Our Outlook for Business & Financial Services
Don't paint all insurance companies with the same brush.
Quarter-End Insights
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While our coverage on the business and financial services team encompasses a wide range of industries, we're going to focus on the insurance industry in this discussion.
2008 and early 2009 was a traumatic period for a lot of insurance companies, but that dark time has given way to some recovery in the last six months. Unlike banks, insurance companies can't all be painted with the same brush. Different segments in the insurance sector have different operating styles, different balance sheet structures, and different sensitivities. These differences have been drawn in sharp relief during the events of the past couple of years and it is these differences that will determine the segments' paths in the future.
In terms of underwriting, life insurance companies are the most stable segment. It's much easier to predict average life spans than determine when and how hard the next hurricane might hit. But this seeming stability ended up being a curse, as it justified investing float in longer-dated and less-liquid securities and working off of a small equity cushion. This meant that even relatively small losses in these companies' investment portfolios heavily affected the equity base, and the increasingly risky nature of these companies' investments led to sizeable losses when the capital markets crashed. This left most of the life insurance companies in a truly precarious position over the last year, and it forced many to raise capital. The last six months have seen substantial reverses in these investment losses, although capital ratios are still not back to pre-crisis levels. Going forward, then, these companies represent, from the investor's point of view, a highly leveraged bet on fixed-income markets. As equity analysts, we're loath to predict the direction of these markets, but we can give a sense of the sensitivity to explain our cautious view of this segment. Within our domestic life insurer coverage, a 5% increase or decrease in the value of these companies' investment portfolios (with the assumption of a capital raise on the downside) results in a 31% increase and a 48% decrease, respectively, in our average fair value estimate. It should be noted that over the course of the capital market decline, most of these companies took hits that were bigger than 5%.
Property and casualty (P&C) companies certainly felt some sting during the crisis, but their balance sheets were better prepared to meet this man-made disaster, as they were designed to withstand natural disasters. P&C companies work with a much higher equity base than life companies, and they typically invest in shorter-term investments to match their shorter-term policies. Looking forward, on the whole, we are not overly concerned with the state of their balance sheets. A bigger question going forward is when the insurance pricing cycle might swing back. Demand and pricing has been weak during this recession, as is typical, but large price spikes typically follow recessions, and the hit to industry capital from the capital market decline would seem to be another spur for higher prices.
But the investment losses could create a new wrinkle in the pricing cycle this time. While insurance is typically viewed as a commodity product, we think some customers are paying closer attention to insurers' ability to pay out in the event of a claim. We think the companies that have largely avoided investment losses and maintained a rock-solid balance sheet, such as Travelers (TRV), are in a better position to firm up their pricing and will enjoy a relative advantage in the near term. A large hurricane or other catastrophe while the industry is still working off the effects of the financial storm could further segment the industry on the basis of financial strength.
Valuations by Industry
While we still see some individual stocks that are trading at a sufficient discount to our fair value estimate for us to recommend them, the recent rally in the stock market has left all of the industries we cover trading near an appropriate value.
| Business & Financial Services Industry Valuations | |||||
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| Star Rating | Price/Fair Value* | P/FV Three Months Prior | Change (%) | Uncertainty Percentile** | |
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| Asset Management | 2.80 | 1.00 | 1.05 | -4.8% | 78.7% |
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| Business Services | 3.04 | 0.96 | 0.75 | 28.0% | 46.8% |
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| Education & Training Services | 4.00 | 0.78 | 0.77 | 1.3% | 5.3% |
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| Insurance - Brokers | 3.65 | 0.85 | 0.68 | 25.0% | 11.7% |
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| Insurance - Life | 2.52 | 1.36 | 1.35 | 0.7% | 95.7% |
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| Insurance - Property & Casualty | 3.01 | 0.97 | 0.82 | 18.3% | 53.2% |
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| Insurance - Specialty | 3.12 | 1.00 | 0.93 | 7.5% | 41.5% |
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| Management Services | 3.18 | 0.95 | 0.93 | 2.2% | 38.3% |
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| Personal Services | 3.54 | 0.89 | 0.71 | 25.4% | 16.0% |
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| Reinsurance | 3.93 | 0.75 | 0.67 | 11.9% | 6.4% |
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| Staffing & Outsourcing Svs | 3.92 | 0.85 | 0.75 | 13.3% | 7.4% |
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| Waste Management | 3.00 | 0.91 | 0.96 | -5.2% | 57.4% |
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| Data as of 09-14-09. |
We think the for-profit education space is worth keeping an eye on. Concerns over any new regulation are overblown, in our opinion, and in the meantime, these somewhat countercyclical companies have been posting strong results. Their impressive growth might slow when the economy stabilizes, but we think the main factor that has driven their growth, the increasing demand for education and the inability of traditional schools to increase supply, remains firmly in place.
We noted our cautious view on the life insurance industry above, but with the recent recovery in the markets and these companies' stock prices, we also don't see valuations that would warrant taking the gamble, and we think the risk/reward proposition for these stocks skews negatively for investors at this point.
Our Top Business & Financial Services Picks
| Top Financial-Services Sector Picks | |||||
| | | | | |
| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Forward P/E | |
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| Arthur J Gallagher |  | $35.00 | Narrow | Medium | 17.5 |
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| Paychex | | $46.00 | Wide | Medium | 23.3 |
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| Weight Watchers | | $41.00 | Wide | Medium | 10.6 |
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| Data as of 09-23-09. |
Arthur J. Gallagher (AJG)
Founded in 1927, Arthur J. Gallagher has become one of the largest risk management services firms in the United States. Gallagher provides insurance brokerage, third-party claims administration, and risk consulting services to a wide swath of targeted niche markets. The firm stands out for a distinct, adhesive culture dedicated to high-quality customer service. The external environment hasn't been kind to Gallagher in recent years, leading to what we believe to be an attractive valuation. Gallagher has labored in the weak economy, as it has in past recessions. The particularly severe employment downturn in our latest recession has taken a significant toll, as Gallagher's revenue mix has an outsized contribution from services dependent on payroll counts. Soft insurance prices have also cut into Gallagher's commission revenue linked to premium rates, as well as its profitability. And a regulatory cloud has been hanging over brokerage compensation practices since 2004, reining in margins as well. But blue skies are now breaking with a developing economic recovery, firming insurance rates, and material positive developments on the regulatory front, including a recent agreement allowing Gallagher to produce "contingent commission" compensation revenue again.
Paychex (PAYX)
Employment-related firms are typically very cyclical and have seen wide swings in their top and bottom lines. However, if you are looking for exposure to the employment sector, we would suggest the more stable payroll processors like Automatic Data Processing (ADP) or Paychex. In the case of Paychex, which trades at a steeper discount to our fair value than ADP, we believe the market has unduly penalized it, treating it more like a cyclical staffer than a steady payroll processor. Paychex's success is based more on the overall level of employment, which is more stable than the volatile unemployment rate. Despite the challenging employment environment, Paychex was able to grow revenue and produce solid operating margins of 40% during fiscal 2009.
Weight Watchers (WTW)
Weight Watchers' strong brand and highly developed network of meetings earn the company a wide moat. While the company is tied to consumer spending habits, we think its long-run prospects are bright as it continues to expand its client base to include men and grows its international presence. In addition, the company benefits from the increasingly overweight global population coupled with greater awareness of the health effects of being overweight. The major risk to an investment in Weight Watchers is the outside chance that a miracle weight-loss drug will eliminate the need to manage weight by healthy eating and exercise, but we see no drugs in the pipeline that could present a credible threat in the foreseeable future. We think the current market valuation presents a rare opportunity to own such a quality company.
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