QBE – Does it eat twisters and floods for breakfast?

Companies, Insightful Insights, Insurance | Comments (36)

QBE – Does it eat twisters and floods for breakfast?

In March this year I shared my insights about QBE with readers of Alan’s Eureka Report. Since that time QBE’s share price has fallen from over $22.00 to $19.00 – a decline of around 15%. That may explain why I have received a few requests asking for an updated estimate for QBE’s value?

If you take your cues from price action, you would probably conclude something might be wrong with the company.

Open up a newspaper, flick on the TV, or do both on your new iPad and you will be overwhelmed with the events in the US, the debacle that is the Euro zone, and BP’s oil spill – one of man’s greatest catastrophes.

With 40% of gross written premiums being derived in the US and a further 40% from London and Europe, it is likely QBE is exposed, somewhere.

Even at home the company appears to be right in the firing line of the Lennox Head twister, Victoria’s bushfires and recent floods.

It’s not all bad news though – the declining Australian Dollar ensures QBE’s overseas earnings are now worth more.

So is there something wrong at QBE? Or is the market just reacting to bad news? Buffett says you pay a high price for a cheery consensus, so maybe bad news is just what’s needed to make QBE attractively priced…

You have to remember that QBE is in the business of forecasting and betting against bad news – it exists to manage risk and spread it around when there is too much for it to shoulder alone. And given its successful decade-long track record of doing so, I can strongly argue that it performs this activity significantly better than many, if not most, of the other insurers listed on the ASX.

Things that you and I perceive as negatives are usually positives for insurance companies. Think of the last time you had to make an insurance claim. Did your premium rise the next time you chased around for a better price?

In March this year a sensible price to pay for QBE was $19.83. Now a sensible price is $19.92. So even with all the negative news and natural disasters, the only thing that appears to have changed is the market price.

The truth is that the business operations that make up QBE’s brand have been moving much slower than its share price would suggest, and the rising valuation suggests things are believed to be improving.

While the price was well above the estimated valuation three months ago, I couldn’t have predicted the share price would fall below it.

I did say that “With a gun to my head and forced to make a decision, I would bet with Frank O’Halloran at QBE every time”. That remains the case today.

I do get excited when the market, in its wisdom, decides that it temporarily dislikes great businesses. The result is a fall in the share price. Who doesn’t like to buy more of a good thing for less? The price however may not have declined far enough to provide the sort of Margin of Safety Ben Graham said should be required in Chapter 20 of his Intelligent Investor – arguably one of the two most important teachings in investment history.

There are a bunch of insurance businesses listed on the ASX. Some are pure insurers and some have insurance divisions within the business. I am interested to hear what you think of any of them. Have you had to deal with them and have you had a good or not so good experience? Do you work in the industry? Can you shed some light on who you think is the best and why? Share your thoughts by clicking Leave a Comment below.  AND REMEMBER – YOU MUST OBTAIN PERSONAL PROFESSIONAL ADVICE BEFORE CONDUCTING ANY TRANSACTION OF ANY KIND IN ANY SECURITY IN THE MARKET.

Posted by Roger Montgomery, 11 June 2010.

INVEST WITH MONTGOMERY

Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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36 Comments

  1. Matthew
    :

    Hi Roger,

    QBE announced a profit downgrade secondary to decreased investment returns. Insurance profit however increased.

    How do you think this impacts the value of QBE?

    Does a drop in investment income affect your value as much as a drop in insurance income? I would think that a drop in insurance income would be much more concerning than a drop in investment income given that investment income is to a large degree outside of QBE’s control while a drop in insurance income could indicate pressure on margins, drop in policy standards etc

    Your thoughts would be appreciated

    Thank you

    • Roger Montgomery
      :

      Dear Matthew,

      When you own a business you own all of the parts of that business. The value of QBE has fallen. This years valuation now drops to $16.04. Interestingly intrinsic value has declined every year since 2007. Remembering that Buffett talks about owning businesses who’s intrinsic value is rising at a satisfactory rate, it is worth keeping the current intrinsic value in perspective.

      • Matthew
        :

        Thanks – yes, what I meant is an investor might look at how the poor performance of one part of the business (investment income returns) skews the result of the core business (insurance).

        However, on further consideration after my previous post I can see three problems with my previous logic:

        (1) being a successful insurance company requires good returns on float because insurance companies often have negative returns on their insurance business, but maintain that because they value the return on the float and
        (2) as you pointed out, the company has to be considered in whole and shareholders returns are a result of that whole, and therefore nit picking about whether one part of the business has skewed the result of the whole business may be irrelevant because at the end of the day the whole company performance has been skewed and that means lower returns for the owners of the company (who obviously own the whole thing, good parts and bad!).
        (3) If you had a macro view that all this fiscal stimulus and government debt was going to lead to higher interest rates, thereby helping QBE’s returns on float you might be bullish on QBE, but that isn’t something you can accurately predict and therefore value. Or to say it another way, you can only value a company using what you can confirm in historical financial statements and approximately predict in earnings projections, trying to assess macro effects is far too nebulous and therefore introduces unnecessary room for error. Just move on to another company! You don’t need to be monogamous with stocks.

