Can You Limit Your Risk With These Stocks?

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I've found some of my best investment ideas by using a stock screener. The advantage of a screener is that it allows the investor to weed through thousands of companies and find only the stocks that meet your criteria. A common screen I run is one that looks for highly rated dividend paying stocks. I recently ran a Motley Fool CAPS Screen of the insurance sector for companies rated 4 – 5 stars, with a 3% dividend.

I selected the insurance industry because many times these stocks are sold when uncertainty occurs in the market. However, many of these companies end up being sold off in a sort of “baby with the bathwater” type of thinking. Good insurance companies can be undervalued for a while until the market realizes that financial Armageddon isn't going to happen. Usually while investors wait, the company pays a good dividend, and when the market realizes its mistake, the stock can recover very quickly.

If you don't believe me go look up Aflac on a stock chart going back to 2009. The stock has sold off multiple times because investors worried about the company's investment portfolio, and then recovered nicely after the panic-sellers liquidated their positions. My screen turned up three other companies for our consideration: ACE Limited (NYSE: ACE), Cincinnati Financial (NASDAQ: CINF), and Manulife (NYSE: MFC). All of these companies operate in the insurance industry and two of the three pay a dividend of 4% or greater. But before we get to the dividends, let's first look at how the market is valuing each.

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>P/E on '12 Earnings</strong></p> </td> <td> <p><strong>Growth Expected</strong></p> </td> <td> <p><strong>PEG</strong></p> </td> </tr> <tr> <td> <p>ACE Limited</p> </td> <td> <p>9.73</p> </td> <td> <p>6.80%</p> </td> <td> <p>1.43</p> </td> </tr> <tr> <td> <p>Cincinnati Financial</p> </td> <td> <p>25.31</p> </td> <td> <p>5.00%</p> </td> <td> <p>5.06</p> </td> </tr> <tr> <td> <p>Manulife</p> </td> <td> <p>9.15</p> </td> <td> <p>10.00%</p> </td> <td> <p>0.92 </p> </td> </tr> </tbody> </table>

In typical fashion, three companies that operate in essentially the same industry sell for largely different multiples. ACE Limited is in the property & casualty, auto, marine, and workers compensation insurance fields, just to name a few. Cincinnati Financial also offers property & casualty, but branches out by offering commercial casualty, life insurance and more. Manulife Financial offers life insurance, health insurance, annuities, pension management and is more on the investment side of the insurance industry.

In this industry the mantra is simple: collect premiums from customers, invest those premiums to make money, and underwrite the risk appropriately so that when claims come the company can afford to pay them. This may sound simple on the surface, but the risk of underwriting miscalculations and ever present investment risk makes the business anything but simple to run. That being said, on the surface Manulife appears undervalued relative to its growth rate and its competition. On the other end of the spectrum, Cincinnati Financial has a long history of dividend growth that likely leads to its seemingly extended valuation. ACE Limited falls in the middle somewhere selling for a premium to its expected growth. (Manulife – 3, ACE – 2, Cincinnati – 1)

When it comes to earnings growth, I've found that taking analysts expectations with a grain of salt makes sense. A company that beats estimates on a regular basis many times will continue to surprise to the upside, and vice-versa. As you can see in the following table, Cincinnati Financial leads the field in this measure. 

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>Beat Estimates</strong></p> </td> <td> <p><strong>Missed Estimates</strong></p> </td> <td> <p><strong>Avg. Beat or Miss</strong></p> </td> </tr> <tr> <td> <p>ACE</p> </td> <td> <p>4</p> </td> <td> <p>0</p> </td> <td> <p>14.23%</p> </td> </tr> <tr> <td> <p>Cincinnati</p> </td> <td> <p>3</p> </td> <td> <p>1</p> </td> <td> <p>26.73%</p> </td> </tr> <tr> <td> <p>Manulife</p> </td> <td> <p>2</p> </td> <td> <p>2</p> </td> <td> <p>19.78% </p> </td> </tr> </tbody> </table>

While all three companies beat estimates on an overall basis, Cincinnati Financial beat estimates by the largest average amount. ACE Limited was more consistent, but actually beat by the least amount. In a strange twist, Manulife missed twice, but still managed to beat estimates overall. (Cincinnati – 3, ACE – 2, Manulife – 1)

One of the primary reasons to invest in these companies is for their dividend. While ACE Limited, at a 2.59% yield, doesn't quite meet our criteria, we don't want to ignore the company for being below this threshold. Cincinnati Financial takes this category, due to the fact that it has consistently raised its dividend for 52 years. With a yield of 4.30% versus 4.35% at Manulife, the two company’s yields are nearly identical. (Cincinnati – 3, Manulife – 2, ACE – 1)

Since insurance companies are constantly under pressure from possible losses in their business or investments, we want a company that has a strong balance sheet. According to Peter Lynch, the most fundamental measure of the strength of a financial institution is its equity-to-assets ratio. Using this measure, Cincinnati Financial comes out on top, with an equity-to-assets ratio of 31.97. ACE Limited comes in second with a ratio of 28.40, and Manulife's slightly different business shows in its much lower ratio of 5.29. (Cincinnati – 3, ACE – 2, Manulife – 1)

Adding up the totals, we find the following scores: ACE Limited - 7, Cincinnati Financial - 10, and Manulife - 7. Cincinnati Financial sells for the highest valuation, and could also surprise to the upside with earnings, as it has been doing in the past. But I hesitate to recommend the stock at its current value. Even if the company continues to beat earnings expectations by more than 25%, this would still only give an indicated 6.25% growth rate. While the company's dividend yield and growth are factors, I don't believe this all adds up to a stock that should sell for over 25 times earnings estimates. I would suggest investors wait for a dip in the stock before pulling the trigger.

MHenage has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

blog comments powered by Disqus