Alternative Investment

3 Reasons To Buy American Financial Stock (NYSE:AFG)

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Introduction

Insurance companies are a solid business. I found another interesting insurance company that has made a lot of profit in recent years. I’m talking about American Financial (NYSE:AFG). Their earnings growth is well reflected in their share price. If an investor were to buy his shares 20 years ago, he would be sitting on a nice annual return of 15.4%. So, the question is: are the shares still attractive?

Chart
AFG Total Return Level data by YCharts

American Financial thrives during higher interest rates thanks to its bond and alternative investment portfolio. American Financial stock is a buy because:

  1. The earnings per share are expected to increase in the coming years.
  2. The valuation is favorable.
  3. An upcoming share repurchase program or special dividend is expected.

About The Company

American Financial was founded in 1872 and provides property and casualty insurance products in the United States. Among American Financial’s products are property and transportation insurance, specialty casualty insurance, and specialty financial insurance.

Most of its gross premiums come from Specialty Property & Casualty operations. Its four business segments are doing well.

Specialty Property and Casualty Insurance - AFG Investor Relations

Specialty Property and Casualty Insurance (AFG Investor Relations)

Quarterly Results Were Outstanding

Second quarter results were excellent. The company reported a core year-over-year return of 21% and delivered double-digit premium growth (11%) compared to last year.

Financial Highlights - AFG Investor Relations

Financial Highlights (AFG Investor Relations)

Property and Casualty combined ratio improved by 2.1% compared to last year. The higher property and transportation combined ratio was the result of higher catastrophic losses and lower favorable development. The Specialty Casualty group improved their combined ratio by a strong 7.8%. The company has good control of losses and costs

Combined ratio

6/30/22

6/30/21

Property and Transportation

92.4%

86.6%

Specialty Casualty

80.1%

87.9%

Specialty Financial

78.4%

86.4%

Other Specialty

114.6%

103.2%

Combined ratio – Specialty

85.8%

87.9%

The company increased their full year 2022 core operating earnings guidance to $10.75-$11.75.

Rising Interest Rates Are Beneficial For American Financial

American Financial invests its income primarily in fixed maturities such as bonds. Approximately 69% of their investment portfolio is allocated to fixed maturities. About 7% of the portfolio is made up of equities and the rest of the portfolio is considered alternative investments.

Higher interest rates are beneficial to the bond portfolio and the alternative investment portfolio. Newly issued bonds are issued at a higher yield, so the investment income from bonds is higher. However, the value of bonds decreases as interest rates rise further. But that’s not a problem for American Financial as they are held until maturity.

The alternative investment portfolio benefits greatly from higher interest rates. The company expects an overall annual return of 10%-12% on alternative investments, including strong performance from multi-family investment. Investments linked to multi-family housing represent approximately 55% of the alternative investment portfolio

Total Cash and Investments - AFG Investor Relations

Total Cash and Investments (AFG Investor Relations)

The fixed-maturities portfolio consists of corporate bonds (17%), which make up the bulk of the bond portfolio. Corporate bonds have a higher yield than the much safer US Treasury bonds, which is good for the company’s earnings, but also carries a slightly higher risk. Over 91% of their fixed-maturities portfolio is investment grade (BBB or higher), so there’s not much to worry about. The annualized yield is 2.99% and the average maturity of the bond is 4 years. Due to the short average maturity of the bonds, the company is well positioned for interest rate hikes.

Fixed Maturities - AFG Investor Relations

Fixed Maturities (AFG Investor Relations)

Share Repurchase Or Special Dividend Expected

From its second quarter transcript, American Financial hinted that they could initiate a shareholder repurchase program or pay a special dividend with the excess cash they have after the sale of their Annuity business. I cite Stephen Craig Lindner:

While all of AFG’s excess capital is available for internal growth and acquisitions, based on assumptions underlying AFG’s current guidance, we still expect to have $400 million to $500 million of excess capital available for potential share repurchases or additional special dividends through the end of 2022 while staying within our most restrictive debt to capital guideline.

American Financial’s market cap is $11 billion, so the buyback yield (or special dividend yield) will be about 4%. The share repurchases should drive their share price up. The company pays a common dividend of $2.24, which at current stock price translates to a dividend yield of 1.7%. The company has been paying dividends for more than 10 years.

What about its valuation? The PE ratio is currently 11, which is lower than the average PE ratio of the past 10 years (average PE ratio is 12).

Chart
AFG PE Ratio data by YCharts

The share price is valued below the 10-year average PE ratio, while earnings per share are expected to grow in the coming years. This is a favorable combination. Three analysts estimate earnings per share will be $12.24 in 2024. EPS multiplied by the average PE ratio of 12 and we arrive at a share price of $146 (up 14% excluding dividends). It’s hard to guess what American Financial will do with their excess capital (special dividend or share buybacks), but keep in mind that the stock price is attractive, and earnings are expected to grow. You can expect a good return from this share.

Conclusion

Founded in 1872, American Financial provides property and casualty insurance. The company offers property and transportation insurance, special accident insurance and special financial insurance. These four business segments are doing well. The core annualized return was 21% and premium growth was overall 11%.

American Financial is benefiting greatly from higher interest rates in their fixed-term and alternative investment portfolios. Fixed maturities make up about 69% of their investment portfolio. Newly issued bonds generate more investment income in a higher interest rate environment. The average maturity of their bonds is only 4 years, which is beneficial for American Financial as they can reinvest at higher rates. The company and analysts have therefore raised their expectations and expect earnings per share growth in the coming years.

The company still has $400-$500 million in excess cash available after the sale of their annuity business. This will be paid to the shareholder through a special dividend or share repurchase program. The PE ratio is currently lower than the average 10-year PE ratio of 12. Analysts expect earnings per share to be $12.24 in 2024, at the average PE ratio, the share price should be $146 (an increase of 14% excluding dividends). Earnings per share growth, favorable valuation and shareholder-friendly management make AFG stock a buy.

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