Cuts in earnings estimates in the second quarter from the insurance sector are forecasted based on disappointing first-quarter earnings reports, lower interest rates and relatively weak equity markets, says Joanne A. Smith, CFA, a Director and Senior Equity Analyst at Scotia Capital.
“I was expecting a lot more upside surprises than were delivered. There were only four companies in my universe of stocks that actually outperformed expectations, and there were four disappointments,” she said, “and then, there were two that met expectations, and I was expecting more positive results, part of which was due to some adverse mortality.”
Smith has Aflac Inc. (AFL) as a top pick in her coverage universe as the company has always traded at a significant premium to the peer group, given it produces exceptional profits. She says Aflac has had a track record up until the past couple of years of generating double-digit earnings growth while delivering ROEs that are well above 20%.
“The problem with Aflac right now is that it has become a little bit more complex. People used to love it for its simplicity, and it’s not as simple as it once was,” Smith said. “But I think that once investors are able to digest some of the changes that have taken place at the company and realize that it has not strayed materially from its traditional strategies and core strengths, that the stock will regain its ground.”
The connector segment within the electronic components sector is expected to benefit from increased automation in the automotive and industrial spaces as companies move to cut costs over time, says Michael J. Wherley, an Analyst at Janney Montgomery Scott LLC.
“The main driver for the connectors industry is increasing electrification of pretty much everything. So whether that’s in automotive, with all the different devices that go into cars today,” he said, “whether its in industrial automation, where the price in labor has been increasing pretty dramatically in large chunk in China over the last five years.”
Wherley favors Amphenol Corporation (APH) due to its decentralized model with 75 business units that operate independently, which is different than most large, multinational companies. He also likes Amphenol because of its 16% compound annual growth in the past decade, versus the top 10 companies in the connectors industry at 6.3%.
“As it all grows, the question is ‘Can they maintain this performance even if they double in size in the next five years?’,” Wherley said. “But we believe that they have a model that works and we believe, at least for the near to midterm, that this model works very well, and there’s no reason to doubt that they can’t keep working.”
Investors should look to insurance companies with more stable income due to uncertainty over how long favorable reserve development in the industry is expected to continue, says Robert Farnam, a Senior Vice President at Keefe, Bruyette & Woods, Inc.
“Workers’ compensation is actually a line, one of the largest commercial lines, and I think that that line is deficient. So you’ve already started to see some companies reporting adverse development there,” he said. “A lot of the commercial lines, I think, kind of the casualty lines, have questionable reserve adequacy, which could lead to adverse development going forward.”
Farnam has an “outperform” rating on Maiden Holdings, Ltd. (MHLD), a smaller Bermuda reinsurance company. He says the benefit of Maiden is that it’s different from other Bermuda reinsurance companies because it does not write property catastrophe risk, so its earnings are more stable.
“Their issue right now is that they are still sitting on too much cash. I think they still have to try to put that to work in this weak environment though. But stability is the key for them,” Farnam said. “I think they haven’t had a combined ratio out of the 90s since they’ve been in existence. So I think it’s attractively valued relative to what its performance expectations are.”
Investors need to look at those insurance companies that have catalysts ahead of them, because these events may boost ROE despite the low interest rate environment and choppy equity market, says Sean Dargan, a Vice President and Senior Analyst at Macquarie Group Limited.
“Both of these headwinds certainly impact some companies more than others. To a certain degree, low interest rates negatively impact all insurance companies, but some are impacted less than others,” he said. “And the equity market performance does not impact those companies that are not large sellers of variable annuities or investment-management-type products.”
Dargan recommends MetLife, Inc. (MET), which is currently trading around 65% to book value, and is expected to to earn about 11% ROE. He says MET has catalysts on the horizon due to uncertainty about the regulatory environment surrounding the company and its ability to engage in capital management.
“So I think there is a catalyst ahead for this company in that it’s going to complete the sale of its bank deposits to GE Capital, which should allow the company to relinquish its bank holding company charter,” said Dargan, “which in turn should allow the company to no longer be regulated as a bank holding company by the Fed, and allow the company to raise its dividend and start buying back its stock.”
With valuations under pressure and the market skeptical of any growth stories in the electronic components sector, investors need to find companies that offer extreme valuations, confidence in management and operating leverage opportunities, says Steven Fox, CFA, a Managing Director at Cross Research LLC.
“In terms of how we are differentiating our stock picks, generally, we are looking for extreme valuation cases, obviously, because there are a lot of stocks in my group that have seen valuations cut, so below industry average EV to EBITDA, p/e multiples, positive cash flows, cash flow yields, etc.,” he said.
Fox likes TE Connectivity Ltd. (TEL), a connector company, because it is a well-run business with 35% of its sales focused on auto markets, which seems to have some good trends ahead of it, and TEL is the leader in auto connectors. He says the company also has outsized market share in auto connectors and tends to make good margins on its auto products.
“TEL also offers high incremental margins, in general. So on slow growth, we think they can improve their margins at a faster rate than sales,” Fox said. “Additionally, TEL just acquired a company called Deutsch, which turns them into a leading position in the military and commercial aerospace connector market, while expanding their opportunity in harsh environment connectors used in industrial applications.”
