Investors searching for opportunities will be hard pressed to find stocks that are still undervalued. It seems like this rally has pushed every sector to very high levels. Perhaps, it may be time to look in more off-the-cuff places for investment ideas.
One possibility trades on the Amsterdam-based exchange, the Euronext. The Dutch insurer, Delta Lloyd Group, which has operations in the Netherlands, Germany, and Belgium, is a profitable company with a favorable balance sheet that trades at a significant discount to its book value. In the first half of 2010, it generated €767 million of income after taxes and non-controlling interests, a 263% increase. At the same time, it has €3,903 billion in tangible assets net of all liabilities, but a market cap of just € 2,810 billion as of January 11. In other words, investing in Delta Lloyd is like buying assets, with all liabilities paid off, at a 30% discount.
This alone is not enough to make it a suitable investment. After all, a number of financial companies also trade below their book value, why not buy those? There are a few key distinctions that make this Dutch insurer a much safer bet than most other seemingly-similar stories.
Banks vs. Insurers
Not all financial companies are made equal. The business model is a fairly standard one -- a financial firm takes on liabilities to acquire assets and hopes that those assets generate a return good enough to make a profit. But despite almost all financial companies using this model, a bank and an insurance company use a completely different variation to make money. A bank primarily uses deposits and loans as its liabilities while an insurance company uses the premiums it attains from writing insurance.
Under normal circumstances, the two methods are basically the same. When things go wrong, though, the differences become crucial. With the FDIC insuring most deposits, the fear of the infamous bank run is largely gone. But as shown by the subprime crisis, the bank run's modern cousin is just as dangerous.
Banks often rely on the repo market, a form of short term financing, to function daily. When the system or an individual bank is in trouble, lending on the repo market tends to dry up. This is dangerous enough, but there is also risk coming from interest rates. If interest rates rise, all of the forms of short term financing that banks rely on would become more expensive.
Insurance premiums are a different animal. The risk with insurance is that the conditions for a payout could happen on an unprecedented scale -- for a life insurance company, this most likely means a form of disease epidemic or a cataclysmic disaster.
While this is something to consider, the most likely scenario is that the payouts are more normally distributed and more predictable, a good thing. Consider how many times interest rates have spiked or the financial system has been disturbed over the last few decades and compare that to the number of plagues and outbreaks that have taken place among people that tend to have insurance. The obligations of insurance companies are subject to different risks, and a strong argument can be made that these are safer.
Despite this distinction, banks, like Citigroup or Bank of America, tend to trade at greater than or equal to multiples of insurance companies, like Reinsurance Group of America or Delta Lloyd. Over 55% of Delta Lloyd's total liabilities (not just its financing) are related to life insurance.
If the tenet of investing that buying a company's stock is buying a piece of its business still holds, liabilities are only half of the equation. The majority of Delta Lloyd's assets are in the form of investments and the management team has shown an ability to invest wisely.
Most of Delta Lloyd's assets are equity securities, debt securities, and loans. Being based in the Netherlands, the company naturally has a large amount of exposure to Europe. This could theoretically be a cause of concern with all of the recent talk surrounding the Eurozone, the PIIGS, and those dreaded bail outs.
However, the management team has shown remarkable prudence with respect to these concerns. Its exposure to the government bonds of Portugal, Ireland, Italy, Greece, and Spain, the most problematic members of the Eurozone, was a mere €1.6 billion as of June 2010 out of total investments that measure over €60 billion. This is a decrease of 60% from December 31, 2009.
Its loan portfolio is focused on the Netherlands, Germany, and Belgium, three of the strongest countries on the European continent. The vast majority of its loans are made in the Netherlands, an area with strong bankruptcy laws, favorable tax treatment of mortgage interest payments, and traditionally low loss ratios. Delta Lloyd also has no loans on its books that qualify as subprime or Alt-A, the two lowest quality ratings.
Well Run with a Margin of Safety
The quality of Delta Lloyd's assets and its strong management led the President of Greenlight Capital, David Einhorn, to strongly recommend the stock.
According to calculations in the firm's financial reports, it could survive extreme swings by its financial assets and still not fall below the solvency ratios it is subject to. Simultaneously, its fixed income, equity, and property investments have outperformed their pre-determined benchmarks by 5.7% in the first half of 2010. Considering the quality of the Group's assets, the nature of its liabilities, and its ability to invest effectively, Delta Lloyd deserves more credit than the market has given it. In fact, it is only trading so cheaply because its largest investor, Aviva, sold nearly half its interest after losing a legal settlement for control of the company.
Worth a Look
While Delta Lloyd does not have an ADR, it is an opportunity worth looking at for all investors. Despite the risks that come with investing in a financial company and an insurer, the upside potential is difficult to ignore for investors willing to venture into nontraditional stocks.