Follow Buffett’s Lead with These “Free Money” Stocks

In his 1979 letter to shareholders, Warren Buffett offered his belief that “insurance can be a very good business” to own and invest in. His belief continues to this day and Berkshire Hathaway (NYSE: BRK-B) is among the world’s largest insurers in the world, which is due to Buffett’s ability to ferret out solid management teams and acquire successful insurance businesses over a career that spans more than six decades.

Other money masters also single out insurance as one of the best industries in which to invest. This is due primarily to insurance float, which is a common industry term that Buffett defined in his most recent letter to shareholders as “money that doesn’t belong to us but that we hold and invest for our own benefit.” Basically, it’s the funds insurance companies collect from policyholders. Much of it is eventually paid out as insurance claims, but in the process the insurer gets to invest that money. This float can be very substantial and is one of the key factors cited for Berkshire’s jaw-dropping growth rates over the years. 

Investing in the insurance industry is timely right now, for couple of key reasons.

The first is because of what the credit crisis did to the businesses. Ironically, most insurance companies, save American International Group (NYSE: AIG), which made a disastrous foray into credit default swaps that effectively ruined the firm, did not see their underlying business hit during the credit debacle. Instead, their sizable investment portfolios (the float mentioned above) became caught up in the extremely volatile financial markets and caused the write down of most stocks, bonds and other investments on the balance sheet. Lately, however, balance sheets have recovered along with a return to a less volatile investment environment.

When an insurer may has to continually pay claims that can occur many years out into the future, it makes sense for it to invest in bonds. The problem, though, is low bond yields  are making it hard for insurers to earn a decent return.  Low yields are being driven by the Federal Reserve, which has lowered interest rates and flooded the economy with billions of dollars of liquidity to boost the money supply and make it easier for companies and individuals to borrow, invest and take on activities that will eventually boost the economy again.

This condition will eventually reverse course, though. In fact, interest rates have recently jumped due  to concerns about the Federal Reserve using quantitative easing to try and kick start the economy. This near-term concern fits with other worries that inflation will pick up going forward, both of which will likely increase rates and mean higher yields for insurers.

Another concern that should work itself out is that the industry is currently in a “soft market,” which is signified by high levels of competition and weak growth in insurance premiums. An insurer’s main revenue source comes from earning premiums on insurance, which occurs once the time has passed for a customer to be able to make a claim on his or her insurance.

Too much competition means insurers are likely to lower prices for insurance and may fight for market share over profitability. A lack of major catastrophes, which removes industry capital as claims skyrocket, can also mean too much capital in the industry and contribute to a soft market. Less capital shifts the focus to earning profits over market share, which in turn helps boost premiums.  

The above two industry conditions — low rates and a soft market — have pushed many leading insurance players’ share prices to low multiples off book value.  Book value is the theoretical value that would be left over for shareholders if a company completely liquidated its operations. A general rule of thumb for financial stocks, insurance companies included, is to buy at or below book value and sell at more than twice book value.

The biggest players in the industry, including property & casualty (P&C) insurer Travelers (NYSE: TRV) and life insurer MetLife (NYSE: MET), are trading right around book value, at 1.1 and 0.85 times book value, respectively. (This is simply calculated by dividing the current share price by book value per share.) Second-tier life insurers such as Hartford Financial (NYSE: HIG) and Lincoln National (NYSE: LNC), are at a pretty big discount to book, at 0.54 and 0.85, respectively. P&C and auto insurer Allstate (NYSE: ALL) also looks interesting at about 0.89 times book value.

Action to Take —> Another key industry metric is return on equity (ROE). In the past year, Travelers has posted an impressive ROE of 13%. The other names above have much less impressive ratios in the mid single digits, though this should improve over time. Given Travelers is also among the largest in the industry, it represents a safe bet for investors at current levels.

Overall, gaining exposure to the insurance industry is looking like a solid investment idea right now, given that yields should rise at some point going forward and a soft insurance market can’t continue indefinitely. A change in the market will favor the largest players in the space, such as Travelers, although  another appealing way to gain exposure to the industry could be to take a basket approach and invest a smaller amount in a number of leading firms.