The insurance brokers offer attractive exposure to the property and casualty insurance sector due to the segment’s potential for organic growth and margin expansion, as well as the group’s ability to control its expense base, versus underwriters, says Ray Iardella, a Vice President and Senior Analyst at Macquarie Group Limited.
“Like I said, for the brokers, it’s not just about growing for the sake of growing, but to grow to expand margins, increase EBIDTA, and ultimately, increase their EPS. I think these are all important things that you need to see in these companies to drive multiple expansion,” he said.
Iardella favors Marsh & McLennan Companies, Inc., (MMC) because the company has been the best-growing, from an organic revenue perspective, insurance broker of the group over the past 12 to 18 months, and that growth is expected to continue.
“So I think MMC has that going for them on the topline side, but also they have been able to deliver meaningful margin expansion over that same time period,” he said. “I think that trend is going to persist as well, because management’s focus is on controlling expenses, and basically growing expenses at a slower pace than organic revenue growth to drive margin expansion.”
Year to date, REITs are outperforming targets, with a little bit of growth in the U.S., which is underpinning some selective demand for space, however there are considerable concerns going into the second half of 2012 due to the economy and the uncertainty around the U.S. election, says David Harris, a REIT Analyst for Imperial Capital, LLC.
“On the investment side, we have very low interest rates, which are underpinning tremendous demand for yield product. We can see that in Treasury bonds of sovereign countries with perceived stability and safety,” he said. “We can see it in high-grade corporate bonds, and we can see it in the high-quality real estate markets.”
Harris has a positive view on Simon Property Group Inc. (SPG), a mall company that offers some relative value and has performed well in the markets. He says Simon Property’s dividend is 11% higher than the prior peak.
“If we look at retail, aside from the growing portion of the market that is taken up through e-commerce and Internet sales, there’s a firm bid from healthy retailers for space in the most productive locations,” Harris said.
Timber REITs are recommended as a two-to-three-year, medium-to-long-term play on a U.S. housing recovery with large, liquid companies that often have good balance sheets and are paying a dividend yield today, says Joshua Barber, an Analyst at Stifel Nicolaus & Co., Inc.
“We favored that group for a little while, just in the sense that they trade at bigger discounts to net asset value than virtually any other real estate asset class, although there are probably some good reasons for it,” he said. “They also are among the more economically sensitive ones, particularly to the housing market.”
Barber has a “buy” rating on Rayonier Inc. (RYN), which within the timber REIT space is his top pick. He describes Rayonier as the least home-construction sensitive among the timber REITs, and says a large percentage of its business comes from specialty dissolving pulp, which has been a great growth engine for RYN for the past four or five years.
“They have a great balance sheet, they have a wonderful management team, and we think that the dissolving pulp business has some pretty good growth left, especially with that mill conversion next year. So we like the earning there,” Barber said.
Originations and valuations are the most critical factors right now to selecting a BDC as an investment option as there is more differentiation between companies that are able to capitalize on any dislocation and those that are stuck in the transitional period, says Mike Turner, a Senior Vice President and Research Analyst at Compass Point Research & Trading, LLC.
“For the industry as a whole, credit quality is something that we watch, and arguably, I don’t believe we have hit the trough quite yet. Strong credit quality is typically a reflection of a healthy economy, which should then translate into origination growth,” he said.
Turner likes MCG Capital Corporation (MCGC) although the company is going through a transitional period as it recovers from some sour investments during the past few years in the capital structure. He says MCGC, going forward, is aiming to recycle out of some of those poor-performing investments and reinvest in senior debt positions.
“It’s really a transitional story where they’ve shrunk their balance sheet and right-sized their cost structure. They’re cleaning it up and getting earnings and the dividend to a stabilized level. The process isn’t complete, but in the low $4 range, the stock seems to price in a worst-case scenario,” Turner said. “So at that price, you’re getting a nice dividend yield to wait and the downside protection of buying it at a big discount to NAV.”
The BDC sector is expected to enjoy strong returns in the current stage of the corporate credit cycle, where corporate defaults are going to run well below their historical levels over the next several quarters, regardless of GDP growth, says Matt Howlett, a Vice President at Macquarie Group.
“Our thesis is that corporate credit defaults or higher defaults are going to run well below 2% in the next two to three years, I should say the broader leverage loan market below 2%, default rates over the next two to three years,” he said. “That would be 50% of the long-term average of 4% and about 20% of where they peaked up in 2008.”
Howlett favors American Capital, Ltd. (ACAS), although the company is not paying a dividend right now. He says he believes ACAS is overlooked by a lot of people in the space, given BDCs typically pay a dividend, however the company is returning capital through buybacks, and it’s deleveraging and paying down some of its debt.
“We think when the company is fully done deleveraging or paying down their debt, they’re going to be in position to really access the financing markets in a unique way that will be able to lift earnings and resume the dividend and resume capital raising,” Howlett said.
