It’s always important to monitor the macro-economic environment of your investments. Otherwise strong businesses can sometimes be disrupted by unforeseen headwinds that are completely outside of a given company’s control. This has certainly been the case with the ongoing coronavirus pandemic, and the world’s mitigation efforts to counter it. When we did an overview profile of insurance company Chubb Limited (CB), we had identified what we determined to be a blue chip business within the insurance sector. We came to that conclusion after reviewing the company’s operating metrics and financials. And while there is still a lot to like in Chubb Limited, the macro-economic environment has become increasingly unfavorable for Chubb Limited. Because of this and where shares currently trade, we now see limited upside in Chubb Limited as a holding for the time being.
To view our initial coverage of Chubb Limited and an overview of the complete business model, please see the article HERE.
Less Upside, More Risk
Insurance companies have two primary mechanisms of generating profits. The first is by selling policies and other insurance products and collecting the monthly payments (premiums) from its customers. The second mechanism is that an insurance company pools those premiums into an investment portfolio to generate investment income. The investment portfolio is where we see growing risk in Chubb. This isn’t to say that there is fundamental danger in Chubb, but we see headwinds ahead that will make Chubb less profitable because its investment portfolio will struggle.
The first aspect of this, is the low interest rate environment that we currently operate within. Insurance companies invest in conservative instruments because they cannot afford to risk the capital should it be needed to payout policy claims. These conservative instruments often include treasury bonds, mortgage backed securities, etc. When interest rates and yields are low, there is less return on these investment instruments for companies such as Chubb.
We can see that rates and yields have steeply fallen since the pandemic, and this will drive lower returns on these types of investments. Chubb has little exposure to treasuries, but broad exposure to various borrowing entities. For example, Chubb places a third of its portfolio into US Corporate bonds. The prime rate influences the rate at which corporations can borrow, so a lower prime rate is also a negative impactor on investment income.
source: Chubb Limited
The other aspect where we see increasing risk, is the economic disruption caused by the pandemic and the trickle down effect that is occurring. Mitigation efforts to contain the virus have people sheltered in their homes, and economic activity has halted overnight in various sectors. While Chubb’s portfolio is mostly composed of high quality assets, credit ratings can’t fully account for a sudden systemic economic shock like what is taking place. Some projections are calling for double digit unemployment across the US, and record setting contractions of GDP as a result. Depending on what type of sectors Chubb is invested in, it could expose these bonds to elevated risk as many types of corporations are poised to see operating results rapidly deteriorate in the quarters ahead.
Valuation Isn’t Quite There Yet
The market has recognized these headwinds, and shares have been hammered throughout the market crash in March. The stock has fallen from a 52 week high of $167 per share, and is now trading at $104. This price is actually below our previously noted potential entry point of $119/share.
However, the environment that Chubb is operating in has fundamentally changed. As a result, we are looking for a larger margin of safety. Analysts are projecting 2020 EPS of $10.92, resulting in an earnings multiple of 9.56X. This is a 23% discount to the stock’s 10 year median PE ratio of 12.49X, but with the increased risk and lower rate environment, we would like to see the stock drop a bit further.
If we look at Chubb’s price/book value, we see that while we are off of decade highs – there is still room for downward momentum. The current crisis we face is similar is severity to the financial crisis a decade ago, yet price/book hasn’t yet fallen to a similar level.
If shares were to come down another 15%, it would place shares at a price/book not seen since we were coming out of the financial crisis. This would mean a potential entry price of $88-$90 per share. We would also have a resulting earnings multiple of just over 8X, which provides a large margin of safety to insulate investors from increased risks in Chubb’s investment portfolio. Insurance companies such as Chubb are typically slow growing entities, so valuation becomes a crucial factor in long term total returns. While our target entry price represents a steep drop from highs, we feel that it’s necessary to account for both the company’s modest growth trajectory as well as increased risks associated with the company’s investment portfolio going forward.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.