Two 5-Star Stocks Ripe for the Picking
The insurance broker pay debate should recede. Here are two stocks we like.
Margins have been crushed at several large insurance brokerage firms in the past few years. Industry compensation came under regulatory scrutiny, and some firms paid hefty fines and agreed to stop accepting so-called "contingent" commissions from insurance companies. Declining premiums amid a soft market have weighed on broker revenue as well.
Insurance is a cyclical industry, and soft markets can take time to play out. However, premium rates will not decline forever. More fundamentally, I expect the uncertainty over broker compensation to fade away. Commission methods will evolve and allow brokers to more fully realize the value they provide their clients. I think the current state of affairs has created some compelling investment opportunities, particularly for buyers of Marsh & McLennan (MMC) and Arthur J. Gallagher (AJG).
How Intermediaries Add Value
Distributors provide valuable services to buyers and sellers of a wide range of goods and services. Many stockholders have been richly rewarded by buying seemingly mundane "middle man" businesses, and holding on for the long run. Fastenal (FAST), a distributor of nuts and bolts whose CEO won our 2006 CEO of the Year award, has been one of the best stocks in the entire market over the past several decades. Nuts and bolts? There's gold in those hills.
Insurance brokers and industrial fastener distributors make for an interesting comparison. The fastener business is surprisingly complex, and distributors can help manufacturers and construction contractors solve difficult inventory problems. Successful distributors like Fastenal earn rents on their strong customer service reputations. Similarly, in the complex risk-management marketplace, insurance brokers can help customers understand their unique exposures and find the most-cost-effective options.
The Controversy over Broker Pay
Unlike fastener distributors, insurance brokers do not buy and resell products, but make money on the spread. Insurance premiums are typically paid first to the broker, who retains a negotiated commission and gives the balance to the insurance company. Brokers can also earn investment income on balances held temporarily, as well as fees paid directly by buyers.
This has long been the basic model. Beginning in the 1960s, as inflation accelerated and rising claims expenses cut into insurers' profitability, "contingent commissions" were developed. Insurance companies cut their base commission rates amid profit pressure and offered other payments that would vary with the volume and profit that the brokered business provided the insurance company. The practice has long been widely known, even if buyers and brokers chose not to discuss the specific terms of individual agreements. Among the benefits, contingents helped reduce "adverse selection," as brokers reduced their presentation of buyers of above-average risk--who can raise rates for buyers in general.
In mid-2004, just before the regulatory crisis hit the industry, an association of commercial insurance buyers released a statement asserting that contingent commissions were "endemic to the manufacturer/distributor relationship, and that there was nothing inherently wrong with them." Yet in August 2004, the ax fell, at least for an important subset of industry participants. Following investigations into disclosure practices and assertions of conflict of interest, New York attorney general Eliot Spitzer announced a civil suit against Marsh & McLennan, one of the largest brokerage firms in the world. The suit focused not on contingent commissions per se, but specific alleged fraudulent practices at Marsh involving bid-rigging and antitrust matters. These practices were alleged to steer buyers to purchase insurance from companies that were offering Marsh undisclosed contingent commissions.
I believe that contingent commissions and the related disclosure issues do not deserve as much stress as the authorities have applied. Specific cases sparked an overly general regulatory response. This has weighed on the markets, and in ways that won't last. Over time, markets will prove out. Brokers forced to abandon "contingent" commissions will earn their keep in other ways. Broker value will be more fully reflected in compensation, and in ways that satisfy regulators.
Profit margins at these two companies in particular look lower than they will be tomorrow, and their stock prices look lower than they should be today.
Marsh & McLennan (MMC)
Business Risk: Average
Economic Moat: Wide
Marsh brokers have long been recognized as standouts for their insurance expertise. Synergies among Marsh and other high-performing branded subsidiaries like Mercer (human resources consulting), Kroll (security and investigative services), and Guy Carpenter (reinsurance brokerage) reinforce the firm's wide moat. The firm has assembled a great leadership team, and Marsh is likely to start hammering out market share gains as well as margin improvement. Traditionally focused on larger customers, Marsh also has a well-organized initiative to penetrate the middle market.
Marsh has weathered its regulatory storm, and it is leaner, meaner, cleaner, and ready to grow. I expect higher revenue growth to couple with margin expansion, and the cash flow implications push my fair value estimate for Marsh to $45, well above the March 28 closing price of $29.25. For dividend aficionados, Marsh recently hiked their payout 12%, the first increase since cutting the dividend in half in 2004. The current yield is 2.4%, well above the average for the S&P 500. In coming years, Marsh's dividend payout should increase with its stronger cash flow. As Morningstar DividendInvestor editor Josh Peters has stressed, putting dividend yield as well as dividend growth together can make for a great investment. Putting it all together, we see a bright future for Marsh, its customers, and its investors.
Arthur J. Gallagher (AJG)
Business Risk: Average
Economic Moat: Narrow
Gallagher's narrow moat rises from a niche strategy and the development of related scale and scope economies. Gallagher's customer base includes shopping centers, universities, construction contractors, and sports teams. The firm levers its specialized niche expertise over a backbone infrastructure that performs basic service fundamentals valued throughout its diverse customer base. These services include high-quality claims processing and employee benefits consulting.
Gallagher has taken a measured, targeted yet still-aggressive approach to acquisitions. Several other publicly traded firms in this industry have driven revenue growth via especially aggressive acquisition strategies, buying firms to buy scale per se. Rising competition for acquisitions and other factors will likely dampen returns from strategies like these down the road. I like Gallagher's approach, however.
Like Marsh, Gallagher is also a dividend play, but for a different reason. Gallagher has long paid a relatively high yield. At 5.4%, the current payout rate is 3 times as high as that of the S&P 500. Gallagher has recently slowed the rate of increase in its dividend, but when you combine the high yield with good cash flow prospects--like Marsh, Gallagher's margins have been suppressed by compensation uncertainty in recent years--the result is an attractive investment. Our fair value estimate for Gallagher is $37 per share, well above the March 28 closing price of $28.22.
Bill Bergman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.