Cincinnati Financial Stock: Dividend King Gets Interesting

CHUNYIP WONG

Over a year ago, I recommended waiting for a correction of around 20% from Cincinnati Financial (NASDAQ: CINF) before buying the stock due to the exceptionally rich valuation of the stock at the time. Since my article, the stock has down 25% but the business landscape has completely changed for the insurer, at least in the short term. Therefore, the big question is whether the stock has finally become a bargain.

Company presentation

Cincinnati Financial is a property and casualty insurance company. It offers business, home and vehicle insurance products as well as financial products, such as life insurance and annuities.

As an insurer, Cincinnati Financial generates its profits from two sources. It receives funds through insurance premiums from the policies it sells to its clients and also generates investment income by investing its earnings in stocks and bonds. Warren Buffett took a particular interest in the insurance sector from the early stages of his investment career thanks to the advantages of free float, which can generate attractive returns through investments in bonds and equities.

After several years of favorable business conditions, Cincinnati Financial is currently facing a perfect storm as inflation soared to a 40-year high and the Fed’s aggressive interest rate hikes, which are likely to cause an impending recession. Higher interest rates negatively affect the insurer’s investment income and book value because they negatively impact the current value of stocks and bonds. Stocks make up 42% of Cincinnati Financial’s investment portfolio, while bonds make up the bulk of the remaining 58%. In addition, the pronounced economic slowdown in the economy should have an impact on sales of insurance products in the coming quarters.

Cincinnati Financial’s deteriorating business landscape was clearly reflected in its latest earnings report. In the second quarter, the insurer went from earnings per share of $4.31 in the year-ago quarter to an excessive loss per share of -$5.06. About 87% of the earnings gap was caused by a sharp decline in the fair value of stocks and bonds in the company’s investment portfolio. Adjusted earnings per share fell 64%. As if the fall in the value of the investment portfolio was not enough, Cincinnati Financial posted a disheartening combined ratio of 103.2% in its insurance business due to high catastrophic losses. Overall, this is the company’s second-worst quarter in the past 19 quarters.

However, investors should not be myopic, especially in the highly volatile P&C insurance industry. Instead, they should always focus on the long term. First, P&C insurance is well known for its volatility, which results from the unpredictable nature of catastrophic claims. The last quarter was particularly unfavorable for Cincinnati Financial, but it is reasonable to expect an average reversion on this front in the coming quarters.

Additionally, the Fed’s aggressive interest rate hikes have caused the current value of Cincinnati Financial’s investment portfolio to plummet, but will soon have a positive effect as the insurer is now able to invest its funds available at higher interest rates. Rising yields should begin to boost the company’s investment income in the near future, after several years of declining yields.

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Cincinnati Financial Investment Income (Investor Presentation)

It’s also important to note that the recent drop in the market value of Cincinnati Financial’s investment portfolio should prove temporary. This is certainly true for bonds in the investment portfolio, as these securities are held to maturity. This also has a good chance of holding true for equities as well, as long as the Fed restores inflation to normal levels and the economy begins to recover.

In summary, if the Fed achieves its inflation-reduction target, the market value of Cincinnati Financial’s investment portfolio should recover, along with the bond and stock markets, and the insurer will benefit as well. high returns, it will lock in its new funds until interest rates fall to lower levels.

Evaluation

When I wrote my previous article, Cincinnati Financial was trading at an all-time high and a nearly 10-year high price-to-earnings ratio of 26.3. This level was well above the stock’s 10-year average price-to-earnings ratio of 20.9%.

Since the article, the stock has undergone a 25% correction and is therefore now trading at a price-earnings ratio of 20.4, which is almost equal to the stock’s historical average. Even better, analysts expect the insurer to recover from its current downturn and therefore expect it to increase earnings per share by 10% next year and 17% in 2024. Consequently, the stock is currently trading at just 16.1 times its expected earnings. in 2024. It thus offers an attractive entry point for patient investors who can withstand stock price volatility and maintain a long-term outlook during the current bear market.

Dividend

Cincinnati Financial has increased its dividend for 61 consecutive years and is therefore a dividend king. This is one of the longest streaks of dividend growth in the investment universe and so is admirable, especially as the company operates in the highly volatile P&C insurance industry. The exceptional dividend record bears witness to the insurer’s disciplined underwriting policy. Plus, with its healthy 49% payout ratio and promising growth outlook, Cincinnati Financial can easily continue to increase its dividend for many years to come.

Additionally, thanks to its correction this year, the stock is currently offering a nearly 4-year high dividend yield (barring the early pandemic sell-off) of 2.9%.

Chart
Data by YCharts

While this yield is uninspiring on the surface, it is likely to prove an attractive entry point for long-term investors when combined with the stock’s attractive valuation.

Risk

Cincinnati Financial’s current stock price will likely turn out to be a bargain, but only if inflation returns to its long-term average of 2% over the next few years. If inflation remains excessive for years, it will continue to put pressure on Cincinnati Financial’s valuation, as it will continue to put pressure on the present value of the company’s future cash flows. Therefore, only investors confident that inflation will soon begin to return to normal levels should consider buying Cincinnati Financial around its current price. Fortunately, the Fed is clearly determined to bring inflation back to normal levels, as it has prioritized this objective, even at the expense of short-term economic growth and unemployment. Therefore, the adverse scenario of persistent inflation for years is highly unlikely.

Final Thoughts

Cincinnati Financial has become attractive thanks to its 25% correction and the resulting improvement in its valuation and dividend yield. However, the company is facing short-term headwinds as its stock is in a strong downtrend. Therefore, I advise investors to wait for a further 10% correction and buy the stock near its technical support around $85.

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