The Investor Advisory Service doesn’t proffer much political commentary, but there is one political issue we have lately been forced to comment on over and over again: budget battles—“fiscal cliffs,” if you like. We can’t ignore the subject because we have an interest in the macroeconomic winds which whip up the stock market’s waters, and budget battles make very stormy waters. Budget wrangling seems to affect almost every important aspect of the greater macroeconomic picture, from overall government spending levels, to tax policy, to Federal Reserve interest rate policy, to money-printing and the future value of the U.S. dollar. Add in the subplot of Red-versus-Blue political theater, and budget battles become both too important and too enticing to ignore.
However, just because we feel duty-bound (and maybe inwardly compelled) to comment on the stock market significance of Washington’s periodic spasms, we do not necessarily relish in the act. In the January 2013 issue of IAS, we simply tried to look past the impending Fiscal Cliff. Rather than try to unpack both sides of the debate, we just rubbernecked a little and drove on. Our expectation, as always, was that politicians would find a way to kick the can down the road, maintaining the status quo for a few more months. Over and over, that prediction has turned out to be mostly right.
Turning our attention to other matters, we remained positive on strength in the housing market. The median home price had increased 11% year-over-year, reflecting higher prices and better quality in the market. Automobile sales were also brisk, with November 2012 sales up 15% to an annualized rate of 15.5 million units, a level not seen since January 2008. Energy prices were falling, a boon to consumers heading into the holiday season.
Let’s take a closer look at one of the companies featured in the January 2013 issue: Reinsurance Group of America, Inc. (NYSE: RGA). Insurance companies pay RGA to reinsure their own pools of risk, allowing them to turn around and write more insurance policies while remaining in compliance with the myriad overlapping laws which govern the insurance market. Reinsurance is a complex industry, and too unsexy to sustain a fan club when things look bleak. However, when the industry is out of favor it can offer good values to investors. The S&P 500 was up about 15% year-to-date in 2012 as we were writing the January 2013 issue. We noted that RGA had been left behind in the rally, and we presented it to readers at a price of $52.18, with a buy-up-to of 58. We modeled long-term EPS growth of 10%, with a potential high price of $125 and a low price of $42.
It’s worth noting that investors typically value insurance companies at a modest multiple of book value, in contrast to our habit of basing valuations on a multiple of earnings. We think the earnings-based approach makes more sense for a growing, well-managed insurance company, while the book-value approach is somewhat more conservative and more appropriate for average and below-average operators. The big catch is that insurance companies’ earnings are constantly being affected by a slew of one-time events and recurring accounting re-measurements. It falls on the investor to interpret a “true” rate of underlying earnings—no easy task! We have been following RGA for a few years now, and we feel comfortable each quarter giving our readers a reasonably consistent picture of what the company’s underlying earnings look like to us. Like a TV catching a signal through old “rabbit ears,” sometimes the picture goes a little fuzzy on us, but eventually it comes back.
Readers didn’t have to wait long for this pick to turn out. As the stock market continued its ascent in 2013, RGA made up for its lost 2012. Our first quarterly update after the January write-up came in the March issue, in which we noted that RGA had a surprisingly strong finish to 2012. Quarterly GAAP EPS, always volatile, increased 49%. With the start of the new year, management actually brought down its long-term growth expectations modestly, but investors were cheered that the adjustment came with a simultaneous uptick in plans to return capital to shareholders through increased dividends and buybacks. On the back of a strong Q4, RGA passed our $58 buy point, although it would briefly dip below that level again as late as April 2013.
The March quarter, which we reported on in our June issue, was equally solid. We continued to ratchet up our buy price as earnings grew, but the stock managed to surpass our new $64 price nonetheless. We don’t recommend that readers treat our buy-up-to prices as sacrosanct. We consider this newsletter to be a source of ideas, not a strict portfolio management system.
The stock’s performance got a little rockier during the summer months. In July, management disclosed that RGA’s Australian business was facing enormous losses based on inaccurate pricing data. Luckily, Australia represented only 10% of the overall company book. The stock took a hit, but turned up again going into Q3. As the stock continued to climb, our sentiment actually began to turn quite negative. We had simply seen too much bad news, and we remained a little underwhelmed with the company’s reduced growth estimates. However, confirming the stock market’s positive sentiment, Q3 results surpassed our expectations. We noted in the December 2013 issue that earnings growth was averaging just 7.6%, below our long-term 10% targets. We continue to follow the stock, but we no longer score it as a “buy.”
At a recent price of $75.36, plus $1.08 in dividends, Reinsurance Group of America has returned 46% since the time of selection, outperforming the S&P 500’s 30% gain during the same period. A 46% 1-year gain qualifies as spectacular, especially when it comes from the staid world of reinsurance. There are always values to be found, especially if you’re willing to look in some dusty corners. A year ago, we found a winner with RGA.