3 reasons to buy US financial stocks (NYSE:AFG)

lamyai

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 the price. If an investor bought their stocks 20 years ago, they would be sitting on a nice annual return of 15.4%. So the question is: are equities still attractive?

Chart
AFG Total Return Level data by YCharts

American Financial thrives when interest rates are higher thanks to its portfolio of bonds and alternative investments. American Financial stock is a buy because:

  1. Earnings per share are expected to increase in the coming years.
  2. The valuation is favourable.
  3. An upcoming share buyback program or special dividend is expected.

About the company

American Financial was founded in 1872 and offers property and casualty insurance products in the United States. American Financial’s products include property and transportation insurance, specialty liability insurance, and specialty financial insurance.

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

Property and Casualty Insurance Specialty - AFG Investor Relations

P&C specialty (AFG Investor Relations)

Quarterly results were exceptional

Second quarter results were excellent. The company delivered a base annual return of 21% and recorded double-digit premium growth (11%) over last year.

Financial key figures - AFG Investor Relations

Financial key figures (AFG Investor Relations)

The Property & Casualty combined ratio improved by 2.1% compared to last year. The increase in the combined ratio of goods and transport is the result of higher catastrophic losses and lower favorable development. The Specialty Casualty group improved its combined ratio by 7.8%. The company has good loss and cost control

Combined report

06/30/22

06/30/21

Ownership and Transportation

92.4%

86.6%

Specialized accident

80.1%

87.9%

Specialized financial

78.4%

86.4%

Other specialty

114.6%

103.2%

Combined Ratio – Specialty

85.8%

87.9%

The company raised its full-year 2022 base operating profit forecast to $10.75-$11.75.

Rising interest rates are good for US financiers

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

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

The alternative investment portfolio largely benefits from higher interest rates. The company expects an overall annual return of 10% to 12% on alternative investments, including a strong performance from multifamily investing. Investments related to collective housing represent approximately 55% of the alternative investment portfolio

Total cash and investments - AFG Investor Relations

Total cash and investments (AFG Investor Relations)

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

Fixed Maturities - AFG Investor Relations

Fixed Maturities (AFG Investor Relations)

Repurchase of shares or expected special dividend

In its second-quarter transcript, American Financial hinted that it might launch a shareholder buyout program or pay a special dividend with the excess cash it has after selling its annuity business. I quote Stephen Craig Lindner:

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

American Financial’s market capitalization is $11 billion, so the redemption yield (or special dividend yield) will be around 4%. Share buybacks should drive up their stock price. The company pays an ordinary dividend of $2.24, which at the current share price translates to a dividend yield of 1.7%. The company has been paying dividends for over 10 years.

What about its valuation? The PE ratio is currently 11, which is lower than the average PE ratio of the last 10 years (the 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. It is a favorable combination. Three analysts estimate that 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 its excess capital (special dividend or stock buyback), but keep in mind that the stock price is attractive and earnings should rise. You can expect a good return from this stock.

Conclusion

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

American Financial is benefiting greatly from higher interest rates in its fixed and alternative term investment portfolios. Fixed maturities represent approximately 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 advantageous for American Financial because they can reinvest at higher rates. The company and analysts have therefore raised their expectations and expect earnings per share growth in the years to come.

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

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