When it comes to thinking about investing for novices, I’m always torn by insurance companies, because while they tick some of the important boxes, they have some less desirable qualities too.
My favourite in the sector at the moment is life insurer Aviva (LSE: AV) (NYSE: AV.US), which has been doing well for us in the Fool’s Beginners’ Portfolio. Part of the reason I chose Aviva was because it seemed clearly undervalued at the time, and I think it still is, but short-term valuation is something I’m trying to mainly avoid in this series of articles.
From both sides
So I’ll tell you what I think are the things to watch out for, and hopefully you’ll agree that with me that Aviva is a good prospect.
While the life insurance business might seem simple, it actually covers savings and investments and there’s a lot of financial stuff going on behind the scenes — just like the banks, which I think are among the hardest-to-understand investments out there. The company reports can be quite daunting, too — Aviva had 100 pages of notes tacked on to its financial statements in its 2012 annual report.
There’s also the problem with dividends.
But dividends are good, right? Well, yes, they are, but they must be trustworthy. It’s no good paying top prices to get an 8% or 9% yield if that yield is not sustainable and ends up crashing. And that’s exactly what happened to a couple of our insurers, including Aviva, last year.
Overstretched
In 2011, Aviva paid a 26p dividend, which amounted to a yield of 8.6%. But earnings per share (EPS) can be erratic for insurance companies, and that year followed on from two previous years of falls with EPS slumping to 11.1p per share — less than half the cash handed out as dividends.
Now that can happen, occasionally, if EPS is expected to rebound the next year. But these are hard times, and Aviva had kept its dividend too high for too long — it even made a high first-half payment in 2012.
The inevitable happened, the 2012 final dividend was slashed, and the share price took a sharp dive when it was announced.
Rebased is good
This year there’s a dividend of 16p per share being forecast for Aviva, and that would provide a lower (but still attractive) yield of 3.9% on today’s share price of 428p — a price that has recovered well, and is even higher now than before the dividend crisis.
Something similar happened to non-life insurer RSA — dividends barely covered by earnings, final payment for 2012 drastically pruned, and the yield down from 8.7% in 2011 to a forecast 5.4% this year.
Importantly, the rebased dividends will now be well covered and are sustainable. For the year to December 2013, forecasts suggest Aviva’s dividend will be 2.7 times covered by earnings. And its price-to-earnings (P/E) ratio based on those forecasts is under 10 — the FTSE average is around 14 and, other things being equal, lower is better.
Buy Aviva?
Insurers provide a vital service for which demand will continue for a long time, and that’s key for a long-term investment.
So, bearing in mind that my bullish stance is based to some extent on current valuation, I reckon an insurer like Aviva can be a great investment providing you’re getting a decent dividend that must be well-covered by earnings, and the shares are on a low P/E — and if the dividend cover falls too much, it could be time to get out.