Smart Investor: RSA stands out in an under-rated and lucrative sector

Insurance is one of the best businesses to be. The house always wins.

Investments not working out? Increase the premiums. Investments doing well? Reduce premiums and win new business. Either way, insurers have it covered. As I explained in a recent article on the sector, they also have other methods of ensuring the odds are always in their favour. For instance a lack of new entrants, legal guarantees for certain insurances and loss adjusting teams to reduce the amount paid out in claims.

For smart investors this is certainly an industry to consider and a good place to start is with FTSE 100 listed Royal & Sun Alliance (RSA).

Whilst the past is only a guide to the future, it is the sole means by which smart investors can judge how a company is likely to perform. In RSA’s case the previous 5 years have been very encouraging. In four of the last five years net profit has ranged between £419 million and £628 million, giving a return on equity of between 11.5% and 20.5%. This is partly due to the high dividends paid out which restrict growth in net assets, but is still a very impressive return for an established business.

Whilst on the topic of dividends, RSA currently yields 6.1% at £1.33 per share. This is amongst the highest in the index and is a true inflation buster. Furthermore the dividend paid per share has increased year on year for the last five years.

Of course a high dividend is of little use if the share price falls, but RSA’s chart over the last five years paints an encouraging picture. With a chance of a ‘double dip’ recession still high, smart investors need to ensure that the share prices of the companies they invest in have shown some resilience in the difficult trading conditions experienced in the past couple of years.

RSA’s share price fell to around £1.14 during the credit crunch. This is less than 15% below the current price and, whilst a double dip could mean the share price makes lower lows than this, it shows that RSA has a reasonable degree of resilience to fluctuations in the stock market. Indeed if it fell much lower than £1.14 it would be trading close to net asset value, as discussed below.

RSA also ticks a few other crucial boxes on the smart investor cheat sheet. Gearing is perfectly acceptable at 45% whilst cash at bank is just shy of £1 billion; representing over a quarter of net assets. This is a very sensible level given it is an insurer and may require cash for large and unexpected payouts on claims, but at the same time is not too high to be caught out if fears of high inflation materialise.

Last but by no means least, RSA’s net asset value per share is £0.99; meaning that just one-quarter of the price paid per share is future profit. This is mightily impressive in spite of the fact that insurance companies are not currently en vogue and therefore attract less goodwill than a major mining company such as Rio Tinto or BHP Billiton does.

This relatively small amount of goodwill means that smart investors should feel comfortable buying in at the current price because it offers a substantial margin of safety. In other words, since the price does not include vast amounts of future profit, there is not a vast amount of pressure for net profit to grow in order to give investors a significant return on their investment in the long run.

Of course no company is perfect and there may be clouds on the horizon for RSA. Indeed it recorded a small loss of £20 million in 2006 as a result of write down costs totalling £500 million from the sale of the US part of its business.

It should be noted that this is a Discontinued Operation, was a one-off cost and should therefore not impact on future profitability. Furthermore its Operating Profit remained strong throughout. However it is a black mark on RSA’s record and reduces the Intrinsic Value of the company quite significantly.