        Thanks for your reply, I very much enjoy reading all your articles and the ensuing comments back and forward

        I’m in Adelaide & your book hasn’t arrived yet. Local post office said to allow two extra days for the road transport. Excitedly waiting.

        Obviously I also am making no recommendation on the soundness or otherwise of an investment in QBE

      • Roger Montgomery
        :

        You are really getting it Matthew,

        You do need to produce some scenarios to produce a range of valuations rather than just one. When good value is presented, its is really obvious. You don’t need to think about it. BTW, The best insurance companies generate a profit on their insurance business, which makes the cost of float free.

  2. Eamon
    :

    QBE share price has dropped alot today, Ive noticed profit margin has declined. Hmm something to think about, Eamon.

      • Eamon
        :

        hey Roger,

        How do you determine/forcast future prospect to determine decline in intrinsic value as a going concern? Personally I assume it would decline because of the increase disaster and decline in provision set aside and decline in operating margin. Is there anything else I should be looking at?

        Eamon. ;)

  3. Eamon
    :

    The problem Im seeing is that the company may continue to drop give the higher disaster probability occuring through the year then forcast by managements. Even though management has set aside a sufficient cash to met these disaster provision, we may see increase disaster occuring going forward. Hence the overall industry may not look so bright anymore, even though QBE is the better choice from its sector. Eamon

  4. Martin R
    :

    Hello Roger

    I am an increasingly avid follower of your writings on Eureka and now here on your blog page which I recently discovered, and am enjoying learning about value investing after suffering some horrendous losses in 2008-09 trading in penny stocks. I am re-educating myself now with some success.

    Anyway, having been an AMP shareholder for more than 10 years, I have seldom been highly impressed with the stock’s performance during that time. I have watched QBE closely for the last 8 months now, and after deciding it could be a better long term insurance based investment than AMP, I have been heartened to read your musings on it. My father and I often debate which is the better investment, although I understand they are quite different in their operations. He is a staunch supporter of AMP, whilst I argue QBE is the better choice, using the last 10 years of share performance along with current growth forecasts as the basis for my argument.

    Having considered your words about a “sensible price to pay” for QBE for some weeks now, I was happy to finally pick some up yesterday at more than $2 less than said price and plan to keep them long term. I wondered if you would share your thoughts on AMP vs QBE as a long term investment based on current forecasts?

    We have ordered your book and I look forward to reading it. Thanks for all the information you share about value investing, it is extremely helpful to me and I am learning more about it every day.

    Regards, Martin

    • Roger Montgomery
      :

      Hi Martin,

      Just be aware that I am not recommending QBE nor can I predict the share price. The share price could halve from here (I just don’t have any way of predicting it) so be sure you avail yourself of some personal professional advice, which will ensure the investments and their size, for example, are appropriate for you and suit your financial needs and circumstances. Also recall I said “The price however may not have declined far enough to provide the sort of Margin of Safety Ben Graham said should be required in Chapter 20 of his Intelligent Investor – arguably one of the two most important teachings in investment history.” With regards to comparing AMP and QBE, give me a little time to get onto that one. You will have to keep the debate going with your father for a little longer!

  6. Paul
    :

    Hi Roger

    I’m interested in the assumptions you use to calculate intrinsic value, particularly your required rate of return used to discount cashflows. I did a rough intrinsic value calculation using 2 discount rates for QBE. 10% and 12% (an additional 2% as one form of margin of safety). Other assumptions included:

    ROE on initial book value = 19.7%
    ROE on retained earnings (based on management minimum ROE target for acquisitions) = 15%
    Payout ratio =60%
    Future EPS capitalisation multiplier after 10 years = 12.0

    I capitalised EPS after 10 years after looking at what QBE has historically traded at rather than projecting values beyond ten years.

    Instrinsic value range using 10%-12%: $21.31 – $24.67

    Since I participate in the DRP, I dropped the payout ratio from 60% to 0% to assume my dividends are reinvested to earn at least QBE’s minimum required ROE of 15%. Using a 10% discount rate, this pushes my intrinsic value calculation under DRP from $24.67 to $32. I haven’t heard you comment on how you allow for full DRP participation in your intrinsic value calculations so would be interested in your thoughts.

    Thanks Paul

  7. Rici Rici
    :

    Roger how do i account for the franking eliment(ie franking credits) when determining intrinsic value.

