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- By Ben Reynolds
The Travelers Companies (TRV) is one of the 6 best dividend-paying insurance stocks. It is one of the 30 stocks of Dow Jones but, surprisingly, it passes under the radar of most investors, probably due to its "boring" business model. But the company has a rock-solid fixed-income portfolio, which generates 70-80% of its total earnings.
In other words, a great portion of the earnings of the insurer are completely secure. Thanks to this defensive feature and some other characteristics, investors should put Travelers on their radar and wait for an opportunity in order to purchase this stock with a long-term horizon.
Travelers offers commercial and personal property and casualty (P/C) insurance, with annual revenues around $30 billion. This type of insurance has some particular characteristics and hence investors should be extremely careful in order to avoid investing disasters.
First, in favorable years, with few natural disasters, some insurers may thrive even though they do not price the actual risks of such disasters adequately. They can attract many customers by lowering their prices and keep posting great profits, in the absence of major disasters. However, when a rough year shows up, with many catastrophic losses, it affects severely the insurers that have not priced the actual risks. Therefore, a disciplined underwriting policy is paramount in P/C insurance. It is thus critical for investors to examine the growth record of a P/C insurer for at least a decade before purchasing its stock.
Travelers follows a disciplined underwriting policy and thus it has exhibited decent earnings growth during the last decade. If it meets our earnings-per-share estimate around $11.00 this year, it will have grown its earnings per share at a 5.7% average annual rate in the last decade. While this growth rate may look disappointing on the surface, investors should realize that interest rates have remained suppressed during the last decade and thus they have provided a strong headwind to Travelers, which generates most of its earnings from its fixed-income portfolio.
Travelers has a fixed-income portfolio of approximately $70 billion. In 2018, this portfolio had an average after-tax yield of 2.6% and thus it generated $1.78 billion in annual earnings. Given the share count of about 263 million shares, Travelers generated earnings per share of $6.77 (76% of its total earnings per share) from its fixed-income portfolio.
As 97.7% of these bonds are of investment grade and have an average duration of four years, they can be considered essentially risk-free. To cut a long story short, Travelers generates a great portion of its total earnings from its entirely secure fixed-income portfolio.
The insurer generates the rest of its earnings from its non-fixed income portfolio, which currently has a much higher after-tax yield (6.1%) than the fixed income portfolio but has wider variation in its performance.
Travelers has been adversely affected by the suppressed interest rates of the last decade. While interest rates have risen in the last two years, they are still at low levels from a historical point of view. The Fed has paused its interest rate hikes lately in order to make sure it does not hurt economic growth. If the Fed resumes its interest rate hikes, it will provide a strong tailwind to Travelers. Overall, it is reasonable to expect at least 6% annual earnings-per-share growth from Travelers in the upcoming years. This growth rate is in line with the 10-year average growth rate of the company.
Dividend and share repurchases
As Travelers has rallied 30% off its bottom in the Christmas sell-off, it is now offering a lackluster 2.2% dividend yield. The company has an interesting dividend record, however. It has paid a dividend for nearly 150 years and has raised it for 15 consecutive years. Moreover, it has raised its dividend at a 9.1% average annual rate in the last decade.
In addition, Travelers has repurchased its shares aggressively in the last decade. In the last nine years, it has reduced its share count by 49% or at a compounded annual rate of 7% on average. As a result, share repurchases have been a major growth driver throughout the last decade.
Moreover, the aggressive share repurchases have enabled the company to raise its dividend at a fast clip without increasing the financial burden of the dividend, as the latter is distributed to fewer shares every year. To provide a perspective, while the annual dividend per share almost tripled, from $1.04 in 2006 to $3.03 in 2018, the annual amount of dividends paid to the shareholders increased only 12%, from $724 million in 2006 to $814 million in 2018. It is thus evident that Travelers has been able to almost triple its dividend in the last 12 years without being financially burdened from this shareholder-friendly policy.
Unfortunately, there is a caveat on the shareholder-friendly policy of Travelers. In late 2015, its previous CEO, Jay Fishman, retired due to health issues. Under his tenure, Travelers repurchased its shares aggressively and raised its dividend at a double-digit rate while it also achieved strong growth of earnings per share. Unfortunately, since the company changed its CEO, it has remarkably slowed its share repurchases and its dividend growth rate. The share count has decreased only 2.5% per year on average in the last two years while the dividend has risen only 6% per year in this period.
As the company has a rock-solid balance sheet and income portfolio and a low payout ratio (30%), it is unclear why the new CEO has shifted to a less shareholder-friendly policy. It is also remarkable that the stock tends to trade at low price-earnings ratios. Hence, its share repurchases greatly enhance shareholder value, as a given amount can repurchase more shares. Overall, it is prudent to expect slow share buybacks and mid-single digit dividend hikes under the new management team.
Due to the market's stance towards P/C insurers, Travelers has traded at markedly low price-earnings ratios most of the time. The stock is currently trading at a forward earnings multiple of 13.2, which is higher than our estimated fair level of 11.0. If the stock approaches our fair valuation level over the next five years, it will incur a 3.6% annualized drag in its returns.
Given all the above, we expect Travelers to offer an approximate 4.6% average annual return over the next five years, thanks to 6.0% annual earnings-per-share growth and its 2.2% dividend, which will be partly offset by a 3.6% annualized contraction of its valuation level.
Travelers is an exemplary P/C insurer, which follows a strict underwriting policy and thus has a decent growth record. The company is also exceptionally defensive, as it generates the vast majority of its earnings from its investment-grade fixed income portfolio. If interest rates resume rising, they will provide a strong boost to the earnings of Travelers.
This is an important characteristic, which should provide relief to investors, as most stocks tend to sell off when the Fed raises interest rates. Nevertheless, as Travelers has enjoyed a 30% rally since the end of last year and is now trading near its all-time highs, at an elevated price-earnings ratio, investors should wait for a correction before purchasing this exceptional stock.
Disclosure: No positions in any stock mentioned.
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This article first appeared on GuruFocus.