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Tuesday, June 10, 2014 - 14:15
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Tuesday, June 10, 2014 - 14:15

This Unloved Sector Is Heating Up

Wednesday, June 11, 2014 2:30 PM

As is often the case with an extended bull market, value is now trumping growth.

Many once-soaring tech stocks have come crashing downward in 2014, even as some once-loathed sectors are heating up. And few sectors were as disliked as the insurers, which have been among the deep value plays in this bull market. Back in April 2013, I noted that Protective Life (NYSE: PL), for example, sported a stunning 23% free cash flow yield.

And a month later, I noted that many insurers, including Protective Life, traded at a considerable discount to book value. This insurer is no longer a deep bargain, now that Japan's Dai-ichi has announced plans to buy it for $5.7 billion. Notably, Protective Life carries just $4.2 billion in tangible book value, implying a nice premium to book in this purchase price.

Why would Dai-ichi pay such a stiff price? Because the Japanese financial services firm realizes that the U.S. insurance market is on the cusp of a cyclical upturn, thanks to rising insurance premiums. Insurers always have pricing power when companies start to feel more optimistic about business conditions. In fact, Dai-ichi intends to use Protective Life as a platform to acquire other, smaller U.S. insurers.

Frankly, it's unrealistic to expect other insurers to garner such a huge premium to stated book value -- if they are acquired. But it's equally clear that insurers don't deserve to trade below book value. Yet a number of them still do.

To be sure, some of these below-book insurers are simply too large to acquire. I remain a big fan of AIG (NYSE: AIG), but the current $80 billion value renders a buyout nearly impossible. Book value is on track to exceed $75 a share by the end of 2015, and this stock remains a bargain as long as it trades below that price.

Some of these insurers are in the midst of share buybacks, which makes a lot sense whenever shares trade below book. In a recent profile on our sister site, ProfitableTrading.com, I suggested that municipal bond insurer Assured Guaranty (NYSE: AGO) had roughly 35% upside, thanks to a recently-articulated buyback plan.

Still, it's fair to wonder why insurers end up trading at sharp discounts to book value. National Western Life Insurance, for example, is a very profitable insurer, and has managed to boost tangible book value by 44% since the end of 2008. Perhaps the triple-digit share price scares many investors away. Perhaps it's because CEO Robert Moody's family controls the board through a separate class of stock. Or perhaps it's because this insurer pays a very small dividend. Regardless, value investors will do very well with this stock over the long haul, as book value moves higher and higher.

Some insurers trade on the cheap due to a legacy of troubled operations. Genworth Financial (NYSE: GNW) generated very weak returns in both its mortgage insurance business and its long-term care business, though recent results suggest that those lagging niches are now much healthier. "Many investors appear to have anchored their perceptions of the stock to a time when the company faced much greater uncertainty than it does currently," notes BTIG's Mark Palmer, who rates shares a "buy" and expects Genworth to start a buyback program of a dividend payment scheme later this year.

Book value at many insurers is expected to keep on rising, especially as long-term interest rates start to move up. These insurers carry considerable cash balances, which are currently earning subpar rates of interest income. You can see the book value trajectory in an insurer like CNA Financial (NYSE: CNA), which currently trades for around $40 a share. Book value stood at $44 a share at the end of 2012, and Merrill Lynch's analysts see that figure rising to $52 a share by the end of 2016. These analysts concede that "CNA's discount to book value is warranted due to a below average ROE (return on equity)," but they add that "improving returns should allow for gradual multiple expansion."

Risks to Consider: Some of these insurers are exposed to major events such as hurricanes, so book value won't rise every year.

Action to Take --> As the acquisition of Protective Life shows, insurers hold great appeal thanks to robust cash flow, strong balance sheets and an economic tailwind. Until these stocks move up to or even exceed book value, they are safe to buy.

The only thing better than investing in high-quality companies is investing in high-quality companies that return money directly to shareholders. In our latest research, we've found 13 market-dominating companies that have been hoarding billions in cash since the financial crisis -- and they're set to pay out $39.5 billion in dividends in 2014 alone. For access to the names and ticker symbols of some of these companies, simply view this special report.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.