Share tip of the week: high-quality insurance giant

published 12 February 2010

A major indicator that the FTSE might plummet again is a strengthening dollar. Over the past month the dollar has broken through two key resistance levels against the euro and sterling. So for now I prefer high-quality firms with sound balance sheets and a cheap share price.

Enter Aviva, the world's fifth-largest insurer. The firm derives around 70% of its income from outside Britain and so will benefit should the pound lurch down again. The group's main activities are long-term savings (80% of sales) and general insurance (20%). These are all made under the Aviva brand name after the firm ditched smaller ones, such as Norwich Union, last year.

Unlike some rivals, Aviva did not have to resort to a rights issue to boost its capital base during the credit crunch. It started 2009 with £2bn more capital than the minimum regulatory requirement. By December that had been boosted to a hefty £4.5bn, thanks to a bounce in corporate bonds, the disposal of its Australian life business for £450m and the flotation of Delta Lloyd (58% owned) for gross proceeds of £1.03bn. Moreover, there is another £1.1bn stashed away as a rainy-day fund in the form of a default provision against its UK annuity book.

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Aviva's CEO, Andrew Moss, updated the City last week, saying that fourth-quarter 2009 life and pension sales had jumped an impressive 21% over the previous quarter. Despite being hit by £100m of losses from the autumn flooding, I estimate the firm's year-end embedded value (the main measure of profitability across the industry because it adjusts net assets for the expected long-term returns on policies already written) to be about 530p a share. After being cut by a third, the dividend should come in at 21.7p. That offers income-seekers a 5.5% yield.

Aviva plans to exploit its immense scale by cross-selling products in different territories and by closing offices and making redundancies in order to reduce its overheads by another £261m a year. Reassuringly, Moss said that he is "cautiously optimistic" that the worst is behind Aviva, which "starts 2010 in a strong position". Analysts have pencilled in 2010 and 2011 underlying earnings per share (EPS) of 66.0p and 72.5p. This puts the stock on a price/earnings (p/e) ratio of less than six.

However, with the stock already trading at a 30% discount to embedded value, these concerns are more than priced in. Indeed, if the markets dive again, I could even see the group benefiting as institutional investors scale back risk, dump hedge funds and migrate to cheaper, less volatile and more transparent fund managers. Keefe, Bruyette & Woods has a target price of £6.28 with preliminary results due out on 4 March.

Paul gained a degree in electrical engineering and went on to qualify as a chartered management accountant. He has extensive corporate finance and investment experience and is a member of the Securities Institute.

Over the past 16 years Paul has held top-level financial management and M&A roles for blue-chip companies such as O2, GKN and Unilever. He is now director of his own capital investment and consultancy firm, PMH Capital Limited.

Paul is an expert at analysing companies in new, fast-growing markets, and is an extremely shrewd stock-picker.