Prudential (LONDON:PRU) plc recently announced its 2014 results so I thought I’d take another look at this popular and relatively defensive financial services company.
I think most private investors are vaguely aware of Prudential and what it does, but if not then a super-quick summary would be that Prudential is FTSE 100-listed insurance group, established over 150 years ago and today it consists of the following companies:
- Prudential Corporation Asia– providing insurance products to the fast-growing middle class
- Jackson National Life– savings and pension products for the US market
- Prudential UK– life insurance, savings and pensions for the UK market
- M&G– the group’s Investment management arm
I wrote about some of Prudential’s more recent history, both good and bad, in an article for the BullBearings website last summer.
In that article I thought Prudential’s shares, at 1,400p (June 2014), were probably close to fair value. In turn I thought that outperformance over the next few years would be no more likely than by chance alone.
Now that Prudential has published its latest results the picture has changed and my previous assessment needs to be revisited.
New annual results and more dividend growth
For 2014 the run of success which has characterised the company’s performance in recent years continued. Net asset value was up over 20%, basic earnings were up over 50% (from a weak 2013) and the dividend grew by 10%, on a per share basis.
That’s impressive in a single year, but Prudential has managed to achieve similar results for many years, as the chart below shows:
Using some key metrics from my stock screen, Prudential’s financial performance looks like this:
- 10-year Growth Rate of 10.7% (FTSE 100 = 0.8%)
- 10-year Growth Quality (consistency) of 75% (FTSE 100 = 54%)
- 10-year ROE = 18.5% (FTSE 100 ROCE approx. 10%)
So in terms of results Prudential is clearly an above average company in that it has produced market-beating progressive dividend growth, supported by equally rapid growth in earnings and net asset value.
A strong balance sheet
Life insurance balance sheets can be a bit of a nightmare to analyse for risks, or at least they are for me. After much spreadsheet-bashing I have found a reasonable correlation between a company’s ability to maintain its dividend in tough times (such as the financial crisis) and the amount by which it exceeds its minimum regulatory capital.
If you don’t know what “minimum regulatory capital” means, it’s to do with the strength of the company’s balance sheet.
In simple terms an insurance company’s balance sheet shows its assets (saved and invested premiums that will be used to cover future insurance claims) and its liabilities (expected future claims).
Regulatory capital is effectively the surplus of assets over liabilities, i.e. the company’s ability to pay those expected future claims, plus a few other things like “subordinated” debt.
Most insurance companies listed in the UK have to exceed certain minimum capital requirements, defined under either the EU’s Insurance Groups Directive (IGD – for insurance companies) or Financial Groups Directive (FGD – for financial conglomerates, e.g. companies that combine insurance and banking).
In my opinion only slightly exceeding the minimum regulatory capital is not enough.
History shows that insurance companies with only slightly more capital than the required minimum may meet their legal obligations, but they often have to cut their dividends or carry out rights issues to strengthen their capital positions when things get tough.
Both of those unpleasant actions were common after the dot-com bust and the financial crisis. However, some companies sailed through relatively unharmed.
As a general rule of thumb I’ve found that the insurance companies which avoided dividend cuts in the financial crisis had at least twice their regulatory minimum capital.
In Prudential’s latest annual results its actual IGD regulatory capital was 2.4 times its required minimum, so it meets that rule of thumb. It also has one of the most prudent balance sheets, by that measure, among the big insurers.
A reasonable share price, but it’s no bargain
When I last review Prudential in June last year its share price was 1,400p and I thought that was about fair value. Today its share price stands at 1,750p, which is 25% higher than before.
Unless the company has improved its underlying results by more than 25%, or unless the rest of the stock market has become more expensive even faster, it’s not looking good for Prudential as a value investment.
Here are my valuation metrics for the company relative to the market:
- Dividend yield of 2.1% (FTSE 100 = 3.4%)
- PE10 (price to 10-year earnings average) of 30.8 (FTSE 100 = 14.7)
- PD10 (price to 10-year dividend average) of 70.7 (FTSE 100 = 34.3)
To some extent I would expect a highly successful company like Prudential to have a premium price, but if the price paid is too high then future returns may be stunted, regardless of how good the underlying company is.
And that’s my concern in this case because Prudential trips up on a few of my other rules of thumb.
Prudential breaks too many of my investment rules of thumb
First of all I have six core metrics, three for quality or defensiveness (Growth Rate, Growth Quality and ROCE) and three for value (dividend yield, PE10 and PD10).
Generally I like the companies that I invest in to beat the FTSE 100 on at least four of those metrics. So sometimes the companies I invest in will be high quality with a reasonable valuation, and sometimes they will be medium quality with a low valuation.
Prudential beats the market on all of the quality/defensive metrics but none of the value metrics, so it is clearly a good company but the price just isn’t attractive (at least to me).
Another rule of thumb I have is to never buy any company where the PE10 ratio is above 30 or the PD10 ratio is above 60. From experience I’ve learned that those are reasonable cut-offs, beyond which I may be overpaying, even for a great company.
At its current share price Prudential breaks both of those valuation rules and so for me I would not invest at 1,750p, no matter how quickly it was growing.
The price I would buy at
So if I wouldn’t buy at 1,750p, or even 1,400p, what price would I buy at?
Given its current dividend and earnings history, Prudential would meet my rule of beating the market on at least one of my valuation metrics if its share price fell to 1,100p.
At that price it would have a dividend yield of 3.4%, equal with that of the FTSE 100 at 7,000. It would also have a PE10 ratio of 19.3 and a PD10 ratio of 44.5, both of which are within acceptable limits as far as I’m concerned.
For me that would be a much more attractive entry point.
Do I think it will ever get that cheap?
It’s seems unlikely unless the company runs into some problems, such as producing a year or two of zero growth. But while such a share price fall may be unlikely, it’s not impossible.
I thought Rolls Royce would be attractive at 800p in July 2014, when its share price was 1,045p. By October that share price “target” was reached, although of course that does not make me an oracle.
What it does mean is that even the best companies can trip up, fall out of favour and move from overpriced to underpriced in just a few months.
It also means that patient value investors would do well to have a watchlist of target companies and target prices, so that they are ready to make the most of opportunities as they arise.