Our top 10 insurance companies...
In today's Friday Digest, I'm going to share with you a few secrets we've recently discovered… and proved… about insurance stocks.
Now, before I bore you to tears... let me try to explain why I've spent so much time and effort figuring out the insurance sector. Or better yet, let me just show you the picture.
The stock chart below shows you (in black) the total return history of one of our highest-rated property and casualty (P&C) insurance companies. The other line (blue) is the total return history of the S&P 500. The chart assumes all dividends were reinvested, and it goes back about 25 years.
The insurance company has made almost 14% a year on average. The S&P 500 has earned 7.4% a year over the same period. As you can see, nearly doubling the average return on stocks year after year creates an immense financial advantage. The highly rated insurance stock has a 25-year total return of almost 2,500%. The S&P 500, by comparison, has only earned investors 500%...
Over the years, I've told individual investors they really ought to take the time to learn about selling puts, buying corporate bonds, and short-selling stocks. I believe knowing how to put these strategies to work will make it easier for you to be successful as an individual investor. But...
Those are all "advanced" strategies. I'd recommend learning how to use them only after you've mastered basics of asset allocation, valuation, and risk management. In my view, these latter strategies are requirements for successful investing. Without them, it's very unlikely you'll be successful.
Understanding the insurance sector is definitely an advanced tool. You don't need to ever own an insurance stock to be a successful investor. But I'm willing to bet, if you'll take a moment today to learn just a little about it, you'll figure out pretty quickly that insurance stocks are one of the easiest ways to safely make a lot of money in the stock market.
One word of warning, however. As we both know, there's no such thing as teaching... only learning.
I'll do my best to explain what we've figured out below. But if you hope to profit from this information, you're going to have to read carefully and think. I know most people would rather do anything than think.
And in this case, refusing to think could be very dangerous to your wealth. While it is possible to make a lot of money with insurance stocks, this is also an area of the market that can wipe you out overnight if you're not thinking. So... with that in mind... let's get started.
Investors make a killing with insurance stocks because of something called "float." Float is free money. Sometimes float is even better than free. How's that possible? How do insurance companies get all their capital (and more) for free?
A well-run insurance company is the only business in the world that routinely enjoys a positive cost of capital. In every other sector or type of business, the cost of capital is one of the primary business considerations. But a well-run insurance company not only gets all the capital it needs for free… it will actually be paid to take it. After all, clients pay upfront for insurance policies. This capital belongs to the insurance company until legal claims are made upon the policy. All the gains made with that capital before those claims are filed belong to the insurer. And it's not hard to generate huge returns on invested capital when your cost of capital is less than zero.
The trick to understanding which insurance stocks are likely to be the best performers is to first figure out which companies have the largest amount of float – the biggest pools of free capital. Wall Street doesn't make this easy to figure out. You won't find "float" mentioned on any annual reports or other forms filed with the Securities and Exchange Commission. Instead, you have to learn how to calculate it yourself or estimate it by looking at other numbers that are disclosed by the insurance company.
You also have to be able to judge which companies are likely to have the most underwriting discipline – or else, sooner or later, the float is going to leak out the door to pay claims. The insurance sector isn't Lake Woebegone. Not everyone is above average. In fact, the industry as a whole loses money selling policies. Most companies don't charge enough in premiums. Most of these stocks won't provide you with a nearly risk-free way to compound your capital effortlessly.
Now... here's the hard part. Most of the normal ways analysts measure value in publicly traded stocks don't work with insurance companies. The main measure of value for operating companies is the market cap of the stock (all the shares multiplied by the share price) divided by its earnings. Typically, analysts will use the price-to-earnings (P/E) ratio, which uses the income statement (market cap divided by net income). Or analysts will use cash flow (enterprise value divided by cash from operations).
Neither of these measures is very useful for insurance companies because the companies themselves decide how much of their premium revenue to set aside each year in reserve. Insurance companies literally "guess" how much their profits will be each year. Believing management guesses isn't a great way of doing your homework.
These factors make insurance companies both Wall Street's best overall bet for long-term investors... and nearly a closed game. I don't know of any other publicly available research group that's ever published a comprehensive analysis on the entire property and casualty segment. But my new Stansberry Data service (which is available to lifetime, Capital-, and Advanced-level subscribers of my Investment Advisory newsletter) does exactly that – and updates all of the numbers monthly.
We hired an experienced analyst (Bryan Beach) – who worked at a senior level for major accounting firms and has a decade of experience investing in insurance companies – to build out our own insurance company rankings.
We based our rankings on more than a dozen key variables, most of which are unique to the insurance industry. These include things like: the size of a company's float, its underwriting profitability, its investment acumen (how much it earns on its float), and its corporate structure (how much stock do the key decision makers own).
We built out our database and published our first insurance company recommendation based on our proprietary rankings in March 2012. As the companies in the sector have now all published their final results for 2012, we can see exactly how well our model of the industry matched the actual results of these companies.
