When disaster means opportunity

The disastrous earthquake that struck Japan on Friday is – above anything else – a humanitarian catastrophe. My thoughts go to anyone affected.

But The Right Side is about investment. And my job today is to look at what’s happened from a business angle.

There’s no doubt that – with this latest disaster following hot on the heels of the Chilean and New Zealand quakes – it’s been a terrible start to the year for the insurance industry. And that could well be affecting you and your money…

See, my favourite insurer Amlin (ticker: AML), which I tipped just a month ago, took a 5% hit as news of the quake emerged on Friday. As I write it’s down another 2% today.

So in terms of profit/loss on the trade, we’re straight back to where we started.

But as bad as it looks, I want to show you how this is precisely what some insurers thrive on – it’s why they’re in business after all.

I want to show you a way of assessing companies that strips out the short-term effects of random disasters. It allows us to see value where others get frightened away. This is an important quality for any serious contrarian investor.

So let’s look a little closer at Amlin…

Buy at the bottom of the cycle

Amlin took the first two quakes in its stride. But with the Japanese quake likely to cost over £20bn to put right, the share price has taken a detour from its amazing 10-year + run. As you can see from this chart, this excellent stock (blue line) has trounced the FTSE (red line) over the long term.

Amlin Vs FTSE 100 since 2000

Amlin Vs FTSE 100 since 2000 

But what’s the Japan situation going to mean for the company?

Let’s say that Amlin is on the hook for £200m from the latest quake. You may think that should take £200m straight off its stock market valuation. But that would be an over-simplification.

That’s because we don’t generally value companies by net worth. Not unless it’s a property company, or investment trust – i.e. something where book value is the main criterion for buying the company.

The vast majority of companies are valued on a multiple of future earnings – you know, the price to earnings or p/e.

And the important point here for Amlin is that – if history is anything to go by – this string of natural disasters will enhance future earnings.

I’ve got 15 yrs of experience with Amlin. I know that disasters come around from time to time and when they hit, the share price takes a temporary lurch into negative territory. But that leaves an opportunity…

Disasters are what this company thrives on. And over the medium term this is good for business.


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Three reasons I reckon things will turn out all right for Amlin

First, everyone in the industry knows that premiums will go up to pay for these calamities. Businesses and individuals in high-risk quake regions will face steep hikes in premiums. That’s why premiums in flood areas often skyrocket after a major flood, even right here in the UK. Higher premiums are good for Amlin.

Second, these disasters ram home the importance of re-insurance. That’s where insurance companies pay a premium to off-lay their risk on to other insurance companies. Just imagine if a local insurance company in Christchurch, NZ hadn’t re-insured these types of risks. They could quite easily go bust as claims go through the roof – that would be an even bigger disaster for the locals.

Small insurance companies will increasingly be forced to hand over some of their profits to the big boys for underwriting major catastrophe risks. And Amlin will be well covered in this regard.

Third, less-established competitors will crawl back under a stone. The insurance business tends to work in cycles. Things go well for a while, then suddenly freak events crop up. Don’t ask me why, but catastrophes, like London buses, all come along at once.

During the good times, loads of insurers crop up to take advantage. Then at some point (like now) they’ll end up with a bloody nose – they’ll skulk back to whence they came. That leaves the big boys like Amlin with the market to themselves.

But are these insurance companies cheap?

The best way to value businesses with volatile earnings

Clearly earnings in this sort of business are going to be volatile and forecasting profits is nigh on impossible.

The best thing to do is to take a long-term approach. Instead of using the price earnings ratio to value the business, we use something called Cyclically Adjusted Price Earnings (CAPE).

It was developed by Professor Robert Shiller of Yale University. He came up with a simple, but effective idea…

Instead of using just one year’s earnings to value the business (as with a standard p/e ratio), we take the average earnings over the last ten years – which we’ll assume is close to one business cycle…

Amlin’s earnings per share over 10 years

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

45

94.1

17.1

66.3

50.4

33.6

23.4

21

11.8

-34.2

Amlin actually made a loss in 2001 – which would normally mean you can’t use a p/e ratio (as there are no earnings). But in this case it doesn’t matter. If we sum all the earnings (and losses), we end up with a total of £3.28 in earnings per share over 10 years.

So on average, earnings came in at 32.8p each year. With the shares at £3.80, CAPE is 11.5 times (3.80/32.8 = 11.58).

That looks cheap – remember, the lower the p/e, the cheaper the business. The FTSE 250 trades on over 17 times with an average 2.4% dividend yield.

So, to me – with a cyclically adjusted 11.5 times earnings and offering a juicy yield of nearly 6% – things look good for Amlin.

Don’t worry about short-term effects of disasters on large insurance companies. The market’s knee-jerk reaction is usually overdone. In the long run, earnings will smooth out. And anyway, today’s disaster could be the very foundations of a stronger business for tomorrow.

If you took my advice and bought Amlin last month, you’ll have enjoyed a nice run-up since then. Unfortunately with Friday’s news, we’re back to where we started.

But don’t worry – this is a great stock for the long-term. I’m sure she’ll be back to her winning ways soon enough.

• This article was first published in the free investment email The Right side. Sign up to The Right Side here.

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Your capital is at risk when you invest in shares – you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.

Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.

Managing Editor: Frank Hemsley. The Right Side is issued by MoneyWeek Ltd.
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