VALUE INVESTING
Liquid Assets & Insurance

By Stephen Bland (TMFPyad)
December 10, 1999

The latest edition of the Investors Chronicle has a spread of water company half-year results. As anyone following the sector will know, it has been in a very severe downtrend over the last year or so due to regulatory concerns, in particular the effect of that on EPS and consequently dividends. More results have been announced after the IC went to press, including United Utilities (LSE: UU.), one of the largest in the sector, being a combined water and electricity company.

When a sector has been creamed in such a vicious manner, there is the likelihood of value or crisis plays arising because the good are driven down with the bad. I am not a sector player with my pyad shares. I don't go looking in particular sectors for them, they find me by virtue of their ultra-cheap fundamentals.

But it does happen sometimes that I find more than one over a short period in a particular sector, not because I am looking in that sector but because the falls that have occurred naturally create opportunities for the value hunter. A good example of this over the last fifteen months or so was the housebuilding sector where I picked out Barratt (LSE: BDEV) followed a few months later by Fairview (LSE: FRV). I was definitely not looking in the sector but because the whole lot had been heavily marked down by the market, it threw up these two successful shares.

A few weeks ago I wrote on the value board suggesting that utilities were crisis plays. At the time they had already fallen a very large amount. They have since fallen further. Following the latest falls more readers posted messages recently about whether these companies might be crisis plays. I think that some of them are so and expect to see substantial short term recovery here over the next few weeks amongst them now that this round of regulatory rulings are out in the open. The clever time to buy of course was just before the actual new rulings were published, on the grounds that the anticipation was probably, though not certainly, going to be worse than the event. That would have been the classic crisis approach. To go when all looked bleak.

Yields are substantial, 7% and more in many cases although for anyone anticipating holding for more than a very short time, try and establish that the dividends will be maintained. Some may be cut. P/Es are very low, around 5 to 8.

Another angle is that some of the water companies have diversified into non-regulated businesses. Severn Trent (LSE: SVT) for example has stated that it hopes to make 26% of profits by 2005 from such non-regulated activities. If they get this right, and it is a big if, that will overcome regulatory problems over increasing EPS to some extent. Of course they could get it wrong which could leave them wishing they had stayed with pure water and the good old regulator, but that's the risk you take. In any event if you are a value/crisis player in the sector you are probably not looking years ahead, just long enough for the oversold situation to recover to an extent to make a decent profit, perhaps 20-25% in a short time and maybe a dividend as well if you can buy cum dividend.

I am not in any water companies personally, but one crisis play that attracted me recently, as I wrote on the board a few days ago, was Royal & Sun Alliance (LSE: RSA), the large insurance company. It was not a pyad share, just the case of a large Footsie company driven down, too far in my view, by the market for reasons I believe to be invalid. I found it an interesting side bet, not one to bet the farm upon, in the now trite phrase, but worth a punt.

It was trading at under book value and has a high yield of over 6%. There were several theories as to why it had become so cheap, which readers mentioned, amongst them the Y2K problem and various natural disasters. The insurance industry is quite cyclical and the shares are somewhat out of sync with the cycle it seemed to me. Thus I think it appears ripe for recovery at around the price at which I went in, a little below 380. It smelt just right. Since then a reader kindly posted nine months' results today, which seemed to confirm that the smell remains sweet. Blue chips are the safest crisis plays, as I have said before. The risk is minimised. I would rarely use this strategy on anything other than a Footsie company.

The company has been mentioned many times on the value board by various readers, including Bruce Jackson (TMF Googly) a while back. Somehow I was never attracted to it before. It was under book even when Bruce mentioned it, but I didn't get the feel that I needed. Last week I did and went in.

I did seriously well out of the old Royal Insurance a few years ago, prior to the Sun merger, in similar circumstances. General insurance companies, ie. those that are not pure life, are bloated, badly run institutions. Have you tried dealing with one? Especially if you want them to pay out! They can also be predatory and there have been several large mergers in the last few years. They go through a cycle over a lengthy time period and can be outstanding recovery plays if bought around the right moment with possible bid prospects in for nothing as well. Additionally they tend to maintain or increase their dividends even when EPS are down so you get a good yield whilst you are waiting.

You may wonder how to time it. Well, some clear signs for guidance are a high yield and a share price below book. Typical value factors of course. That situation can last for some time though and that is why I find a high yield useful. It can give a return higher than bank deposits, as is the case with Royal now. Other signs are, as we've seen here, where the company publishes decent results whilst the share price remains very low. But you will need your olfactory sense on full alert as with all shares in the value or crisis game.

I responded to a reader yesterday on the Ask A Foolish Question board about whether it is possible to predict crashes. This is really the same as asking whether the market can be timed in general – in answer to which, I believe not. But then again, as I said also in my message, I personally have no interest in "the market" or fad sectors. But I do believe that individual shares can be bought at certain times to realise profits in the short to medium term using the sort of ideas about which I have written, whatever is happening to the rest of the market in general. I am not sure whether this justifies the term "prediction", which implies some sort of mystic powers which, last time I looked, I don't possess. More some fairly simple fundamental analysis and a willingness to go against the crowd. And maybe a kind of almost mad belief that you are right and everyone else is wrong.

Post your comments and questions to the Value Shares board.