Shooting first and asking questions later



In Australia, the market, after a positive open, closed lower on Wednesday, with the ASX200 edging down 6 points to 5664. The energy sector and resource stocks generally were higher, and made up for weakness elsewhere. South32, in which we are overweight, was one of the standouts, rising 2.2%. QBE and Telstra lost further ground, suffering on the back of broker downgrades. Technical damage has clearly been sustained in both instances, but there is certainly extreme value on offer at current levels.

QBE broke below $10 after some negative broker notes, which harboured concerns over the insurer’s ability to withstand further ‘events’ following recent hurricanes. QBE has an annual ceiling in catastrophe cover of US$2.05 billion, and JP Morgan analysts believe that reinsurance levels will be “OK assuming no more catastrophes”…but with some “potential for breach going forward”.

QBE has a CAT budget of US$1.15 billion, with around US$0.9 billion in reinsurance cover, making for $2.05 billion in total. Estimates are that around $1.85 billion of capacity has been used up which leaves around $150 million of remaining cover – which is not a great margin of safety. Clearly that is what the market was concerned about yesterday, when QBE lost 2.2%. Whilst the probability of another “super storm” is low this year – given the insurance industry has just incurred a one in 100 year event with back to back super storms (and earthquakes), the market is clearly “shooting first”.

However, I think the time to buy insurance stocks is after super cat drawdowns within the sector, which eliminates capacity and drives up premiums. QBE could well find that next year sentiment changes as premium rates rise along with interest rates that will boost investment income.

Whilst the unprecedented hurricane losses sustained by the industry will suck out capacity, some will argue that climate change is having an impact on storm frequency and this could lead to significant pricing changes over the medium term and certainly at a minimum, push up cat insurance rates. This will be to the benefit of well capitalised insurers that can add capacity, and QBE is certainly in that boat.

The other concern within the analyst fraternity would appear to be that inbound CEO Pat Regan will engage in some ‘write downs’ upon his arrival, and reset the earnings bar somewhat lower. This is of course a risk, but looking at the company’s operations, 90% of the business is performing fairly well now, after a host of turnaround initiatives. Emerging markets are something of a trouble-spot, but I would argue that the bad news is already out. Still as I have noted before, I think Mr Regan, and some fresh blood, could be just the ticket to lead a revival in a crucial metric – investor sentiment.

Clearly, QBE has not added value for shareholders over the past decade. We went overweight QBE earlier this year and it may be six months yet before we see a significant sentiment turnaround. However this will be the stock that everyone “wants to own” when a turning point is reached, so I don’t mind being early.

The valuation of QBE is at rock bottom, with the stock valued at a significant discount to international peers, priced on a Price/Book ratio of around 1 times and a dividend yield of 5%. Rising interest rates and rising investment income, along with a more buoyant premium environment should become powerful tailwinds for QBE in 2018.

Disclosure: The Fat Prophets Contrarian Fund declares a holding in QBE Insurance.

Carpe Diem!

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