If you wanted to you could have bought Legal & General shares for less than 25p in March of 2009. Of course, few investors were willing to invest in anything, let alone a finance company, at the exact point at which so many thought the financial world was about to end.
Today the shares stand at 240p. Any investors who were smart enough or crazy enough to invest at the market low would have seen capital gains of more than 960% in just five and a half years.
For a well-established FTSE 100 blue chip that’s not a bad return at all. In fact, it’s pretty astonishing, but the gains may not be over yet if the company’s recent history is anything to go by.
Although Legal & General did indeed go through the meat grinder of the financial crisis its balance sheet was robust enough and its cash flows strong enough to survive relatively unharmed.
Okay, so the dividend was cut in 2008, but that isn’t always a bad thing. In this case, it was to shore up the balance sheet and, along with capital efficiency measures and a focus on cash flows, it did the job – Legal & General survived the financial crisis relatively unharmed.
Personally, I’d much rather see an early and prudent dividend cut for the long-term good of the company than a management that pays a full dividend one day and launches a rights issue the next.
Reasonable medium-term growth, fantastic short-term growth
From a purely numerical point of view, Legal & General’s most recent decade can be broken into three parts.
In the beginning, the company was growing progressively, but not spectacularly, after recovering from a pause in growth and a minor rights issue during the 2000-2003 bear market which affected many insurers.
Then the financial crisis hit, a loss was made and the dividend was cut by a modest amount.
Since then the company has more than recovered; it has positively bloomed. In the last four years, dividend growth has averaged almost 25% a year (partly because it was recovering from a 30% cut in 2008) and the dividend now stands at 9.3p compared to a pre-crisis peak of 6p.
To me, it seems likely that the company’s goal of sustainable and progressive dividend growth is very achievable.
Growth through capital efficiency, cash generation and international expansion
Even before the financial crisis, the company was already adjusting its strategy to focus on continued expansion.
Its first step was to focus on capital efficiency, improving return on equity through strategies such as increasing its use of reinsurance. But then the financial crisis struck and a focus on cash flow became paramount.
This focus on cash flow continued through 2008, 2009 and beyond and has resulted in a doubling of the dividend, even though the company’s book value has only increased by a quarter.
In 2013 this focus on capital efficiency and cash generation took the next step with a structural reorganisation around what the company sees as key growth themes for the future.
The old structure had three main divisions:
- Risk –insurance and annuities
- Savings – pensions and savings products
- Investment management – managing the investments of the Risk and Savings divisions as well as creating investment products for institutional and retail investors
Investment management effectively sits at the heart of the business with assets under management being fed to a large degree by the Risk and Savings divisions.
Of course, there is also a lot of cross-selling, where customers who have a Legal & General pension will often use it to buy a Legal & General annuity, and it isn’t a great leap to see them using L&G life insurance and other investment products too.
The key growth themes for the future were defined as (1) ageing populations, (2) shrinking welfare states, (3) cautious banks and (4) globalising asset markets.
To fit in with these themes the company is now structured around five largely autonomous companies:
- LGAS (Assurance Society) – Insurance, savings and pensions
- LGIM (Investment Management) – Global investment management
- LGR (Retirement) – Annuities, corporate pension fund de-risking solutions
- LGA (America) – US life insurance through Banner Life and William Penn Life
- LGC (Capital) – Direct investment in companies
Again the idea is to feed funds into the investment management business as well as having significant synergies and cross-selling opportunities across the five companies.
The most interesting addition I think is the Capital business, which uses the long-term nature of annuity assets (they never have to be given back) to invest directly in illiquid assets such as companies and property in order to achieve higher risk-adjusted returns.
The focus will be on socially useful projects such as housebuilding, care homes, education and infrastructure, with the first example being a near 50% purchase of housebuilder CALA Group.
In summary then, Legal & General still looks like the bluest of blue chips, where steady and progressive dividend growth over the long term remains a decidedly reasonable expectation.
High dividend yield, but is it high enough?
As I write the share price is 240p. At that level, the company has a historic dividend yield of 4%. In contrast, the historic yield on the FTSE 100 is 3.5%, so Legal & General investors will have a head start over passive investors when it comes to cash returned to their pockets.
The assumption must be that, on balance, investors think the FTSE 100 dividend is likely to grow faster than the dividend from Legal & General shares.
That must be the case otherwise FTSE 100 investors wouldn’t be willing to sacrifice some income today. In other words, they must be expecting greater income in the future.
But how reasonable an assumption is that?
Of course, it’s impossible to say for sure, but in the last decade, the FTSE 100 dividend grew by about 2.7% a year while the L&G dividend grew by about 5.5%. As I said earlier the Legal & General dividend has grown by closer to 20% in recent years.
However, Legal & General’s recent rapid growth is very unlikely to continue for much longer.
The dividend has been raised as part of a deliberate policy of increasing the payout ratio (the ratio between dividends and earnings) as the company has become more capital-efficient and therefore does not need to retain as much cash in order to grow.
Just as importantly, is unable to allocate as much cash at a high enough rate of return, therefore it’s better for shareholders if the cash is returned to them.
Still, given the company’s history of success, the expanding international opportunities and macro tailwinds, it seems reasonable to me to assume that Legal & General can grow faster than the market as a whole, at least over the medium-term, although probably not much faster.
A decent price, but not spectacular
And so by putting all that together my eventual conclusion is that Legal & General shares, with their slightly above average dividend yield and reasonable prospects for above average dividend growth, are slightly undervalued by the market at 240p.
I won’t be rushing out to buy them though as I prefer a much wider margin of safety over the average than that. The 25p price of 2009 would do nicely, although, in reality, I think something below 200p might be a more realistic purchase price.
Note: Readers of my investment newsletter may wonder why I’m somewhat upbeat about Legal & General’s shares given that they currently come 205th out of 247 dividend-paying UK stocks in the newsletter’s stock screen. Normally I’d expect a stock with such a low rank to be from a declining company or overvalued, but in this case, it isn’t. That just goes to show you that you shouldn’t always trust your stock screen and that analysis by a real live human still has value.