In the wake of Britain’s unexpected decision to secede from the European Union, stocks with direct exposure to financial market volatility, and those leveraged to rising interest rates, were ubiquitously jettisoned from investors’ portfolios. QBE, which falls into both categories, was no exception.
As a result, QBE is trading at a significant discount to our forward valuation and may be a potential opportunity for value investors. We view improvements to the structure and makeup of the underlying business, and an achievable strategy to increase group ROE, as offsetting the increased risks associated with the Brexit.
The heart of the market’s concerns regarding QBE revolves around the valid argument that it is now unlikely that the US Federal Reserve (Fed) will increase interest rates this year. QBE is a direct beneficiary of higher rates because:
- Its assets have a shorter duration than its liabilities (albeit the gap is closing); and
- It is directly invested in financial markets.
Previously, the market had priced in improvements to earnings and profitability driven by assumed increases to US interest rates. Its expectations (and our own) have rebased to assume no changes to US rates in 2016. This has been modelled within our updated estimates and valuation.
With regards to the second major issue, QBE (like all insurers) has significant financial markets exposure. Volatility following Brexit has been inflated, and returns have been strongly negative. Bond prices have spiked, cratering already low yields. These are however, simply aftershocks from an unexpected, price sensitive event which should dissipate over the coming months. Longer term, business conditions in the UK (and to a lesser extent Europe) may be more constrained and additional regulatory costs may arise.
On 27 June, QBE published the following in response to the Brexit decision:
Figure 1. QBE response to Brexit (ASX release)
Though grappling with external volatility and bearishness, QBE is still primarily focused on rationalising its business. It recently completed a capital raising to shore up its balance sheet and continues to divest low ROE businesses to increase group profitability. Improvements to the group’s structure are evident and we believe the business is much better placed now than in the past. In our opinion, QBE’s roadmap to increasing ROE is achievable over the medium term and forms part of our investment thesis with a timely execution of this strategy being the catalyst of a re-rate in the share price towards our intrinsic value.
Figure 2. QBE strategic initiatives
Source: QBE 2016 Investor Presentation
As it stands, QBE appears attractive as a deep value stock with a partially franked, 6% forward yield. Our base case sees NROE rising above 12% in by FY19, as QBE executes on its strategy. We view an NROE of 11.5% as sustainable over this period, against a required return of 10.5%. QBE has also opted to lift is payout ratio, which we view as sustainable at ~70% over the medium term. Adopting these metrics, we derive an FY17 value of $12.38.
For a more detailed analysis of QBE and our investment thesis, you can read our recent article on StocksInValue. Not a member? Start a 10-day trial.
Written by Damen Kloeckner, Analyst.
Disclosure: Clime Asset Management owns shares in QBE on behalf of various mandates for which it acts as investment manager.