And, how to avoid this sort of value trap in the first place.
RSA Insurance Group was the first insurance company to join the UKVI Portfolio back in 2012 and it has been a mostly disappointing – although not catastrophically bad – investment.
In short, it was a value trap and the most important thing to do if you’re stuck in a value trap is:
- Get out profitably and
- Learn the right lessons so that you can hopefully avoid similar value traps in future
In January 2012 RSA appeared to have turned itself around after a problematic period in the early 2000s, which included a dividend cut and rights issue to strengthen the balance sheet.
When I reviewed the company its dividend yield was 8.8%, so clearly the market was pricing the shares as if a dividend cut was inevitable.
In this case the market was right because the dividend was subsequently cut, the CEO “resigned” and a rights issue was carried out.
However, thanks to recent acquisition interest from Zurich Insurance RSA’s share price has reached a point where this particular value trap can now be escaped profitably.
The table below summarises the results of this weak but still profitable investment:
|Adjusted purchase price|
544p on 09/01/2012
525p on 01/06/2015
3 Years 6 months
|Capital gain (inc. Nil Paid Rights)|
5.8% per year
The classic value trap: A super-high dividend yield
I was well aware of the risks of investing in a company with such a high yield, but I rationalised the risks by thinking that even if the dividend was cut in half the yield would still be above the market average.
In other words, I thought the risks were already accounted for in the price.
On the plus side, if the dividend wasn’t cut, or was only cut very slightly, then the shares were likely to re-rate upwards, producing large and rapid capital gains.
The chart below shows RSA’s latest financial results at the time of purchase in January 2012 (up to the 2010 annual results).
RSA’s problems at the start of the decade are clear to see, with normalised earnings falling essentially to zero. I summarised the underlying problems in my original analysis back in January 2012:
“In very simple terms insurance companies can make money in two ways: one is to make money on each policy so that the premium income more than offsets any losses; the other is to invest that premium while it’s held in reserve waiting to cover any losses. If this ‘float’ is invested well it makes money which goes on the bottom line.
Unfortunately it seems that RSA had been depending too much on the stock market and when that fell for three years between 2000 and 2003 it hurt the company a lot. The dividend was cut from around 25p eventually down to less than 5p [20p after recent share consolidations]. Just as bad was the more than £900m rights issue that was used to strengthen the balance sheet.”
So the company had a history of recent failures of judgement, but it seemed that things had gotten better and none of the metrics I used in 2012 told me otherwise.
After analysing the company I was comfortable investing 3% of the UKVI Portfolio into RSA and a similar amount with my personal investments.
Holding on through dividend cuts and CEO “resignations”
Unfortunately RSA did still have underlying problems which needed sorting out, and these were pretty much the same issues it had exhibited during the 2000 – 2003 period.
These problems resulted in a bumpy ride for investors, as the share price chart below shows:
Investors were hit with wave after wave of bad news, including a major dividend cut, a resigning CEO and a significant rights issue.
I’ll start with the dividend cut, which was announced in the 2012 annual results, published in February 2013, where the main reason given for the dividend cut was exceptionally low bond yields.
At the time RSA had more than £11bn of its customers’ premiums invested in bonds and was clearly relying on returns from bonds and other investments to fund a portion of its dividend.
This is normal for an insurance company, but it does perhaps hint at RSA’s inability to generate significant cash from its underwriting (i.e. insurance) activities rather than its investment activities.
As usual I did not sell when the dividend cut was announced.
In general I think there are better opportunities to sell than immediately after a dividend cut.
Dividend cuts often result in new management taking over, changes being made and companies being improved. At some point down the line some good news is likely to appear and the market will hopefully raise the share price accordingly.
In RSA’s case, Stephen Hester (of RBS turnaround fame) joined the company in 2014 to turn things around.
By holding on I was effectively waiting for that turnaround to come good, or at least for the market to think the turnaround would come good and therefore raise the share price to where I could sell the company for a decent profit.
However, I would have preferred to avoid this value trap altogether and, with hindsight, I think RSA’s problems were visible beforehand if I’d known where to look.
Low profitability: A sign of weak competitiveness and/or a lack of capital discipline
RSA’s first problem was weak profitability.
One of the ratios I now apply to insurance companies (which I didn’t in 2012) is the Combined Ratio, which works a bit like profit margin.
It is a combination of the Loss Ratio (the ratio between claim expenses and premium income) and the Expenses Ratio (the ratio between operating expenses and premium income).
