I sold Beazley PLC because its share price may be close to fair value

Summary:

• Beazley PLC is a leading international insurer which specialises in insurance policies that are complex and bespoke.
• I added it to the model portfolio in 2015 because it was a good company trading at a reasonable price.
• I decided to sell because the share price has almost doubled, leaving the shares close to “fair value”.

As a specialist insurer, Beazley doesn’t write many “cookie-cutter” policies such as car insurance or home insurance. Instead, it covers a diverse array of risks, from celebrity weddings to supertankers and kidnapped CEOs.

I added Beazley to the model portfolio in 2015 because it had all the key features I look for in a company:

1. Above average growth
2. Above average profitability
3. Little in the way of debt

However, unlike many of the companies I invest in, Beazley wasn’t facing any valuation-depressing difficulties at the time of purchase. Everything seemed to be ticking along nicely and the company’s valuation wasn’t obviously cheap (the dividend yield, for example, was just 2.8%).

Given this not-obviously cheap valuation, my hope was that Beazley would continue to grow at something like 5% to 10% per year and that – for one reason or another – Mr Market would become enthusiastic about the company and offer to buy my shares at a much higher price.

In the end that’s more or less what happened, although Mr Market became enthusiastic far sooner than I had expected, which led to much better results than I had expected:

• Purchase price: 329.2p on 4th September 2015
• Sale price: 605p on 4th May 2018
• Holding period: 2 years 8 months
• Capital gain: 81.8%
• Dividend income: 17.1%
• Annualised total return: 31.5%

Buying an outstanding insurance company at a reasonable price

What do I mean when I say Beazley had all the features I look for in a good company?

For a start, it had a long history of above-average growth, measured across net asset value (insurance companies don’t have “revenue” as such, so I look at their net assets instead), earnings and dividends. This growth had taken the company from the proverbial “broom cupboard” in 1986 to a company generating more than a billion pounds of insurance premiums every year.

Beazley was also more profitable than average. My usual measure of profitability is a company’s ten-year average return on capital employed (ROCE), but that doesn’t work for banks and insurance companies. Instead, I use two metrics: Ten-year average return on equity (ROE) and five-year average combined ratio.

The median ten-year ROE for insurers on my stock screen is 11%, which is pretty close to the average ROCE for non-insurance companies. Beazley’s ROE was comfortably above that level at just over 18%.

This is important because consistently high profitability is what you’d expect to see from a company with strong competitive advantages, and strong competitive advantages are what a company needs if it’s going to keep growing at a good pace far into the future.

Whereas return on equity looks at returns (profits) relative to equity (book value or net assets), the combined ratio looks at premium income relative to the combined cost of claims and other expenses.

It’s a useful metric which can highlight insurers writing insurance at a loss just so they can get their hands on the premiums. Those premiums are then invested with the goal of generating enough investment return to more than offset the underwriting (i.e. insurance) losses.

It’s a risky strategy that does not have a good track record, but it’s an easy way to create the illusion of growth and that’s why many insurers go down that route.

A profitable underwriting business will have a combined ratio of less than 100% (i.e. claims and other expenses are less than 100% of premiums earned), so I look for a five-year average of less than 95%, which is surprisingly difficult for many insurers to achieve. In Beazley’s case, it had achieved a fairly steady average of 90%, so the company was clearly doing something right.

It also had a strong balance sheet, with little in the way of operational borrowings and a healthy premium-to-surplus ratio. If you haven’t heard of that ratio before, it’s the ratio between premiums earned and tangible book value (the “surplus” of tangible assets over liabilities).

A general rule of thumb is that earned premiums should be less than twice the company’s net tangible assets. This suggests the company is writing a prudent amount of new business relative to the balance sheet’s ability to absorb claim losses. Beazley’s five-year average premium to surplus ratio was just 1.6, suggesting a prudent level of insurance was being written.

Holding on while Beazley continued to grow

So Beazley had a good track record of growth and profitability, as well as a strong balance sheet. But what happened after it joined the portfolio?

