AFG - Buy American Financial Group While On Sale

2023-06-07 08:10:39 ET

Summary

• American Financial Group (AFG) is a good investment opportunity due to its conservative underwriting, profitable investing, premium growth, productive M&A activity, and strong management with healthy insider ownership.
• AFG stock is currently undervalued, with a P/Core EPS ratio lower than its historical average and a potential for 26% appreciation plus a 7% yield by the end of the year.
• AFG is a less risky option compared to other insurers, with its decentralized underwriting, modest leverage, and high insider holdings, making it a strong buy recommendation.

A big part of my portfolio, even not counting Berkshire Hathaway ( BRK.A ) ( BRK.B ), is invested in insurers. Several, such as Progressive ( PGR ), Trisura (TSU:CA), and UnitedHealth Group ( UNH ), have delivered outstanding results. Others have performed in line with the index. None has failed.

The trick is identifying a good insurer (more about it later) and waiting until it is on sale. This is the best we can do to follow Buffett on a micro-scale.

The opportunity appears open now with specialty insurer American Financial Group ( AFG ).

What is a good insurer?

We will focus here on the property and casualty (P&C) industry only. There are several tests to identify a good insurer.

1. It should be a superior underwriter over many years. Quantitatively it means different combined ratios for different subindustries but below 100% almost every year.

2. Prior years' reserve development should be favorable as a rule. Since the ultimate cost of underwriting becomes known many years after, conservative reserving instills confidence in accounting.

3. Growth measured in either Gross Premiums Written ("GPW") or Net Premium Earned ("NPE") should be palpable over a multi-year period. I prefer to see a CAGR of at least 5-6%. as it helps to filter out overly conservative companies.

4. Investment results should be better than plain investment-grade bonds. It implies holding a reasonable amount of equities, alts, and/or non-insurance subsidiaries. This is not so important for insurers growing very quickly.

5. Management and insiders should be investor-friendly and aligned with outsiders holding material stakes in the company.

These tests are necessary but not sufficient. AFG passes all of them, but every case requires specific consideration.

American Financial Group

I published about it half a year ago - " American Financial Group: Superior Fundamentals May Be Reflected In The Price " ("previous post"). I will skip the company's description (you can find it in the previous post) but for your convenience, I will sum up its important points.

AFG has delivered an IRR of 20%+ consisting of price appreciation, common dividends (growing every year for the last 17), and unusually high and regular special dividends payable 1-2 times per year. Its success can be attributed to 5 factors:

1. Conservative underwriting. As I mentioned, this is a mandatory condition to hold any mature insurer. The low combined ratio is expected to be sustainable because the underwriting decisions are made independently in 35 niche unrelated groups. It is unlikely that underwriting prowess will deteriorate in many groups simultaneously.
2. Profitable investing. AFG manages investments in-house and achieves strong returns primarily due to alternative investments consisting of real estate, private equity, and private debt (~$2B in alts of the ~$14B portfolio). The alts are delivering disproportionately high net investment income - about 50% in both 2021 and 2022. About half of the alts are multi-family properties.
3. Premium growth. It was achieved every year since 2012 with the only exception of 2020 due to the pandemic. NPE's average annual growth rate is slightly above 8%. The management continues to forecast consistent growth. At the end of 2021, AFG acquired a small fintech which is expected to form the core of the 36th underwriting group.
4. Productive M&A activity. The company buys and sells underwriting groups regularly attempting to optimize the mix. The divestment of the annuity business in 2021 for P/B ~ 1.34 was a clear success. At the same time, it allowed AFG to focus on a more promising P&C business.
5. Strong management coupled with healthy insider ownership without supervoting stock. AFG was founded by Carl Lindner, Jr. and his two senior sons serve as co-CEOs for 17 years. Altogether, the family owns more than 20% of the stock.

All the items above remain unchanged.

What has changed?

