For most shares in the FTSE 100, 2013 was a good year and investors have likely enjoyed capital gains and rising dividend income.
That makes me nervous about investing for 2014 and beyond, and I’m going to work hard to adhere to the first tenet of money management: preserve capital.
To help me avoid losses whilst pursuing gains, I’m examining companies from three important angles:
- Prospects
- Risks
- Valuation
Today, I’m looking at life insurance and financial services company Legal & General Group (LSE: LGEN) (NASDAQOTH: LGGNY.US).
Track record
With the shares at 229p, Legal & General’s market cap. is £13,580 million.
This table summarises the firm’s recent financial record:
| Year to December | 2008 | 2009 | 2010 | 2011 | 2012 |
|---|---|---|---|---|---|
| Revenue (£m) | 5,895 | 5,275 | 5,348 | 5,719 | 5668 |
| Net cash from operations (£m) | 1,086 | 758 | 2,707 | 1,557 | 2,799 |
| Adjusted earnings per share | (17.88p) | 14.82p | 14.07p | 12.42p | 13.9p |
| Dividend per share | 4.06p | 3.84p | 4.75p | 6.4p | 7.65p |
1. Prospects
To many people, Legal & General seemed like a basket case in 2009, as the shares flirted with a nadir around 20p. However, a determination to reshape the firm gripped the directors and their efforts to squeeze out costs and modernise the company’s approach to doing business have paid off, with the shares up around 11 times since hitting their lows, and earnings heading upwards.
With the recent three-quarter update, the good news keeps on coming. Cash generation is up 20% year-to-date along with a raft of other positive indicators — Legal & General is trading well. Last year, the firm earned around 66% of its operating profit from insurance and annuities, 22% from investment management and 12% from savings products. Its revenue was generated worldwide — from mature businesses in Britain, the US, France, and the Netherlands, and from emerging areas such as the Persian Gulf, India, Egypt and Asia.
This cyclical turnaround has certainly turned and, business-wise, the future seems bright. The big question is whether that potential success will translate into worthwhile investor returns from here.
2. Risks
From an investor point-of-view, one risk is that Legal & General’s business operates in a cyclical industry, despite its recent perky growth. That’s why the shares crashed in 2009. When the market smells the peak of the current macro-economic cycle, the shares will probably be heading down. P/E compression is likely to crimp share-price progress leading up to peak earnings in the cycle, too.
From a business point of view, Legal & General’s balance sheet strength and the majority of its revenue are both rooted in the performance of financial markets. Investments and derivatives stuff the balance sheet, which create havoc in the firm’s finances when markets slide. That’s why investors say financial companies like banks and insurers are ‘geared to the market’.
Ultimately, if conditions in financial markets get too bad, companies like Legal and General can find it difficult to continue trading without rebuilding their balance sheets, which nearly always works out badly for those invested in those firms.
You may have noticed that Legal & General’s recent business and share-price growth has occurred as the general stock market has risen. One event is linked to the other and the performance of Legal & General’s share price is exaggerating the gains of the general share indices. That gearing effect works on the downside too.
3. Valuation
The forward dividend yield is running at about 5.2% for 2015 and city analysts following the company expect forward earnings to cover the dividend about 1.5 times. Meanwhile, those analysts expect earnings to grow by about 8% a year for both 2014 and 2015, which is a good enough guess, but does imply a tapering from the growth rate that has fuelled recent share-price progress.
You can pick the shares up on a forward P/E multiple of about 12.4 just now, which looks fair. However, I’d expect the P/E multiple to compress as the macro-economic cycle unfolds.
What now?
Legal & General’s dividend looks attractive but we should consider it against the backdrop of the firm’s cyclicality. What will the share price do, and when will deteriorating financial markets pull the rug from under investors’ feet here?
