Insurance stocks are a top pick by a top strategist and where Canadian insurers are concerned, the bullish argument is compelling. Domestic insurance stocks are ideally suited for a rising interest rate environment, are trading at attractive valuation levels relative to the market – and carry substantial dividends.
Credit Suisse strategist Andrew Garthwaite is among the most respected in the world, frequently ranked No. 1 in the annual Institutional Investor survey. In his 404-page "2017 Outlook: Themes, Sectors and Styles," Mr. Garthwaite lists insurance stocks as one of his top investment ideas for the coming year.
The first chart below highlights the crux of the argument for the sector – stock prices are benefiting significantly from rising interest rates. The S&P/TSX insurance index has leapt 25.2 per cent since the June 27 low. The climb has tracked U.S. 10-year bond yields almost exactly.
The second, lower chart indicates the attractiveness of valuations in the sector despite the recent rally. The grey line tracks the steadily rising forward price-to-earnings ratio for the S&P/TSX composite index. For much of the past decade, the P/E ratio for the insurance sector has been only marginally lower than the index as a whole.
Currently, the insurance sector trades close to its most attractive valuation levels relative to the market in the past decade. The S&P/TSX insurance index has traded at an average 17-per-cent discount to the wider benchmark. Prices now indicate that insurance stocks are 29 per cent more attractive than the S&P/TSX composite based on forward P/E ratios.
Hefty dividends are another reason to favour insurance stocks. The S&P/TSX insurance index dividend yield is currently 3.1 per cent. This is not a huge advantage over the S&P/TSX composite's 2.7-per-cent yield. As Mr. Garthwaite notes, however, insurance companies generate high free-cash-flow yields to support dividend payments. This suggests that the significant income available in the sector is extremely safe – an important consideration for investors when profits and asset prices for many other income-related sectors including real estate and utilities are negatively affected by higher bond yields.
The postcrisis period has been extremely difficult for the insurance industry, but the tide may be turning in their favour. Insurers are dependent on compound interest on fixed-income investments to generate the necessary funds to pay future policy liabilities. The steadily lower rates since 2009 significantly reduce bond portfolio returns at a time when demographic factors mean ballooning future payouts. The recent increase in bond yields will be met with relief in the insurance sector, signalling better balance sheet health and profits.
Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market.
Scott Barlow