Several favorable for investors events have occurred since the previous post. Most importantly, the stock has dropped despite strong results. At the time of the previous post (December 2022), the stock was trading above $130. Currently, its trading range is $112-115. This drop, most likely, is attributable to general pressure on financial stocks even though it is not justified in the case of AFG. Let us check its current valuations.

AFG reports 2 metrics for its EPS: GAAP EPS and Core EPS with the main difference being an adjustment for realized and unrealized capital gains. This makes Core EPS a more consistent figure to gauge the results (please note that on average GAAP EPS are higher than Core EPS due to capital gains). Over the last 10 years, Core EPS have grown at 13.5% annually. Since the company expects $11.50 at mid-range in 2023 and regularly beats its forecasts, its P/Core EPS ratio is close to 10. First, this ratio is lower than the Core EPS growth rate. Secondly, it is lower than the average historic ratio of 12.6 with a standard error of 1.9. This makes AFG very attractive from the valuation standpoint.

In Q1, the company announced the acquisition of Crop Risk Services from AIG. AFG has its own significant Crop Insurance segment (comparable in size to the one being acquired), knows the business very well, and is virtually guaranteed to harvest synergies. The closing is expected in Q3, and AFG forecasts accretion from 2024. In 2025, this accretion will stabilize with incremental EPS of $0.40-0.50 per year compared with holding funds in the investment portfolio. Since the net purchase price is ~$210M, AFG has 85.3M shares, and bonds generate about 5% today, the expected ROIC is ~23%.

After paying regular dividends and retaining the capital needed to support its business growth, AFG generates excess capital which is returned to investors in the form of special dividends and/or shares repurchases. For the last three quarters of 2023, the company expects to return about $500M or ~$5.90 per share to investors.

Normally, this return is mostly in the form of special dividends. This year it might be different because of the low stock price that makes buybacks very lucrative. In any case, besides the regular yield of 2.2%, the total capital return might generate another $5.90/115 ~ 5% for the rest of 2023 (the company also paid a special dividend of $4 per share in Q1).

AFG is a growing, cheap, and high-yielding stock simultaneously!

Conclusion

If we assume a P/Core EPS ratio of 12.6, the stock should be trading at 11.50*12.6 ~ $145 in late 2023 or early 2024. It translates into 26% appreciation plus ~7% in yield. After that, the stock should continue delivering returns of about 19-20% in line with its historic results (5-6% in yield plus ~13.5% in Core EPS growth).

I do not see any special risks for the stock compared with other insurers. Quiet on the contrary: AFG seems less risky than many other insurers because of its conservatism, high insider holdings, decentralized underwriting, and modest leverage with mostly very long maturities. Of course, every insurer can experience elevated combined ratios from time to time (even though AFG's highest combined ratio for the last 10 years was 95.4% back in 2012!) but this statement is generic rather than specific. Still, I should mention two items unique to AFG.

First, its combined ratio has improved over the last three years when it became noticeably lower than the long-term average. It may be caused by a favorable insurance market and/or related to better underwriting and growth in scale. The conservative management keeps forecasting strong underwriting.

Secondly, alt returns have more volatility compared to fixed income. However, based on alt managers' results, in particular, on transparent Apollo's ( APO ) Athene ( ATH ), equity-like alts, similar to AFG's, generate 11-12% on average. I do not consider it a real risk.

In December 2022 I rated the stock as "Hold". Now it is a buy.

AFG is not a popular stock. Since I published about it half a year ago, there has been only one other publication on SA. I consider it a strong positive. Not many retail investors are attracted by boring insurers as the excitement and element of gambling seem missing.

To finish I would like to pose a couple of questions for my readers. AFG yield (counting both regular and special dividends) is higher or at least comparable with the yield generated by REITs. However, REITs are extremely popular on SA while AFG is not. Why is that? And why Buffett holds a lot of P&C assets but is virtually not exposed to REITs?

For further details see: