In my opinion the main risk to NWLI stockholders is time. I see the company as earning a subpar ROE, somewhere in the neighborhood of 5-7%. Let's say the fair value for this company is 0.7x book value. That would represent a significant gain and still be somewhat cheap at 10-12x earnings. However, its important to realize how quickly you can get behind in a company that can only grow its book and earnings at 5-7% per year. Certainly buybacks would greatly help as it instantly boosts the return on capital but I think its unlikely at this point. I believe the current valuation provides a great margin of safety, but perpetually invested capital at low returns is exactly why the company trades at its current valuation
I appreciate your theory about how NMLI's price is determined based on an expected return on equity. However this is not always how prices are determined. Please look at the financials of AMZN and CHTR and explain to me how they are priced based on their return on equity. I prefer to believe that the current market is irrational as to how it prices insurance companies in general and NWLI in particular. I personally do not think the era of ultra low interest rates will last forever. I should also point out that a 5-7% roe is quite generous compared to the returns on government securities, CDs, and money market funds.
Return on Equity is certainly not appropriate for all businesses, AMZN clearly being one of them as its valuation relies on aggressive growth assumptions. Some companies, such as DTV, have negative book values but clearly have strong economic value. In NWLI's case, you're buying at a price significantly below book value so if ROE doesnt rebound you should still expect returns north of 5-7% but my point is that NWLI may not be as cheap as it seems. I think the historical ROE for NWLI is about 8% and I think that would warrant a valuation of 70-80% of book value. Ideally, a company thats earns a subpar return should return a large portion of the earnings to the shareholder through dividends or buybacks, but thats unlikely to happen in this case.
low ROE is a near term concern in my view - i think your 5-7% is too low, i believe it's more on the order of 6-7.5%. i think to get above 7.5% we will need to see the 10 year at 2.50% or higher. But i think if we we do see the 10 year at 2.5-3% at the end of 2013, the stock is going to start trading at .7x book value which is going to be 100 points higher.
Interest rates are the big issue. In the near term the challenges are very significant as the rates that they can reinvest at are significantly below their average yield (3.27% vs 4.97%). I hope that theyve made enough changes to the policies that theyre writing to earn a decent return even if rates persist (which i dont think they will for very long). The challenge in a dropping portfolio yield was certainly seen in this last year as pretax investment income( excluding derivatives) only increased $8.5 million even as invested assets(at cost) rose by more than $750 million as the average yield dropped from 5.33% to 4.97%.
As far as ROE GOES, proforma 4th quarter operating earnings give us 24.80 a share annualized. At 3rd quarter book value of 376.47, that equals an ROE of about 6.6%. In my opinion, its likely that this number will continue to drop somewhat given the sharp difference in newly invested vs existing yields. One thing to keep an eye on is the "hidden" book value, the amount by which fair value exceeds amortized cost. When fair value exceeds cost, it indicates that the company is earning more from its investments than it would get in the current market and average yields will be forced downwards. I dont think nwli is a poor investment but i think it will be very challenging for them if interest rates dont start to rise soon