SIF Portfolio: Cyclical turn could make insurer Jardine Lloyd Thompson too cheap to ignore

Last week I wrote about the restricted choice of stocks on offer in the Stock in Focus screen. This week the choice has shrunk even further.

Of the 16 stocks which qualify for my screen at the time of writing on Monday, two are Russian and six are already in the SIF portfolio. A further five are sector duplicates I won’t buy for diversification reasons. And one (Hogg Robinson) has received a takeover bid, so is ruled out.

That leaves just two stocks:

• Insurance and employee benefits group Jardine Lloyd Thompson (StockRank 81)

• German commercial property group Sirius Real Estate (StockRank 80)

The portfolio rules say that the stock with the highest StockRank should be considered next. So Jardine Lloyd Thompson is the stock I’ll be considering this week.

Jardine Lloyd Triple-bagger

FTSE 250 financial stock Jardine Lloyd Thompson may not be a company you’re familiar with. But savvy investors have snaffled a 50% gain since February 2016. Longer term investors have tripled their money over the last 10 years.

The group’s business has two divisions. The larger one is known as Risk & Insurance and provides specialty insurance, reinsurance and broking services. This includes providing cover for airliners, energy industry assets, shipping cargo, buildings and much more.

The smaller half of JLT’s business deals with providing outsourced Employee Benefits. This includes pension administration, healthcare and life insurance and other services with a finance tilt.

The group has a market cap of £2.7bn and trades in the FTSE 250. It was formed when Jardine Insurance Brokers merged with Lloyds Thompson Group in 1997. But as the name suggests, Jardine Insurance was originally spun out Hong Kong-based trading company Jardine Matheson, whose history can be traced back to 1832.

The Stockopedia graphic shows that Jardine Lloyd Thompson’s free float is just 54.8%.

The reason for this is that Jardine Matheson holds a 40% stake in the firm. This probably means that a takeover bid is unlikely here, but I don’t see that as a big problem.

The company comments that Jardine Matheson’s “reputation and local knowledge are of great value” when dealing in Asia. Having a dominant shareholder doesn’t seem to have held back growth or shareholder returns, either:

Is value on offer?

JLT scores quite highly with Stockopedia’s algorithms. Alongside its StockRank of 81 it has a StockRank Style of Neutral and a RiskRating of Conservative, which denotes low volatility.

Conservative stocks have collectively delivered steady gains and relatively few sleepless nights over the last five years, as this chart shows:

My hope is that this conservative profile will go some way to offset JLT’s rather low ValueRank of 47:

Although my favourite earnings yield is satisfactory, at nearly 9%, the other figures all suggest a more demanding valuation than I’d usually seek when buying a financial stock.

These figures are all consistent with each other and don’t suggest any problems to me. This could just be a good business which deserves a premium valuation.

However, I think it’s worth taking a closer look to see if we’re exposed to the risk of mean reversion. If the shares have risen faster than earnings for several years, this process may reverse to return the stock’s valuation returns to its long-term average level.

You can check this by looking at historical share prices and earnings per share. But a quicker and easier way to get a snapshot of past valuations is to look at historic Stockopedia data for a share. You can do this by clicking on the arrow next to the grey ‘Print’ button just below the market cap information:

The earliest StockReport available for JLT is September 2013. Here’s how the firm’s key value and growth metrics 4.5 years ago compare with those today:

JLT’s valuation and growth metrics appear similar in both snapshots. I think it’s probably fair to conclude that the shares aren’t wildly more expensive than they were nearly five years ago.

Based on this conclusion and the stock’s attractive earnings yield, I’m happy to accept JLT’s value metrics.

A fair price for quality

Things get much better when we consider the company’s QualityRank of 91. This suggests a history of high returns and strong cash generation, backed by a healthy balance sheet.

For companies of this kind I think it’s possible to justify a higher starting valuation for an investment (note that the Altman Z-Score is not applicable to financials):

What I’m looking for here is consistency. This snapshot hints at this but I think it’s worth considering the year-by-year figures to confirm this view:

2016 seems to have been a low point for the firm. Happily, performance improved notably in 2017. Looking more closely we can see that this improvement was driven by the insurance business. I’ve circled the relevant figures from the group’s 2017 results:

Insurance generated about 80% of trading profit in 2017, up from 77% in 2016. Margins improved last year and insurance profits were also boosted by exchange rates (CRE is constant rate of exchange).

In contrast, profits and margins in the employee benefits business were flat last year, with only a small benefit from exchange rates. Although profits from this business are lower, this appears to be a profitable niche for the firm which provides stable profits to offset less predictable insurance profits.

I’ve no concerns about either part of the business and am happy with JLT’s quality metrics.

Will recent momentum persist?

JLT’s MomentumRank of 65 isn’t bad. But it’s not dazzling either.

Earnings forecasts were trimmed after the group published its full-year results in February, but I think the picture may be brighter than it appears.

The employee benefits business is now expanding into the international market, having previously been focused on the UK. The segmental figures I pasted in above show margins for the International EB business more than 20%, versus c.10% for UK. Continued growth could generate a worthwhile increase in profits.

In insurance, the management is cautiously optimistic that “the trend of steady price reductions through a number of years seems to have moderated or ended”.

Although this statement was balanced with a comment that “it would be premature to refer to a hardening market”, I think it’s fair to assume that conditions are starting to become more favourable.

Recent commentary by sector rival Lancashire Holdings seems to support this view:

My decision

Although earnings forecasts have been trimmed for 2018, it’s worth pointing pointing out that the current forecast still indicate a 21% increase in underlying earnings this year.

At this point it’s impossible for an insurer to know how many natural disasters or other major claims are likely this year. But I think the wording of the group’s outlook certainly allows room for expectations to be raised as the year progresses.

I’m a little concerned that the nine-month holding period used by SIF is too short for a business like this. But JLT stock passes all of my tests, so I will be adding it to the portfolio this week. I’ll also buy it for my own portfolio after this article has been published.