How did we do? The top 10 companies in our model, on average, increased the size of their float and book value by 13%. (Book value-plus-float is the most important measure of intrinsic value in insurance stocks.) Meanwhile, book value-plus-float actually declined for the rest of the industry (excluding our top 10).
Our top 10 companies also earned an underwriting profit. They posted a "combined ratio" of 98 compared with the rest of the industry's average of 101. The "combined ratio" is a measure of underwriting profitability. A combined ratio of 100 represents breakeven. Anything above 100 represents underwriting losses. Amounts below 100 represent underwriting profits.
If that seems confusing... let me try to simplify it for you. There's no easy way to analyze insurance stocks. So we built a system of data collection and analysis that allows us to see which insurance stocks should produce the best results. Last year, our system proved to be very accurate. Our top 10 insurance stocks were clearly better than the industry as a whole – by a wide margin.
And here's the best part. When we plot the prices of our best insurance stocks (measured by their current price-to-book value ratio) against our proprietary measures of quality, there's clearly no relationship (yet) in the market.
That is, right now, there's no correlation between the price of these insurance companies and their quality according to our model. On the other hand, when we use Wall Street's simple measure of quality (annual return on equity), there's a strong correlation.
That means Wall Street is still valuing these stocks on the basis of their stated return on equity. But remember, that measure of quality depends entirely on the management's own evaluation of its underwriting – on its guesses. Our model, on the other hand, uses actual underwriting profits (or losses) and other tangible measures of quality. In the long run, our model will prove to be a far, far more valuable guide to insurance companies than merely using published return on equity. And that means you still have a huge opportunity in insurance stocks.
Our first recommendation in the sector using our new model was W.R. Berkley (WRB). We're up 28% in about a year. As we grew more comfortable with our model's predictive power, we recommended five more insurance companies last fall. So far, our average return is about 17% – and all of these recommendations have been profitable. These gains, while impressive, are only the beginning. Insurance stocks have rarely been cheaper, and I believe our model provides us with a unique advantage in the sector. This advantage is not yet priced into these stocks.
If you're a subscriber… I strongly encourage you to read this week's Stansberry Data (April 2) update, which is focused exclusively on the insurance sector. It's available on our website, and it's free to all Advanced- and Capital-level subscribers to my Investment Advisory (as well as lifetime members).
While I wouldn't suggest that anyone invest only in insurance stocks, I'd wager that if you limited yourself to only buying the highest-quality insurance stocks, when they traded at attractive prices, you'd earn around 12%-14% annually over time. It's hard to make more than this being a buy-and-hold investor in safe securities. And that's why, if you're not following the sector yet, I'd urge you to.
New 52-week highs (as of 4/4/13): Berkshire Hathaway (BRK), S&P International Health Care Sector Fund (IRY), Utilities Select Sector Fund (XLU), V.F. Corp. (VFC), Abbott Laboratories (ABT), Eli Lilly (LLY), Prestige Brands Holdings (PBH), Consolidated Tomoka (CTO), Dominion Resources (D), American Financial Group (AFG), Chubb (CB), McDonald's (MCD), CVS Caremark (CVS), and Philip Morris (PM).
In the mailbag... a tale of two subscribers. One has discovered the power of compounding returns (by reinvesting dividends). The other believes that making 20% in two months isn't fast enough. Guess which one will end up rich and who will probably end up poor? Send your questions and comments to feedback@stansberryresearch.com.
"I've been reading DailyWealth and other Stansberry newsletters since late 2010. I decided to finally take control of my finances for myself in 2011 and started moving money out of my IRAs with 2 well-known insurance company's 'Variable Annuity' programs into my own IRA trading accounts.
"After a few bumps in the road – part of the learning curve – I feel like I'm getting the hang of it: how to value a company, looking for WDDGs 'on sale,' boosting my profits by selling puts on stocks that I'd like to own anyhow, then selling covered calls on some of them if I'm looking to move my money into a different opportunity, and also learning that 'all that shines is not gold or silver' – some things are better passed up to wait for an even better opportunity in the future. (Patience is a hard virtue to learn when you begin trading online!)
"I just read Doc Eifrig's 'The Dividend Boost' article and I was pleased to see that I had already implemented ALL of his recommendations! I've been using TradeKing as my online broker for my IRA accounts, and in my Roth IRA trading account that I have made more 'long-term' in focus, I have used their FREE dividend reinvestment program. (By the way, I found that I had to call them to ask them to set it up – you can't just do it yourself online yet.) As a result, I have grown my investment in dividend paying stocks that have also grown in value.
"An example: I bought 100 shares of TWO (Two Harbors) at $10.25 per share almost exactly a year ago and directed TradeKing to reinvest the dividends. I now own 111.549 shares of TWO that are valued at $12.01 a share (as of C.O.B. yesterday). So my initial $1029.95 investment ($1025.00 + $4.95 trading fee), plus the additional purchases of about 11 and a half shares via dividend reinvestments, is now worth $1339.70 – a 30% gain in just one year! I didn't have to put out any additional money of my own to get those additional shares – the dividends paid for them!" – Paid up subscriber David Green
Porter comment: It's great fun for us to see what happens when the power of compounding finally becomes "real" in the eyes of our readers. Yes... dear subscribers... the math is real. And it's very difficult to beat long-term compounding returns.
