Hello again everyone, I’m David Walker from StocksInValue.
Today I’d like to discuss QBE Insurance Group’s recent guidance downgrade, why we still hold the stock in the model portfolio, some problems I see with criticism of the downgrade in the media, and how to invest in insurance stocks.
Until last week, QBE shares had been rallying since November on expectations the long and painful turnaround was now complete, business insurance premium rates were rising in Australia and the US, and because late last year US Treasury yields rose on expectations of fiscal stimulus by the new Trump Administration. A good degree of expectation had been built into the share price, so the stock was not primed for the downgrade on the 21st of June, which no one seems to have seen coming. QBE said claims in its emerging markets businesses in Asia and Latin America were higher than expected over the five months to May, so that division will report a first half combined operating ratio of around 110%. Remember QBE has a December balance date so the result to be reported in August is an interim result.
So why are claims suddenly higher? It’s mostly fire and marine claims in Hong Kong and Singapore, crop losses in Ecuador and deteriorating claims trends in the Columbian third party motor liability portfolio, now closed to new business and in runoff, where there have been fraudulent claims. The problem is the small size and frequency of the Asian claims, which hurt the bottom line because they are too small to be captured by QBE’s aggregate reinsurance program.
The outcome is an interim combined operating ratio of 110% for QBE’s emerging markets business, which will also add one percentage point to the group combined ratio. The downgraded guidance for this ratio for the full year is now a range of 94.5 to 96 per cent, up from the former range of 93.5 to 95 per cent. The combined ratio is the ratio of claims and operating expenses to premiums, so a higher figure means less underwriting profit. A figure above 100 per cent means an underwriting loss, so at least QBE is still making a profit by underwriting insurance risk. The interim insurance margin will now come in at 8.5 to 9.5 per cent whereas previously a ratio above 10% was possible.
Elsewhere the business seems to be travelling well. Premium income is consistent with guidance while investment returns are currently above expectations. Underwriting profitability is improving in Australia, New Zealand and North America and Europe was said to be performing well.
Now, while it’s reassuring QBE’s three major regions are meeting expectations, the emerging markets result raises questions about the quality of QBE’s portfolio and whether further divestitures are required. There are also questions about QBE’s ability to cover all bases across a complex global group to frame and deliver on profit guidance. It’s particularly disappointing this downgrade comes just a month and a half after the AGM, which presented an upbeat picture of earnings across the whole group. It’s also disappointing that in a large global group there were no offsets elsewhere in the group or from remediation to the affected portfolios, especially since Emerging Markets contributes only about 10 per cent of premiums. QBE seems to forecast lower emerging markets profits in the second half as well, and there have been downgrades in the market to 2018 earnings. Singapore and Hong Kong are competitive markets, so there might not be assistance from higher premiums.
Now, given these concerns you might be wondering why we topped up in QBE in the model portfolio on 22 June, the day after the downgrade. Our decision goes to how insurance companies, especially large ones, respond to underperformance and the value opportunity we see in QBE.
On the first point, I like ASX large-cap turnarounds because they nearly always succeed and turn out to be opportunities. There’s enormous pressure on underperforming large companies to fix themselves and that will be the case here too. We’re not seriously concerned about QBE’s downgrade because we have confidence management will in time restore the profitability of the emerging markets business or shrink it by reducing the capital allocated to it. They will also set tighter risk limits and diversify their risks. The worst of the damage should be over by mid-2018 if not earlier.
Also QBE has a buyback coming up that should support the share price. A three-year, one billion dollar buyback was announced in February to return surplus capital to shareholders and improve return on equity. QBE can start repurchasing shares from mid-August, so the market will factor this in well before it arrives.
I also think some of the comments in the media about QBE management’s reputation being in tatters after this downgrade miss an important point about insurance stocks. This is a globally diversified underwriter exposed to most geographic regions and inherent in this spread of risk will be more volatile regions and less volatile ones. Downgrades like this are to be expected from time to time and they are one reason why insurance stocks are only for trading. If you look at the model portfolio you’ll see we include QBE in the trading sub-portfolio, which means we intend to sell it and not hold for long-term value growth through the compounding of earnings. The return on equity is too low at around 10% for QBE to be able to reinvest to grow faster than mid-single digit.
I also like stocks where most of the business is performing well but one small part is struggling, because what will happen is the underperforming business will be fixed and then the market’s attention will return to the majority of the business doing well.
So we’ve released QBE from quarantine with an adopted NROE of 12%, above consensus of 11%, and a 2018 valuation of $13.30, which compares with today’s share price around $11.80. This valuation embodies my view global bond yields, especially US Treasury and corporate bond yields, will trend gradually higher. This is bullish for QBE because it’s strongly leveraged to US bond yields due to how its balance sheet is structured.
We see value, so we’ll hold. Insurance stocks are volatile, higher-risk investments and unexpected downgrades can come at any time, so we manage that risk through our weighting of 4.5 per cent.
Thankyou for watching, and I’ll see you next time.