8.5% yield and oversold! Here’s why I’m buying Legal & General shares

Legal & General shares have underperformed the market this year. Dr James Fox explains why fortunes may change for this dividend aristocrat.

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Over the past 12 months, Legal & General (LSE:LGEN) shares have lost 13% of their value. This is partly because of higher interest rates. They increase the appeal of debt and cash over shares, and have also led to a drop in the firm’s assets under management.

Performance remains steady

Despite the falling share price, Legal & General’s performance has been formidable in a challenging economic environment.

In the first half of the year, this stalwart of the FTSE 100 reported an operating profit of £941m. This was a small dip from the previous year’s £958m.

L&G’s Solvency II coverage ratio, a pivotal barometer of financial stability in the insurance sector, saw an upswing from 212% to 230%.

Performing in line with aims

Steady performance in a difficult market has kept the business on track to hit its five-year target of generating between £8bn and £9bn in capital by 2024. Capital generation at the last count stood at £5.9bn.

In turn, the board highlighted a net surplus generation over dividends of £600m, along with new business deferred profits of £600m.

Challenges to overcome

The results, released in August, weren’t enough to stem the downward pressure on the stock. Interest rates have a multifaceted impact on the L&G share price.

First, as I mentioned at the start, when interest rates rise, capital allocation moves towards debt and cash over stocks. This movement could be particularly noticeable for dividend stocks such as this.

However, more broadly, this negative impact on asset prices has contributed to a 10% drop in the value of Legal & General’s assets under management. This isn’t what investors wanted to see at the end of H1.

Falling interest rates, however, should represent something of a tailwind for the business (assuming we do see rates fall, of course).

L&G Investment Management has been something of a laggard for the group over the past year. In an improving rate environment, we may see it become a net contributor.

Long-term boosters

More important, it’s not just in the short term that I expect the business to experience a tailwind. Legal & General is perfectly placed to benefit from positive trends in annuities.

Bulk purchase annuities are financial arrangements made by pension schemes or companies to transfer their pension obligations and their linked risks to an insurance company.

To date, only 15% of the UK’s defined benefit programmes have been transferred to insurance providers. This means a lot of room for expansion.

Index-topping dividends

As noted, I believe there are more reasons to buy this stock than the dividends. However, the payout policy is very attractive.

Legal & General is a strong cash generating business, and that allows it to maintain one of the largest dividend yields on the FTSE 100.

The yield currently stands at 8.5% and was covered two times by earnings last year. A coverage ratio around two is generally considered healthy.

Moreover, the business remains committed to increasing its payouts by 5% a year, providing a strong hedge again inflation.

So, despite the current unfavourable interest rate environment, I’ve built a large position in Legal & General. And it’s a position I recently topped up.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

James Fox holds share of Legal & General. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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