"I have been a subscriber since December of 2012. Your publications have been instrumental in giving me a sense of the true value of various equities. I have learned to be patient and keep an eye to fundamental valuations... I bought a position in two companies based on your thorough analysis. They quickly returned a healthy 15-20 percent in a two-month period...
"I am concerned now, after your clear statements about QE, the treasuries and equities markets seem to be heading for a massive correction, after a 'false' run based on the Fed's stimulus. Inflation will be the major influence on markets in the future. I have no defensive play for my 401k, even the most conservative fund in my account has 42 percent position in treasuries. So I have borrowed the maximum amount from my retirement account and will be investing, hedging the economy. My HR department thinks I am a nuts because I want to trade with my retirement; 'the funds have professionals in charge.' I cannot be smarter than them. I am a contrarian now.
"Even though your advice has changed the way I see my world, your stock recommendations are just a wee bit conservative. They all are winners, but I need to goose my returns since my retirement will probably be worthless when I retire. I borrowed 17k from my 401k and will probably invest most of it in commodities. Precious metals look to have a great risk benefit ratio based on your criteria. Single-digit P/E, great book value, even dividends, and of course, at a bottom as a sector. Thanks! I would have never come to that conclusion four months ago..." – Paid up subscriber DB
Porter comment: Look out below. After reading our letters for less than six months, our friend DB thinks making 20% in two months isn't fast enough. He's borrowing against his savings and speculating in precious-metals stocks. (By the way… for the record, I don't believe P/E ratios mean anything when it comes to resource stocks.)
This mindset... making 20% in two months isn't fast enough... borrowing money to buy precious-metals stocks... is a recipe for disaster.
I certainly wish him all the best... but I'd caution his wife to prepare for the worst. I predict a complete wipeout.
The folks who stay with us the longest and do the best with their investments worry about risk. They avoid it like the plague. Instead of looking for speculations, they spend time searching for values. They obsess over asset allocation. They never worry about the timing of their returns because they know they will come.
Investment profits are what naturally accrue when you've done the right things first – like finding a safe business and buying it at a sensible price. Losses are what naturally accrue when you gamble without any well-defined advantage.
I hope DB will write us a follow-up note in the future to let us know how this all turns out. I sincerely wish him success... but I fear he has some hard lessons to learn. It seems there's no way but the hard way to learn these lessons for most people.
Regards,
It seems everyone is either writing or talking about bitcoin, an electronic currency. That discussion accelerated in the wake of the shakeup in Cyprus, where some business owners reportedly used it to escape the bank account "tax."
While its popularity may be on the rise, I (Porter) can't see it as a viable payment medium. It's just a reflection of similar flash-in-the-pan crazes that are typical of periods of economic upheaval.
Bitcoin seems to be shaping up as a classic example of what happens during great inflationary periods: The mob picks something as a symbol. It could be tulips, which happened in Amsterdam in the 1680s. It could be land, which happened in Florida in the 1920s and Tokyo in the 1980s. You could write a whole book about it. This time, the crowd has decided that a digital currency will become the great example of the madness inflation seems to spawn.
As I understand it, bitcoin is a sort of voluntary association. I mean, it isn't backed by anything. It can't be exchanged for silver or gold. There's no physical place where you can get labor and property in exchange for bitcoins. That explains its volatility.
I guess it's just a different kind of bubble. With enough money floating around, people will seek out anything to blow into the bubble.
Those foolish enough to buy or own bitcoins – the paper version from a worthless central bank or the digital version from a worthless online entrepreneur – will get what they deserve in the long term. But it won't be what they expect.
Inflationary periods exploit people who know the price of things without knowing the value of anything. When the price of something goes up, it creates an illusion for those foolish enough to believe that its value is also rising. That runs against the idea of realizing that price is completely irrelevant in a great inflation... it's a mirage.
I advise people to stick with what they know is valuable or things they recognize as having intrinsic value to someone other than themselves. If you can't do that, you're in a world of trouble. The whole price system is broken. It has been broken deliberately by central bankers striving to erase the debts of the major Western nations.
If you can't figure out what's going on, you haven't been paying attention. This is a cycle that has happened repeatedly in the last decade and throughout time. Paper money has constantly been an invention designed to exploit the ignorance of the masses and erase sovereign debts. That is exactly what's happening again.
Bitcoin may go down in history as the ultimate example of the foolishness of people who understand price but don't understand value. Who in his right mind would even think of exchanging the dollar, a currency of declining value, for a bitcoin, a currency of no value? Don't bother telling me that the price of a bitcoin went up yesterday because it doesn't change anything about the value of a bitcoin, which is zero.
– Porter Stansberry with Sean Goldsmith
The latest example of the madness inflation spawns…