Here’s Why You May Want To Hold Onto Aviva plc And Prudential plc Right Now

Here’s why you may want to add Aviva (LSE: AV) (NYSE: AV.US) and Prudential (LSE: PRU) (NYSE: PUK.US) to your existing holdings right now. 

What To Like

The merger between Aviva and Friends Life is expected to deliver meaningful cost savings, which are likely to support bullish forecasts for earnings growth and cash flows, yielding a forward dividend yield north of 3%. In order to hit its annual synergy target, the combined entity may have to cut more than 1,500 jobs, however, according to my calculations. Say 2,200 jobs are at risk: redundancies shouldn’t pose any problems, however, simply because thousands of jobs have gone at Aviva in recent years and have actually contributed to boost the valuation of Aviva’s shares. 

Aviva stock trades at 536p, and has surged 10% so far in 2015. Based on its trading multiples, the stock doesn’t look expensive, although it is fast approaching the average price target from brokers (586p). Aviva’s results are due on Thursday, when Aviva will have to convince investors that its acquisition-driven strategy will yield higher returns than that of its rivals, and that the balance sheet will strengthen after the integration of Friends Life, thus supporting a rich dividend policy. 

Prudential, meanwhile, pays a lower dividend, and appears to be a less risky investment than Aviva. Its stock is up 9% this year; its more diverse geographical reach points to greater upside for shareholders, although one caveat is that Prudential is more expensive than Aviva, according to the relative valuation of its shares. I still prefer Aviva, but both stocks could sit nicely in a diversified portfolio. 

Regulatory Hurdles

Anybody willing to invest in the insurance sector must consider that regulatory hurdles pose the biggest risk to diversified insurers over the long term, and could have a greater impact on earnings. Take the latest news surrounding the asset management arm of Aviva…

The Financial Conduct Authority (FCA) fined Aviva Investors for £17.6 million last week. That’s not much, of course. If Aviva Investors had not agreed to settle at an early stage, however, it would have incurred in a fine of  £25m, which represents 1.1% of Aviva’s operating profit (Ebit). In total, Aviva Investors had to pay £150 in fines and compensation, which amounts to 7% of the group’s Ebit — some £132m was paid out to eight funds. You may well wonder whether Aviva Investors should be dismantled (the same applies to Prudential’s asset management unit), also in light of its modest contribution to revenues and earnings.

What concerns me is that for almost eight years to the end of June 2013, the group had actually failed to “control the conflicts inherent in the management of funds that paid differing levels of performance fees on the same desk within its fixed income business”. In the UK asset management industry, where assets under management are estimated at £6.2tn (40% of Europe’s total), fines could grow at a very fast pace in the next few years: that’s a big risk, which could push up operating costs and one-off charges. 

“For Aviva Investors, a key component of being a responsible business is how we act as responsible investors – including environmental, social and corporate governance considerations in our investment process,” Aviva Investors states on its website. These are not major issues right now, so you may want to add Prudential and Aviva to your portfolio. 

Alternatively, though, you should consider a solid equity investment that has recorded a +140% performance since 1 June 2012, and still looks rather cheap right now. This company has recorded a similar performance to Prudential over the period but is arguably less risky, and has outperformed Aviva by 30 percentage points! 

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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.