Our Outlook for Business and Financial-Services Stocks
The macroeconomy will dictate when a hardening insurance market will occur.
Quarter-End Insights
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While we cover a wide range of industries in our Business and Financial-Services team, we are going to focus this discussion on the insurance industry. One the key issues we have been watching is the pricing cycle. Insurance pricing has been weakening over the last few years, and although a reversal of this trend would seem to be inevitable, the timing remains open to question.
We had thought earlier in the year that a hardening insurance market might precede a full economic recovery. But the rally in the capital markets, government intervention, and a benign claims environment have mooted that thesis, at least for this year, and we now believe that it will be difficult for the industry to pass along pricing increases until the economy has shown material improvement.
Earlier in the year, the insurance industry was beginning to show signs of separation between the companies with the cleanest balance sheets and those hardest hit by the financial crisis. But the rally in the equity and bond markets has gone a long way toward mending some of the damaged balance sheets and helped some of the weaker competitors catch up with their peers.
Over the last couple of quarters, insurers have seen unrealized investment gains drive their book values upward, and this impact was most noticeable at the weakest firms, as spreads narrowed dramatically in some of the riskiest asset classes such as commercial and residential mortgage-backed securities. A related factor is that the government has thrown multiple lifelines to struggling companies, the most obvious beneficiary being AIG (AIG). These two factors have restored a material amount of capital to the industry, and largely removed the threat that weaker players might be forced to pull back from the market.
We had thought that a turbulent hurricane season in 2009 might further differentiate insurers along the lines of financial strength. A large natural catastrophe following the financial catastrophe of the last year would have further strained the capital of the weaker players, and may have even caused some companies to exit the market. A major hurricane might have provided a catalyst for prices to increase, but the 2009 hurricane season was largely a non-event.
While a boost to their investment portfolios and a lack of claims can hardly be considered bad for the industry as a whole, on the negative side, they may have delayed a hardening market. With the fall in the industry's capital base largely reversed throughout 2009, we think it will take a boost in demand to drive pricing higher, and the state of the macroeconomy will dictate when a hardening market will occur.
In the interim, we think investors would be best served sticking with the highest-quality names. Another fall in the capital markets remains a risk, and we think the strongest names provide both relative downward protection in that scenario and are also best poised to exploit a hardening market when it occurs.
Valuations by Industry
While we don't view our coverage list as being across-the-board cheap, we think the market rally has left behind some pockets of opportunity.
| 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 | 2.90 | 1.01 | 1.15 | -11.3% | 55.7% |
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| Business Services | 2.87 | 1.02 | 0.96 | 6.3% | 47.7% |
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| Education & Training Services | 3.96 | 0.72 | 0.78 | -7.7% | 37.5% |
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| Insurance - Brokers | 3.84 | 0.75 | 0.85 | -11.8% | 21.6% |
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| Insurance - Life | 2.70 | 0.99 | 1.36 | -27.2% | 95.5% |
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| Insurance - Property & Casualty | 3.29 | 0.87 | 0.97 | -10.3% | 58.0% |
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| Insurance - Specialty | 3.31 | 0.84 | 1.00 | -16.0% | 94.3% |
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| Management Services | 3.13 | 0.90 | 0.95 | -5.3% | 31.8% |
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| Personal Services | 3.66 | 0.99 | 0.79 | 25.3% | 59.1% |
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| Reinsurance | 3.89 | 0.79 | 0.75 | 5.3% | 23.9% |
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| Staffing & Outsourcing Svs | 3.95 | 0.87 | 0.85 | 2.4% | 50.0% |
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| Waste Management | 3.00 | 0.94 | 0.94 | 0.0% | 26.1% |
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| Data as of 12-14-09. |
We think the for-profit education space currently looks cheap. Increasing concerns over regulatory changes and some companies' specific issues have lowered market valuations. In our view, continuing skepticism about the value of for-profit education makes these stocks much more volatile than the fundamentals of the industry warrant, and investors should take advantage of these periods of pessimism. We think the industry is fundamentally attractive, as these companies operate at much lower costs than traditional schools but can attract comparable pricing. Additionally, we think the industry still has a growth runway in front of it, as supply at traditional schools is largely capped, and the demand for degrees continues to grow.
While we are not bullish on the insurance sector as a whole, insurance brokers look attractive to us right now. Currently, the double whammy of weak insurance demand and low interest rates is depressing results, but these firms remain solidly profitable. These companies might be a safer way to play the insurance sector, as their leverage to the capital markets is much lower than the insurance companies they work with.
Our Top Business & Financial-Services Picks
| Top Business & Financial-Services Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Price/Fair Value | |
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| Apollo Group |  | $106.00 | Wide | Medium | 55% |
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| Arthur J Gallagher | | $35.00 | Narrow | Medium | 63% |
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| ITT Educational Services | | $143.00 | Narrow | Medium | 63% |
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| WR Berkley | | $36.00 | Narrow | Medium | 65% |
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| Data as of 12-18-09. |
Apollo Group
Apollo is the largest for-profit education provider, with over 440,000 students. The company's stock has come under pressure due to regulatory concerns and an informal SEC inquiry into its revenue recognition practices. However, we feel concerns surrounding both of these issues are overdone. The industry has always been highly regulated and any proposed rule changes should have limited impact, in our opinion. Additionally, we think Apollo's revenue recognition practices are in line with accounting and industry standards, and any revisions in reported revenue won't affect the company's cash flow. In the meanwhile, the valuation is very attractive, with Apollo currently trading at about 9 times its forward earnings and at a 9% trailing free cash flow yield.
Arthur J. Gallagher (AJG)
Gallagher provides insurance brokerage and other risk management services, primarily in niche markets. Several factors have weighed on its results in recent years, including regulatory uncertainty over commissions, softening insurance rates, the economic recession, and reduced investment income due to record-low short-term interest rates.
But Gallagher has been managed well through the difficult environment, with its operating cash flow on the rise in the past two years. In turn, the firm recently convinced the Attorney General and the insurance regulator in Illinois to agree to drop their previous restriction on Gallagher's ability to receive contingent commissions.
Gallagher is particularly exposed to the economy through its third-party claims administration business, which is driven by customer employee headcounts, and the developing economic recovery is improving prospects in that business. At 5.8%, Gallagher's dividend yield looks attractive yet defensible in light of the level and trend in its cash flow.
ITT Educational Services (ESI)
ITT is one of the most profitable firms in the for-profit education industry, with operating margins well above 30%. The company has experienced impressive growth due to the weak economy and its shorter-term program focus. Associate degree programs, which offer a quick turnaround for students looking to get back into the job market, make up the majority of ITT's enrollments and have put the company on track to grow roughly 30% in 2009. We don't expect this type of growth to persist once the economy recovers, but with ITT trading at only 10 times its forward earnings, investors won't need that level of growth to make the valuation attractive.
W.R. Berkley (WRB)
W.R. Berkley offers specialized property-casualty insurance to select niche markets with unique risks. Berkley's underwriters have expertise in these markets, many of which are subject to much less competition than traditional insurance products. Because the risks are so unique, customers in these markets don't often shop on price alone. This strategy has allowed Berkley to generate excess returns over its history, a trend we expect to continue into the future. Due to its strong business model and superior returns, we believe the firm should trade at a premium to its property-casualty insurance peers. The current market price, equivalent to approximately 1.1x third-quarter book value, ignores these returns and lumps Berkley in with more traditional insurers.
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