Stockwatch: Scope to lock in a 7% yield

Down at a two-year low, companies analyst Edmond Jackson believes now could be a good time to follow the CEO and buy a stock which offers long-term value.

As I've recently detailed with Standard Life Aberdeen and Legal & General Group there are now some attractive yields in the insurance sector as negatives have conflated to cut share prices. 

Of particular interest is life-related business where only a few insurers are able to support bulk annuities on the scale required by direct benefit pension schemes – a competitive moat in contrast with general insurance for homes/cars, that's also attracted regulatory attention.

A latest probe by the Financial Conduct Authority into home/car insurance pricing amid complaints about how policy renewal costs soar, typifies such risk, the most exposed example being Direct Line Insurance Group whose stock trades at a three-year low yielding 7.5%.

Macro issues weigh too: Brexit heralds uncertainty as to European market access and, if the UK economy slows, then to what extent might consumer demand be affected?  Financial stocks tend to be perceived as leading the economy, best bought in the trough of a recession and sold as the economy matures.

Yet with cash returns unlikely to rise by much, equities that are able to sustain, or even grow their dividend payments have appeal and, if the feared risks don't prove so bad, then stock re-ratings are baked in for the medium term.

CEO buying also reflects a five-year turnaround completed

A new chief executive at FTSE 100-listed Aviva bought £105,750 worth of shares at 423p on 7 November, after a turnaround specialist spent nearly six years streamlining the group from 28 markets to 14, focusing on areas of competitive strength and investing in new initiatives such as digital.

The chairman declared last October:

"He leaves the group in a far stronger state than when he joined...strengthened balance sheet...delivering solid earnings growth."

Aviva is listed in the life insurance sector, general insurance representing a modest 13% of group profits.  Its stock has fallen 27% this year to about 410p currently, not as low as 346p around the EU membership referendum but at the low end of a five-year range despite its underlying turnaround.  

Source: TradingView (*) Past performance is not a guide to future performance

The table (below) shows volatile financial performance, but management presently guides for operating earnings per share growing by 5% in 2018 after 4% was achieved at the interim stage, and expresses confidence thereafter.  

Completion of a share buyback programme should also help earnings per share (EPS), although I'd be wary about assuming forecasts in the table that result in highly attractive PEG ratios of 0.2 to 0.4 (the price/earnings (PE) multiple divided by the earnings growth rating, where sub 1.0 is deemed to offer value).

Encouragingly, the interim dividend rose by 10%, representing a fourth consecutive half-year of double-digit dividend growth, this trend seemingly buttressed by an £11 billion capital surplus. This relates to EU stipulations on capital, insurance companies must hold to mitigate insolvency risks, in which context a circa 25p ordinary dividend (as forecast) would cost £1 billion.

Management speaks of a "total surplus capital deployment of £2 billion" this year, on debt reduction and bolt-on acquisitions, with £400 million remaining. 

"Our preference remains to invest in our businesses and we remain on the look-out for bolt-on acquisition opportunities."

So, I would not speculate on special dividends, though an implied £9 billion remaining surplus should at the very least underpin ordinary share dividend growth.  Thus, there is scope to lock in a 7% yield - with growth prospects – and capital upside too, if and when this yield is judged generous against Aviva's overall risk profile.

Reverse in investment income dents reported profit

Interim results showed net earned insurance premiums up 13.6% like-for-like to £13.8 billion, however, net investment income plunged from £10.8 billion into to a £0.5 billion loss, hence statutory interim pre-tax profit down from £1.0 billion to £0.4 billion.

A more thorough explanation of this would have helped – it's hardly as if Aviva's reporting lacks detail on group complexities – given October was a relatively more volatile period for financial markets, although income was specified.

This draws attention to insurance groups' investment operations (as principal, e.g. to manage annuity liabilities) being at risk from financial markets' change.

If the equities bull market has broadly peaked as the credit cycle rolls over - and more worryingly, say a scenario where US tax cuts late in the cycle result in stagflation, with China trade issues dragging on – then the stockmarket may continue to rate insurers cautiously. 

So, if you are overall bearish then it may be more comfortable to watch-and-wait.  It's a tricky balance where capital protection vies against the likelihood circa 7% yields won't be offered forever unless interest rates soar.

Source: Company REFS            Past performance is not a guide to future performance

Life-related business drives group profitability

Life business represented 96.8% of interim operating profit after taking into account central office and other costs.  Within this segment the UK contributed 60% and continental Europe 30%, the rest chiefly Asia, hence the significance of the outcome of Brexit talks as regards financial services, including what compromise can be struck on "passporting" into the European Economic Area to serve EU customers. 

Earlier this year, Aviva switched its Irish policy holders to a newly created Irish domiciled company, but it remains to be seen whether using local operations this way will prove a reliable way around the EU's intention that any country leaving the single market must be seen worse-off.  

It's another macro risk explaining insurance groups' de-ratings to exact high yields; so, if you believe Mrs May's deal will eventually pass once MPs stare at the reality of "no deal", even if that takes a second parliamentary vote, then buy now. If you fear that uncertainties will fester into chaos, then watch-and-wait.

What of the 8.75% cumulative preference shares?

There are £450 million of these "prefs" (AV.A), which have been a favourite for conservative investors seeking a relatively secure high yield. But this was jolted last March when Aviva threatened to cancel them in the final stage of a group restructuring, citing their £38 million annual cost.

Having traded at a premium to par value, their market price plunged from 175p to near 120p before investor action halted the plan, hence a bounce to 160p.  The price has since trended downwards near to 140p after the US Federal Reserve has indicated it will continue monetary tightening, given an inverse relationship between bond prices and interest rates.

So, the prefs' situation is not necessarily lower-risk than the ordinaries, in the short to medium-term, despite the historic pattern of long-term bond prices trading inversely to equities.  If you believe this will bear out eventually, then it’s possible to consider holding both equity and prefs.

A net 'buy' stance buffeted by uncertainties

Key factors impacting Aviva may not dissipate soon, but considering the group's streamlining and strong position in annuities, it is understandable an incoming CEO is comfortable buying equity now: the ordinaries offer long-term value despite macro risks that could yet see lower market prices.

A logical response to such uncertainties is to average-in, within an overall stance of: Buy.

*Horizontal lines on charts represent levels of previous technical support and resistance. Trendlines are marked in red.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.