    In QBE’s case the net dividend is starting to become attractive, its the franking component is low, which makes it difficult to compare apples with apples.

      • Rici Rici
        :

        Ah i think i understand, if one is trying to estimate the intrinsic value of the business itself, then issues such as franking credits dont feature.

        However if one is trying to estimate intrinsic value of the investment then it does.

        For example two australian companies, both earn $100, one local ,one with total overseas profits (taxed at 30% by the overseas government). Each company has 100 shares and each company passes out 100% of profits as dividends. They are identical in all other ways.

        So the dividend per share is $1, except the one with localised profits can pass on the franking benefit. The value of this franking credit has to play a part in the intrinsic value of the investment (but not the company).

        Am i looking at this the right way, or am i still ‘missing’ something?????

      • Roger Montgomery
        :

        Hi Rici Rici,

        We could enter a dialogue that began with Pascal and Fermet, was passed to Bachelier and is currently in Mandelbrot’s court. I don’t really mind whether you include them or not. Just be sure to buy at very big discounts. The logical conclusion to your line of reasoning will be a different valuation for everyone because they are all on different tax rates.

      • Paul Kloeden
        :

        But surely if I am looking at two bank accounts – one pays me 7%pa and the other pays me 10% (7% plus franking) then the second is more valuable to me. I agree with Buffett that we need to look at after tax stream of earnings but surely that is after both my tax as well as the company’s.

      • Roger Montgomery
        :

        Hi paul,

        The result will be a different value for a company for every investor in it. That does not sound completely unreasonable but the differences can be overcome by seeking a very big discount in most cases.

  8. James
    :

    Hi Roger,

    I was looking at the upcoming dividends and JRL (Jindalee Resources Limited) and they are paying a fully franked dividend of $0.55 (trading at $1.38 today – which is obviously a huge yield!)

    The reason is below in the hyperlink, but I was wondering if you had an opinion regarding the value for this business?

    I would essentially be looking to get in just for the dividend then out again (but the price will probably fall by around the dividend amount – so I would have to wait a few months for the price to hopefully recover.) I know you will probably call it speculation, but with such a large dividend it may make sense to stick in (unless its a bogus business of course!)

    http://newsstore.fairfax.com.au/apps/previewDocument.ac?sy=smh&ss=SMH&docID=GCA01068032JRL&backTo%3Dhttp%3A%2F%2Fmarkets.smh.com.au%2Fapps%2Fqt%2Fquote.ac%3Fcode%3Djrl%26submit%3DGo!%26section%3Dca&f=pdf

    • Roger Montgomery
      :

      Hi James,

      You need to have a look at the after tax return to you from the dividend + the value of the capital loss from the drop in price when the shares go ex dividend (watch the 45 day rule) and MOST IMPORTANTLY, then you would need to satisfy yourself that the value of the remainder (the equity will drop by the cash paid out) is higher than the anticipated ex-dividend price. There’s a few moving parts but the speculative part is working out the value because the company has made a profit in only two of the last ten years (2008 and 2004). I see it also made a profit in the last six months but this was due to the sale of its 46.8 million shares in Energy Metals Limited (EME) at $1.02 cash via a proportional takeover offer (Offer) from China Uranium Development Company Limited.

  9. Grant
    :

    Seriously whats up with QBE!
    All the figures are fine yet it wont rise with the rest of the financials in the market?!!
    Its released statements clarifiying its position with regard to recent events and still its getting sold down!

    My thinking is a large shareholder may be selling down their stake?
    Anyway I think its an excellent stock presenting us with a very good buy opportunity.

    • Roger Montgomery
      :

      Hi Grant,

      Surely you don’t believe the market makes sense at all times? Remember Graham’s words, quoted by Buffett; In the short run the market is a voting machine – a voter-registration test that does not require intelligence or emotional stability… You get the idea.

  10. Greg Mc
    :

    Morning Roger,
    I like to keep an eye on the various announcements made by fund managers that I respect, and saw this one:

    “Generally, Australian analysts have their earnings forecasts too high for the 2011 financial year.”

    If you were to agree, what do you do?

    a) adopt a more conservative forecast than consensus to do your calculations
    b) keep the same forecast numbers but demand a higher margin of safety
    c) put away your checkbook and go fishing until the actual numbers come out or the stockbroking community revise down
    d) Stick with the original numbers. “Damn the torpedoes!”
    e) other

    Some forecasts are going to be more ‘out’ than others, with probably the dodgier companies suffering more. I think I may be able to guess at your response…

    All the best,
    Greg

    • Roger Montgomery
      :

      Hi Greg,

      In an earlier post, I made the observation that from the entire universe of stocks, I can only find four or five that look cheap and therefore the market is expensive because more than 1800 companies are not cheap. That earlier conclusion was made despite the confluence of earnings estimates you have described. You may also find an earlier post about the fact that I have two valuations for every stock. Those two valuations also ensure a conservative stance is adopted. In the absence of an alternative and in the absence of confidence, just pick ‘c’.