It works like this:
- If the sum of claims and expenses are less than premium income then the Combined Ratio is less than 100% and the company made a profit on its underwriting business
- If claims and expenses exceeded premiums then the Combined Ratio is above 100% and the company made a loss on its underwriting business
Today I use the following rule of thumb for insurance company profitability:
- Only invest in an insurance company if its 5-year average Combined Ratio is below 95%
In the 5 years to RSA’s 2010 annual results (the latest results available when I reviewed the company in January 2012) it had a 5-year average Combined Ratio of 94.7%, which means it would have just about passed that test if I had been using it.
So while RSA’s profitability was weak, it was not weak enough to make me avoid the company, even with hindsight.
However, when the 2011 results were published in February 2012, shortly after I’d bought RSA, its average Combined Ratio crept up to 95.1%, just fractionally outside my minimum profitability.
When the 2012 results were announced a year later (along with the dividend cut) its average Combined Ratio rose to 95.2%, which is clearly going in the wrong direction.
So the company’s profitability was weak at the time of purchase, and getting weaker. It was a definite warning sign that the company lacked a meaningful competitive advantage.
Too much premium, not enough surplus
I now use a range of different metrics for measuring leverage, but for insurance companies an important measure of operating leverage is the Premium to Surplus Ratio. This is the ratio between how much premium a company writes in a given period and how much “surplus” assets the company has over its liabilities.
The idea is that an insurance company has a fiduciary duty to pay out claims and so if push came to shove all of its assets should be sold in order to fund its claim liabilities.
The size of the surplus then dictates, approximately, the maximum amount of new business the company should write, as there is only so much new insurance business a company should take on given its ability to pay existing claims.
I now use the following rule of thumb when reviewing insurance companies:
- Only invest in an insurance company if its Premium to Surplus Ratio is below 2
This is an old insurance industry rule of thumb which has stood the test of time as an indication of prudent underwriting activities.
In 2010 RSA wrote premiums of £7,455m and had tangible shareholder equity (tangible assets minus liabilities) of £2,557m, giving the company a Premium to Surplus Ratio of 2.9. This is clearly above my “rule of thumb” maximum of 2.
If I had looked at the Premium to Surplus Ratio in 2012 I would have seen that RSA was taking on lots of new business relative to its asset surplus. Another way of looking at it is to say that RSA’s asset surplus was too thin for the amount of business it was writing.
Either way it was not running what could be described as a “conservative” operation:
“While the element of risk present in both the underwriting and investment portfolios affects the need for surplus, there is a rule of thumb which sets $2.00 of premiums written for each dollar of surplus as conservative”
Thomas Morrill, President of State Farm Auto Insurance Company, 1970
After the 2011 results, RSA’s Premium to Surplus Ratio increased to 3.3 and in 2012 it increased to 3.7. Clearly RSA’s margin of safety was becoming ever more thin in relation to the amount of insurance it was writing.
This could not go on forever, and at some point premiums written would need to be reduced or capital would have to be raised in order to boost the surplus, or both.
Unfortunately for investors, dividend cuts and rights issues are the primary means for boosting the capital surplus and that’s exactly what RSA did.
Patience and a random event (a potential takeover) have produced a profitable exit price
I do not like to sell on bad news. I prefer to sell when everybody is optimistic about the future of a company.
In the case of an underperforming company like RSA, that usually means waiting for some hint that the turnaround is going well, and that is essentially why RSA was still in the portfolio even though for a long time it was one of the least attractive holdings.
However, Zurich Insurance is apparently now interested in buying RSA for something in the region of 550p per share, if rumours are to be believed.
This boosted the share price to 525p on Wednesday, which is higher than it had been since 2013. For me this means optimism for RSA has returned and any operational improvements from the turnaround are already largely included in that price.
After this recent price increase RSA had by far the lowest rank on the UKVI Stock Screen of any holding.
It is not a company I particularly want to keep in the portfolio and so I have taken this opportune moment to offload RSA at a point where the investment’s total annualised returns are a somewhat weak but not horrendous 5.8% per year over 3 years and 6 months.
RSA has not been the most profitable of investments, but it has been profitable in terms of lessons learned. Thanks to RSA I expect to only invest in much better insurance companies in future.
“The markets are a classroom where lessons are taught everyday. The keys to investment success lie in observing and learning”
Howard Marks, Chairman of Oaktree Capital (quote from his book “The Most Important Thing”)