QBE – cheap at half the price

Chief Investment Officer and founder of Aitken Investment Management
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We are clearly in the “grow on skepticism” phase of an Australian equities bull market. While it would be easy to settle back into “cheerleader” mode, the game from here is to focus in on what we believe are unjustified laggards of the bull market.

With mums and dads now directly controlling 33% of the entire superannuation pool, compulsory superannuation contributions rising, the population ageing and the taxation system favouring buy/hold/fully-franked dividend collection, I am trying to focus on large cap household name stocks, that offer certainty of fully-franked dividend growth driven by earnings growth.

I am sector ambivalent. I don’t care if I find those attributes in mining, energy, banks, telcos, retail, insurance or wherever. I just want to make sure we find them before they are more broadly discovered by investors.

The laggards

If I look at my 16 stock high conviction buy list, it’s broadly doing very nicely, led by the four banks, Telstra, Crown, Fortescue, JB Hi-Fi, Seven Group Holdings, Macquarie Group, Suncorp and Woodside Petroleum, however, the four laggards are AMP, BHP Billiton, Woolworths and QBE Insurance. Those four haven’t yet given me the alpha I expect, but they will, as they slowly overcome current consensus negativity.

The interesting aspect of this is the four stocks I have the most detailed conversations about with institutional investors are the four laggards. I feel all four of them are under-held relative to their ASX200 index weights, investors realise they are good relative and absolute value, but are trying to identify a clear catalyst for value release and alpha generation.

Of course, history suggests you never get good relative and absolute value and an obvious catalyst for value release, occurring at the same time. If we all knew the catalyst, there wouldn’t be value. You can outsmart yourself and miss the entire opportunity by trying to be too cute on timing.

My view is the good relative and absolute value is the catalyst. Once you can be certain in the underlying dividend, that is the true catalyst. If you can see a clear path to dividend growth, that’s a double catalyst.

QBE Insurance

If I said to you there’s a $17.5 billion market cap ASX20 stock that offers 30% EPS growth, rising ROE, 4.6% fully-franked dividend yield, trades on 1.2 times book and 11.4 times earnings, would you buy it?

In fact, this stock sees its EPS double from 2012 to 2014, its dividend rise 30% over the same period and franking of that dividend go from 32% to 100%.

But it gets better. The stock is the same price it was in 2012 and the open short position is 17 million shares.

5 years in QBE

QBE shares have retraced somewhat in recent weeks, due to the FED’s decision not to taper bond purchases. That saw US bond yields fall and the Australian dollar rise. But as sure as night follows day, the Federal Reserve will taper bond purchases in the not-too-distant future and that is the medium-term macro attraction of QBE.

QBE on our consensus estimates offers nearly 50% USD EPS growth in the next two years, driven by insurance margins expanding. If I am proven right and the AUD/USD cross rate falls to the low 80s in that period, the translated AUD EPS growth is multiplied again. We forecast 71% AUD EPS growth for QBE over the next two years, using an average AUD/USD cross rate of 90 US cents for the period starting 1 January 2014.

Yield opportunity

Unusually for a USD offshore earner, the rising dividend yield is fully franked, again opening the way for the self managed super fund army to return to QBE when they get confidence in the recovery.

There is a school of thought out there that insurance stocks are not an appropriate investment for super funds because of the inherent risk of the insurance business. I think that argument is total garbage, as evidenced by IAG and Suncorp in recent years. Insurance stocks are basic financials and can deliver bank-similar total returns with, in reality, not much more real risk than a bank. It all comes down to management.

As is the case with all large cap stocks that have experienced a multi-year period of underperformance, the consensus analyst view is timid. The current QBE buy/hold/sell ratio is 5/8/4, while the median 12-month price target is $16.00.

QBE is a cheap growth stock, almost certainly the cheapest industrial in the ASX TOP 20, but with a pathway to re-rating, as consensus scepticism eases and the FED steps a notch back from QE.

See you all @6,000

Go Australia, Charlie

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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