In At Current Change
19/12/97 1565 RTO 2.55 3.49 36.9%
17/07/98 595 ULVR 6.72 5.56 (17.3%)
11/05/98 736 MKS 5.54 4.34 (21.6%)
17/04/98 337 EMA 11.85 9.25 (21.9%)
Last Rec'd Total # Company In At Value Change
19/12/97 1565 RTO 4040.63 5461.85 1421.22
17/07/98 595 ULVR 4048.38 3308.20 (740.18)
11/05/98 736 MKS 4052.24 3194.24 (858.00)
17/04/98 337 EMA 4043.37 3117.25 (926.12)
Cash: £67.82
Current Total : £15,149.36
Total Invested: £16,184.62
Profit/(Loss) : (£1,035.26)
Value Per Share
Day Month Year History
Qualiport 1.08% 0.52% 22.54% 25.29%
FTSE 100 1.52% 1.36% (0.05%) 2.25%
FTSE All Shares 1.65% 0.94% (1.83%) 0.24%
For an explanation of Value Per Share accounting, please click here.