Here are some recent updates from this month, including some new investments and some thoughts on how the market is setting up in terms of the economic outlook, interest rates and higher yielding (dividend) stocks.
New Investment – Chubb Limited (CB)
Insurance is an interesting industry in which to invest. When run properly, it can be very profitable for investors. It’s also one of the more attractive areas right now in terms of valuation and return potential when I look across the broad market. Many parts of the stock market are still expensive which implies lower future returns than stocks have historically averaged. However, I think some of the better insurance companies can still produce average annual returns in the 10%+ range based on current valuations and industry trends.
Perhaps the two most important metrics to evaluate when analyzing an insurance company are the two ways they make money: 1) the quality of underwriting, and 2) what the company does with the float they have on their reserves. Obviously one wants to partner with the companies with the best proven track records of underwriting and smart capital allocation policies.
Underwriting is simply how they price their insurance products vs. how much they end up paying out in claims, which is based on how much risk they’re willing to take. This can easily be tracked by what is called the combined ratio which is the combination of claims paid, commissions and expenses divided by premiums collected. A number less than 100 indicates profitability and the lower the number the better.
Since an insurance company collects premiums upfront but often won’t have to payout claims for 6 to 24 months, or sometimes longer, they basically have a never-ending interest-free loan from policy holders that they can invest. This is called the “float” and it’s how Warren Buffett was able to build (and is still building) such an incredible track record at Berkshire Hathaway. Berkshire has over $100 billion of float that Buffett and Munger are able to invest. It’s essentially a form of leverage that earns money but costs nothing.
In my opinion, two of best in the insurance industry are Travelers Insurance (TRV), which we’ve partnered with for a few years now, and Chubb (CB), which we just bought a few weeks ago on the dip. Both tend to post combined ratios in a range from upper 80’s to low 90’s. The market tends to price them in a similar manner too (same P/B ratio, same dividend yield, etc.) and the stocks track each other pretty closely so you might be wondering why not just pick my favorite and call it a day. Chubb was acquired by (merged with) Ace in 2016, combining two powerhouses with great reputations and niche business lines. I like Traveler’s capital allocation policy better but I like Chubb’s business model better, so in the end I’m happy to partner with both companies for different reasons; they’re two of the best.
Travelers just reported earnings this morning and posted another strong quarter and a 7% increase in the dividend. Chubb reports after the close today and I’m expecting an equally positive report.
Chubb (CB) – 1 year, daily
Gilead for Celgene Swap
Last week I sold Gilead (GILD) and moved the money back into Celgene (CELG). I think Gilead is relatively low risk at these prices but the issue is that it offers relatively low growth too. We’ve owned it as a “Growth” investment and if I don’t see growth potential looking out five years, it’s time to move on. I was holding on because the company had increased the dividend so much over the past two years but I haven’t been a fan of management’s decision making – I think they let a golden opportunity slip away – and just don’t see the longer term growth prospects materializing anytime soon. Whereas, Celgene has a stronger pipeline over the next few years and the stock has been knocked down quite a bit as investors became concerned about execution missteps and a shakeup in management. We used to own Celgene and fortunately sold it last year at much higher prices. I think the business is being underappreciated at this price and if management is able to get things back on track this year, the stock offers much stronger upside potential than Gilead from here.
Celgene (CELG) – 5 years, weekly
Staples, REITs and Long-Term Bonds
The markets continue to price in concerns of rising interest rates. REITs, Utilities, Telecoms and Consumer Staples – your higher dividend, interest rate sensitive stocks – have all been under pressure for over a year now but this is where I’m finding some very attractive long-term investment opportunities for income oriented investors. The staples have been the latest group taken to the woodshed after Proctor & Gamble reported last week. We’re seeing a triple-threat of concerns: 1) weakness in consumer spending, 2) inflationary pressures increasing costs and reducing margins, and 3) higher interest rates making the dividend yield less attractive (adjusting the price of the stock down and the yield up).
While most of the talk in the media this year has been about a “syncronized global recovery,” I’m starting to see the opposite. Leading indicators are pointing lower for most of the world. This is just the constant back and forth, cyclical nature of the economy. A slowdown doesn’t necessarily mean a recession, it just means the rate of growth is likely to decelerate and could slip into negative territory if some exogenous shock hits while things are slowing. Regardless, I’m expecting to see bond yields hold and likely decrease moving forward this year which should provide near-term support to these yield sensitive stock sectors. The yield curve is sending a similar message as it continues to flatten too.
I think it’s important to be picky on which stocks you own here. A focus on free cash flow generation is key. Some of the more attractive dividend stocks I’m seeing right now for longer-term investors in the Staples sector include Kimberly Clark (KMB), Proctor & Gamble (PG), and General Mills (GIS). All three have yields around 4%. Pepsi (PEP) and Hanes Brands (HBI) are also coming down and are starting to look more attractive. For REITS, I still think Welltower (HCN), Ventas (VTR) and Tanger Outlets (SKT) present extremely attractive long-term opportunities with yields over 6%. As for Utilities, you have to be picky and really dissect the balance sheet. Most utilities carry a lot of debt which can become problematic when credit markets tighten. Obviously these are businesses that are necessary for society (electric, water, etc.) but I just don’t think the stocks have come down enough to compensate for the added risk yet. Debt can get you in a lot of trouble and really restrict a company’s ability to grow the dividend over time.
Thanks for following!
-Nick