For big income, buy this sector

The St Jude’s Day storm really rattled southern England. In the end it didn’t quite live up to the hype, but it sure got people talking. And this week, insurer RSA announced that it’s taking quite a hit from the destruction caused by St Jude. The shares promptly fell 8%.

But these sorts of things need to be taken in context. This is the insurance game, after all. Like the newspapers, it looks like the market has overreacted to the storm.

In fact, what usually happens is premiums tend to rise after these sorts of events. The long-term effect of a catastrophe really isn’t quite as horrific as it first seems – at least, not for the industry.

And I for one quite like the insurance sector. Today, I’ll show you why.

The best bit of the financial sector

I’m not a big fan of the financial sector – especially not the banks. But I do like to have a toehold in most sectors. And the insurance industry isn’t a bad area to be involved in.

The sector is full of income plays, and in terms of valuation, it isn’t very expensive. Trading on 12 times earnings, it’s a little bit below the market average of 14 times. In fact, in the case of RSA, the insurer is now left trading at ten times this year’s prospective earnings, while paying a 5% yield.

But, as this week’s announcement by RSA shows, the insurers are exposed to catastrophes. Even though in the scheme of things, October’s storm really wasn’t a biggie.

And to my mind, the announcement of profit downgrades is often the best time to buy. The City boys go frantic for a while. It’s almost as if it’s their job to react (or should I say overreact?) to market news. But things have a habit of calming down.

Here’s one we looked at earlier

Insurance is a cyclical industry. You just can’t get away from that. During the good times, premiums tend to rise. Things go well for a while. But then the insurers start to get greedy – they want to win more market share, so competition drives down premiums. Of course, I’m not talking about your household premiums – those always seem to go up! I’m really talking about the commercial side of the business.

And when disaster strikes, they always seem to strike together. Take 2011…

Back in 2011, I introduced readers to one of my favourite insurers, Amlin. At the time it was trading at around £4 and yielding over 5%. Not a bad income play, and the shares had been growing very well for the last decade. Solid stuff!

But no sooner had I mentioned the sector than the gods turned against me. 2011 turned out to be the insurance industry’s annus horriblis.

A Japanese tsunami, a major earthquake in New Zealand, flooding in Thailand. That was just in the East! In the States, Hurricane Irene added to the massive destruction caused by freak tornadoes and all sorts of other freak weather conditions. Europe didn’t escape either, where conditions nearly submerged Denmark.

Amlin took a pasting, ending the year at under £3.

But the industry – and the stock – subsequently bounced back. In fact, I’ve got an interesting chart to show you. It’s a summary of Amlin’s key figures over the last five years, with forecasts for the next two.

Now, the first thing to look at is the red box I’ve highlighted. It shows Amlin’s earnings per share (EPS).

Amlin share fundamentals

(Source: Digitallook)

The EPS figures have been up and down like a dog at a fair!

Take 2009, when Amlin reported earnings of 94 pence per share. That’s an amazing income for a stock which traded at about £2.50.

But then there have been horrors too. In the previous year, earnings were only 17p, while 2011’s travails saw the business lose a whopping 30p per share.

There is no doubt that this is a volatile game!

But that’s not really what matters. The most important thing to investors are the figures I’ve highlighted in the green box. That is the dividend – your income.

Just look at how Amlin has consistently raised its dividend throughout the period. Even in 2008 when the business only generated 17p (per share) in profit, it paid out every penny of it as a dividend. Even in 2011, when the company lost 30p per share, the dividend was maintained at 23p.

This is what long-term investing is all about. Solid companies that gradually grow profits over time and grow your income stream. Sure, there will be catastrophes, but that’s no reason to lose sight of your long-term goals.

For RSA, the St Jude’s Day storm was, as they say, a storm in a teacup. It’s not a good reason to dump the stock. That said, like any other business, insurers are not immune to messing things up, even without the ‘hand of God’.

RSA’s management is struggling to keep hold of the reins. Many in the City want to see the CEO out on his ear. The dividend has been cut and problems seem to be cropping up in many different areas of the business.

These are things that should rightly concern investors in the insurance sector, as in any other. But catastrophe is no reason to sell. If anything, it’s a reason to buy.

Next week, I’ll show you an interesting way into the sector.