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Robert Abbott
Robert Abbott
Articles (882)  | Author's Website |

An Insurance Holding Company With Promising Returns

First American Financial is an undervalued predictable stock with a history of share price growth and a promising dividend

November 18, 2020 | About:

One of the most undervalued stocks on the GuruFocus Undervalued Predictable screener, in my opinion, is an insurance holding company called First American Financial Corporation (NYSE:FAF).

First American 10 year price chart

It's also one of the most predictable, with a 4.5 out of 5 stars business predictability rating. Based on GuruFocus backtesting, that suggests First American will likely outperform over the next 10 years, with an average expected return of 10.6% per year and only a 10% chance it will lose money if held for the decade based on historical studies of price trends.

First American is a holding company that has subsidiaries in the insurance business. According to its 10-K for 2019, it operates in two segments. First is title and services, which includes: "title insurance, closing and/or escrow services and similar or related services domestically and internationally in connection with residential and commercial real estate transactions. First American also provides products, services and solutions that are designed to mitigate risk in, or otherwise facilitate real estate transactions." Why are these services needed? To protect owners and lenders against "defects," including adverse ownership claims, liens, encumbrances and other challenges to ownership. Such defects can be expensive, but title insurance reduces most of that risk. Second, the specialty insurance includes property and casualty insurance, as well as home warranty insurance. The bulk of its business is coverage for residential homeowners and renters. It does most of its business in the Western U.S., with 59% of its policy liability located in California. First American also does some auto policies so it can compete with insurers that offer bundled insurance packages.

Warren Buffett (Trades, Portfolio) likes insurance companies because of the unique opportunity they present. Insurers collect premiums from policyholders in advance, allowing them to build up floats or pools of money that can be invested before being needed to pay insurance claims. Buffett has essentially used floats in his companies to build Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) into a financial powerhouse.

First American's investment policy is more prudent: "As of December 31, 2019, 94% of our investment portfolio consisted of debt securities. As of that date, 68% of our debt securities portfolio was either United States government-backed or rated AAA, and 98% was either rated or classified as investment grade." In other words, don't expect the investment fund to contribute much to the bottom line. It also noted in its 10-K that its investment income varies with interest rate decisions by the Federal Reserve.

The biggest risks come from its heavy exposure to real estate, through its title insurance and related services. The company reported the volume of real estate transactions declines when one or more of these factors exist:

  • Interest rates, including those for mortgages, are high or rising.
  • Credit availability declines, constricting commercial and/or residential mortgage funding.
  • Real estate affordability falls.

Exposure to property and casualty claims is also a hazard, but well down the list of risk factors, suggesting it poses a lesser risk.

From an investor's perspective, the current big draw is the valuation. First American's share price still has not yet fully recovered from the spring meltdown:

First American GuruFocus Value chart

The GuruFocus Value chart's assessment of modest undervaluation is backed up by its price-earnings ratio of 8.81. That's well below its 10-year median of 13.1 and below the insurance industry median of 12.39.

Similarly, the PEG ratio indicates the stock is undervalued. It comes in at 0.55, well below the 1.00 that marks fair valuation.

First American also pays a dividend, one that benefits from the relatively low share price:

First American share price and dividend yield chart

What's most encouraging about the dividend is its five-year yield-on-cost of 7.33%. That's what investors would (theoretically) receive if they bought the stock at the current price and held it for five years, so long as the company continues to grow the dividend at the same rate as it has for the past five years.

There is ample room for more dividend increases. The company's dividend payout ratio is 31%, a figure it could increase if it wishes. The three-year average stock buyback ratio is negative, however, so shareholders should not expect a boost in earnings from that source.

First American's financial strength is middling, with a rating of 6 out of 10. In part, that's because it has taken on more debt:

First American cash and debt chart

Turning to profitability, we see its return on equity is strong, and closer examination shows it has been on an upward trend for the past decade:

First American return on equity chart

Its ability to grow its ROE over the long term suggests First American has a moat, although not necessarily a wide one. That's an accomplishment, since the insurance industry typically sees a lot of competition.

What kind of total return might we expect in coming years? Let's start with Ebitda (earnings before interest, taxes, depreciation and amortization):

First American EBITDA chart

If Ebitda continues growing at the historical rate of 14.34% per year, we could see decent returns. To that, we can add the current dividend yield of 3.49%, for a total of 17.83% per year.

Ten of the gurus followed by GuruFocus have positions in First American. The three largest are:

  • John Rogers (Trades, Portfolio) of Ariel Investment, who held 3,529,260 shares at the end of the third quarter. That accounted for 3.16% of First American's shares outstanding and amounted to 2.61% of Ariel's assets under management. During the quarter, Rogers added 11.56% to his stake.
  • Ken Fisher (Trades, Portfolio) of Fisher Asset Management reduced his holding in the stock by 2.42% to end up with 997,961 shares on Sept. 30.
  • Pioneer Investments (Trades, Portfolio) added 0.97% to finish the quarter with 711,166 shares.

Conclusion

First American Financial has a deserved spot on the Undervalued Predictable list. It remains available at a discount price after a decade of solid share price gains.

It is a predictable stock generating earnings that have grown consistently over the past 10 years. Indeed, we saw its Ebitda growth rate averaged 14.34% per year. Assuming it does have at least a narrow moat, we might expect similar growth in coming years.

This stock may be of interest to some income investors since there is a reasonable possibility First American's dividend yield may more than double in the next five years. Growth investors may be interested in its potential share price which until earlier this year had been growing steadily.

I do not own shares in any of the companies named in this article.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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