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.
Yes agree, solid blue chip that is unlikely to disappoint.
The shares were available earlier this year below 200p following the chancellors budget announcement on pension reforms. I was lucky to pick them up for my income portfolio at this time. Hopefully it will be a secure long term hold.
As for the bargains available in late 2008 and early ’09…wish I had been a little braver…
Thanks for the write up and analysis!
Hi John, good to hear from you again. I’ve updated the link that you supplied as you seemed to miss off the ‘uk’ bit in the URL. If this is a case of mistaken identity let me know and I’ll change it back.
Hi John, I held this one after entering at 84, 91, and 92p and sold at 187 thinking it was overvalued 🙂
Well I suppose value is a perception to some degree. One thing does concern me with L&G, which seems as you point out to be a well run company, is the fact it isn’t actually growing.
There seems something wrong with the model and I am beginning to agree with Terry Smith that investing in any insurance company is difficult because the accounts are the very definition of opaqueness – witness RSA an Aviva over the last years.
In 2009 the revenue was £5.275Bn and pre-tax was £1.239Bn
In 2014 the revenue is projected at £5.871bn and pre-tax projected at £1.277
OK you can argue, nice consistency but that’s a revenue growth of 11% over 5 years or or 2.2% a year and profit growth of 3% or 0.6% a year.
During that time they have increased the dividend from 3.84p to 10.98p a rise of 168% and a share price rise that seems off the scale. One can consider here that “how long can you keep giving out more and obtaining the same or possibly less after inflation adjustments in the market”?
Despite my seemingly early exit at 187p I’m sceptical about any entry at 240 given that it trades at a P/E of 14.5 (heavy for the insurance sector) and a market cap to net assets of some 151%.
I haven’t look at the free cash flow cover on this, did you have a figure on this John?
Hi LR, it depends on which years you look at, which is why I like to look at all years over a 10-year period, to see the ups and downs.
The dividend increase does seem surprising, but if you look at the chart in the article it doesn’t look unsustainable to me. The payout ratio has gone up but that’s all part of the plan.
L&G have been focusing on capital efficiency for years and capital efficiency means higher ROE, less need to retain cash and a higher payout ratio. So once the dividend has moved to a higher payout ratio it should then move approximately in line with profits and net asset growth. So I don’t think the 20+% growth in dividends will last much longer before it moves back a more normal level.
Free cash flow is above 20p and has been for many years from what I can see, so I don’t think that’s an issue for the dividend.
L&G? What about the headwinds in its main market: UK pensions?
L&G was a big provider of annuities, half of its profits were from pension annuities, 10% of the new written pension annuities were booked as profit.
It has however some strengths, it has the ‘indexing’ advantage over the other providers of Auto-enrolment solutions, comparing with others which use other firms funds for AE (mainly BlackRock’s). However the margins in AE are rather small.
As fund management, apart from indexing solutions where the competition is very high with margins getting lower and lower, L&G is non-existent in the active management.
The share price is well too high for the headwinds ahead.
Hi Eugen, yes the pension reforms were a big shock for annuity providers, but L&G seem to be well placed to cope with it due to the diversity of their business and ability to pick up bulk annuities from company pensions. From the latest interim report:
“Our expertise in the bulk annuity and longevity insurance markets and the clear intention of the majority of defined benefit schemes to de-risk means we are confident in our ability to more than offset reductions in individual annuity sales with higher bulk annuity volumes.”
Bulk pension annuities which are in fact taking over defined benefits pension schemes are not so profitable.
That would not stop providers to book profits based on actuarial reports. The problem with insurers is that you never know their long term liabilities and if they have enough reserves. I don’t like surprises so I stay out. I prefer general insurers where the risk is usually taken for one year.