VALUE INVESTING
Back Into Royal & Sun

By Stephen Bland (TMFPyad)
November 8, 2002

A few weeks ago I wrote here, in my latest occasional value scroot of the FTSE 100 by reference to low P/E, high yield and low price to book, that Royal & Sun Alliance (LSE: RSA) was the only share to appear in the top ten of all three of these lists. Since then I have done a piece on insurance value, using the same common value ratios. I found that Royal stuck out from the other insurers due to the market perceiving it to possess higher risk. The question for value players is whether the market was overdoing the hatchet job on the company.

Royal is less involved in life insurance than many other of the large insurers. In fact it is classified under the stock exchange sector of general insurers. The company has indicated that it intends to pursue a policy of reducing further its life interests and concentrating on general insurance business.

Royal has been battered over recent times by a series of highly publicised claims incidents such as 9/11 and asbestos. As a result, its shares have collapsed in the bear market of the last couple of years by around 80%, far more than the FTSE 100 itself. A steep fall in the price is not reason alone to indicate value in a share, but when it is combined with the result of creating attractive fundamentals then it attracts the attention of value players. The size of the company is another attraction. To me, a big value share is always better than a small one.

I believe that insurers can become attractive when they trade below book value. In fact I made a profit from such a situation with Royal back in 2000. The obvious problem is that book value is a variable item because a lot of the assets consist of equities, but who ever claimed this game was easy? In a bear market the book value of an insurer will fall as its equity holdings lose value. So it's often difficult to tell whether you actually buying below the latest book value or not. It gets worse because the effect is geared, not merely a simple direct proportion to the overall movement of the market. So it happens that in both falling and rising markets there will be periods when insurers fall much more or outperform strongly.

The trick therefore is to buy an insurer like Royal when it is both under book value and you perceive that markets are more likely to rise than fall. Royal has been under book value for some time now, that bit is easy, but when are markets more likely to rise than fall? If I knew that, as the old joke about Baron Rothschild goes, I'd be a rich man. But for what it's worth I have noticed a lovely smell around financials in general in recent weeks as I think I've mentioned before in this column, and one that I was unable personally to resist with my own odd couple of bob. I could be wrong of course but the fact is that there have already been some good gains amongst many bank and insurance shares. It may be a short lived rally, you can never know, but I don't think it is anywhere near over for financials yet, particularly for the very low rated oversold shares in these sectors, amongst which I count Royal.

This applies particularly to those with patience to hang around for when the market really does put in a serious recovery, which sooner or later it will, though I have no idea when. Because financials are frequently leading movers in markets both up and down, I see large profits to be made and importantly, good yields to be received whilst waiting. The classic value situation. Be aware though that it is likely that Royal's yield is riskier than many other banks or insurers and it has already made severe dividend cuts to preserve cash through its difficulties.

Royal has just issued its lengthy nine month report, upon which I don't propose commenting much though I have read it. It's a bit like the bible, you can find what you want in it to justify either a bullish or bearish view on the shares. Me, I'm a raging bull with one eye on the exit as always, but I took that view before the report anyway.

Perhaps worthy of mention is a refreshing absence in the report of blaming outside factors for the company's poor performance in the recent past. And an insurance company more than most would have good reason to blame external incidents for its misfortunes. The directorspeak refers instead to having "not produced the results a group like Royal & Sun Alliance should be producing" and "not executed our strategy as effectively and as quickly as we should have done." They are admitting, to put it plainly, that they have cocked up and that nobody or nothing else is to blame, such honesty is fairly rare in my experience and may be a clue to the determination with which they are intending to turn the company round.

As usual with value the thing is essentially about perception, playing the old human nature card. Reality is not that important, what is important is that sentiment towards the shares improves sufficiently for some serious wad to be made out of them due to emotional gearing. I sniff that this may be happening.

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The author own shares in Royal & Sun Alliance.