  11. Peter Andersen
    :

    Hello Roger

    It’s probably a good thing that QBE, one of Australia’s most successful international companies, gets limited popular recognition for achievements.
    After all QBE has a lengthy record of managing risk, not overpaying for acquisitions and modest management.
    One of the few large companies I’m personally happy to buy at current levels.

    • Roger Montgomery
      :

      Thanks for sharing Peter,

      I am sure many readers appreciate your thoughts. Please note everyone, Peter’s comments are not a recommendation nor does it constitute advice. Be sure to seek personal professional advice before any activity.

  12. Howard
    :

    Hi Roger,

    I have been looking for quality cheap valued businesses to buy into for the last few months and could not really find anything worthwhile. Although I have been eyeing QBE since they have become quite out of favor with the market in recent times.

    I’m tossing up between getting into QBE or JBH which is another stock you frequently talk about. It seems like they are both great businesses and they are both trading close to their intrinsic value by your calculations.

    However you have mentioned that JBH has a great intrinsic value growth in the next two years of about 50%, but I dont recall you mentioning what you think the intrinsic value growth for QBE is for the next two years.

    A quick check of QBE’s forecast EPS would seem to indicate only a 16% growth in two years which seems subdue compare with JBH’s 47% forecast EPS growth in the next two years.

    What do you think QBE’s intrinsic value growth is for the next two years? Looking forward to your book.

    • Roger Montgomery
      :

      Hi Howard,

      Thanks for your post. JBH’s intrinsic value is currently expected to rise significantly more than QBE’s. But note two things; First, the word “currently” – anything can happen in the near term or distant future that materially changes the relative merits of the companies discussed, and second, don’t do anything without first seeking and taking personal professional advice.

  13. Tiago Magalhaes
    :

    Hello Roger, although I have never contacted you I have been a fan of yours for as long as I started learning about investing in the stockmarket. Well, all I wanted to ask you is advice for my professional career, believe me, I am pretty sure everything that I could learn from you about investing and evaluating a company I have already done so, I watched Sky Business Channel for 2 and half years, my favourite shows were your money your call and Switzer, although I watched that constantly I came to the point an year ago that I do not need to watch anymore, all I have to do is focus on the companies I really like and buy them when the market shows me that they are undervalued, most of the companies that I bought were picked by evaluating them the way I learned from you, companies like CSL, CBA, QBE, JBH, MMS are the ones that take part in my portofolio. I never thanked you for this, THANK YOU!! I recently heard you talking about all of them.
    I think recording sky business shows and watching them all the time for so long is not such a smart thing to do but I knew absolutely nothing about shares, margin lending, taxation etc.
    Roger, I have been a Lifeguard for 6 years, worked for a Council for 5, 3 years as casual and 2 as a full time seasonal where we work 8 months of the year, able to surf all the time and go to Indonesia surfing for months every year. Well, last year I suffered an injury and had many arguments with our main boss and this position you have to re apply every year, so last year I didn’t get the job. I have gone overseas, worked a little bit, done lots of snowboarding, now I am back in Australia, I have decided that I have done my time on the beach. I would love to be a stockbroker, financial advisor, work for a superannuation fund or a fund manager, well, something to do with the stock market. What is the pathway? Financial Planner? Stockbrokers Association? Do I need to go to University to do a course like Business Adminstration? Accounting? I would like to know the shortest way.
    Mate, every tiime someone asks me about shares, all I do is tell them to start watching you, wish someone gave me that advice when I started, would have saved me a lot of time. Well done and thanks for everything I learned from you.

    Tiago Magalhaes

    • Roger Montgomery
      :

      Hi Tiago,

      Thank you for your very encouraging post. You will be competing against university graduates who have sacrificed the beach and ski resorts and have a bachelors or masters degree or even more! But enthusiasm counts so if you can get a bachelors or grad dip in finance or economics or business that will be the start. Its not going to be easy and you will have to start at the bottom, unless your results indicate you are the brightest of your peers. Talk to Kaplan, Finsia and AFMA. I hope that helps Tiago.

  14. Mike
    :

    QBE is a quality business, and sometimes you have to be prepared to pay above intrinsic value for quality. I’d buy QBE under $20 any day.

    • Roger Montgomery
      :

      Hi Mike,

      Thanks for sharing your bullish enthusiasm Mike. Everyone reading should know that neither I nor Mike are making a recommendation. Be sure to seek personal professional advice before doing anything.

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