The answer, for the most part, was business as usual.

For example, in 2015 the company produced solid growth in net assets, premiums and profits, and increased the dividend by 6%. The dividend was further bolstered by a special dividend that Beazley occasionally uses to return excess capital to shareholders.

In 2016 that story was repeated. Net assets and profits increased while the dividend was raised by 6%. And another special dividend was paid, which was a welcome bonus. Just as importantly, profitability remained extremely good, with the combined ratio coming in consistently below 90%.

For me, the most interesting aspect of this period was Beazley’s ability to shift its insurance focus from one area to another, depending on the expected risk-adjusted returns that were available.

As a group of diverse insurance businesses, Beazley was able to reduce the amount of new insurance written in, say, commercial property or reinsurance, where expected risk-adjusted returns were low, and write more insurance covering professional indemnity, management liability and large-scale cyber risks, where expected risk-adjusted returns were higher.

This is very similar to an investor looking around for the best risk-adjusted opportunity. Here’s a quote from Beazley’s Chief Underwriting Officer which sums the process up:

“Our diverse portfolio gives us the ability to exercise discipline in areas where [returns] are under the most pressure, while simultaneously pushing forward in areas […] where we see the best opportunities for profitable growth. This emphasis on disciplined [deployment of capital] across a wide range of products and locations will remain the cornerstone of our […] strategy throughout the next 12 months and beyond.”

– Neil Maidment, Chief Underwriting Officer at Beazley, on the importance of having a diverse range of capital deployment options

Disaster strikes, but Beazley is unfazed

Unlike 2015 and 2016, 2017 was a year characterised by an unusual number of large natural catastrophes.

This affected Beazley primarily through its catastrophe reinsurance business, which provides insurance to other insurance companies so that, for example, they don’t get wiped out when a hurricane flattens hundreds of homes which the other insurer had written home insurance policies for.

For Beazley, the most important catastrophes of 2017 were multiple hurricanes in the US Virgin Isles, wildfires in California and earthquakes in Mexico, with a total cost to Beazley expected to be in the region of $200-$300 million, which is pretty much a full year’s profit.

Despite this, Beazley remained profitable in 2017 in both underwriting and overall terms.

The company also reiterated that exposure to this level of natural disaster is an inevitable feature of its business and as such, much time is spent designing the business to survive and even thrive under these conditions.

How can an insurance company thrive when disaster strikes and millions have to be paid out to claimants?

The answer is that disasters almost always lead to higher premiums.

For Beazley, this should create more opportunities to write more insurance at rates which are more favourable than they have been for many years.

Selling because Beazley’s share price is now much closer to fair value

Beazley wasn’t obviously cheap when it joined the portfolio. Its dividend yield was below the market average at just 2.8% and its PE10 ratio was above the market average at 15.2. However, its high growth rate and good profitability were enough to make that valuation appear attractive.

Today, after share price gains of more than 80%, Beazley’s dividend yield is below 2% and its PE10 ratio is considerably higher at 24.2. However, its growth rate and profitability are about the same, which means the price is not nearly as attractive.

In fact, I’d say the current price is probably quite close to fair value. For example, with a growth rate of around 6% and a dividend of around 2%, Beazley has an expected return under the dividend yield-plus-growth model of 8%. That’s very close to the 7% or so annualised return you might reasonably expect from the stock market; therefore Beazley is currently close to fair value.

The company is also ranked 99th on my stock screen. That’s fairly close to the mid-point of 107 and I sometimes use a stock’s proximity to that mid-point as a proxy for how close or far it is from fair value.

So with Beazley probably close to fair value, I saw no obvious reason to hold onto it. I like the company and I’d be happy to invest in it again, but at its current price my expectations for its future returns are about average and I’m aiming at something more than average.

That’s why I removed Beazley from the defensive value portfolio and my personal portfolio earlier today and, as usual, the proceeds will be reinvested into a new and hopefully equally successful holding next month.