Insurance Space

Lots of companies are showing improved profits these days, but only a few can boast that their profits doubled in the latest quarter from the previous year.

For this column, I screened about 1,700 U.S. stocks with a market value of $1 billion or more, and found about 100 that can make that claim.

By no means would I buy all of these stocks. Some are too indebted. Others sell for a high multiple of earnings or have business strategies that leave me skeptical. Yet several seem to me to have investment merit.

My favorite in the group is Merck & Co. The Whitehouse Station, New Jersey, pharmaceutical company earned $3.4 billion in the quarter ended Sept. 30, compared with $1.1 billion in the same quarter of 2008.

Merck’s appeal starts with its gargantuan pretax profit margin of more than 41 percent. From there I move on to its 4 percent dividend yield, which is amply covered by earnings. Yes, the company hasn’t increased its quarterly dividend of 38 cents since 2004, but unlike many others, Merck didn’t need to reduce or eliminate it during the recession.

Then there’s growth, the very quality that detractors say drug stocks don’t have. As with many of its peers, Merck saw earnings decline from 2003 through 2007. However, earnings more than doubled in 2008 from 2007’s depressed level. Estimated earnings for 2009, at $3.29 a share, seem to me to justify a share price around $49, or $10 above recent quotes.

Merck’s Strengths

Another criticism often leveled at pharmaceutical companies is that they have many important drugs going off patent (this part is true) and that they will be unable to come up with new blockbuster drugs to replace them (false, in my opinion). Merck has about 47 drugs in the latter phases of development, including ones it inherited through its acquisition of Schering- Plough Corp. in November, according to its Web site.

Merck shares are up about 90 percent since I recommended them on March 9, coincidentally the day the U.S. stock market bottomed. The shares are not cheap by every measure, but they sell for 12 times earnings, a valuation I find attractive.

Lancaster Colony Corp. stands out in this group because it is completely debt-free. The Columbus, Ohio, company makes specialty food products, glassware and candles — the sort of items that make a nice gift for your aunt and uncle at Christmas time.

Lancaster Colony earned $28 million in the September quarter, up from $11 million in the same quarter a year ago. Chief Executive Officer John B. Gerlach Jr. owns more than 900,000 shares of the stock, or about 3 percent of the company, a situation I like to see.

Few Followers

Only four analysts cover Lancaster Colony. They split evenly between “buy” and “hold” ratings. That, too, is a situation I like to see, since some academic research suggests that under-followed stocks perform better than heavily researched ones.

The company just increased its quarterly payout to 30 cents a share, from 28 cents. In my opinion, Lancaster could afford to boost the dividend even higher — and should.

Chubb Corp., a property and casualty insurance company out of Warren, New Jersey, is next up. It notched profits of $596 million in the September quarter, compared with $264 million a year earlier.

Chubb shares are up about 25 percent since I recommended them in May. Yet they are hardly pricey, trading at eight times earnings and only a little over book value (corporate net worth per share).

Profits Climb

Chubb made close to a 12 percent profit on underwriting last year. That is, the premiums it collects exceeded claims (58 percent of premiums) and company expenses (30 percent). By contrast, many insurance companies break even or worse on underwriting and try to make up for it with investment income.

I also like Unum Group. This Chattanooga, Tennessee, company specializes in group and individual disability insurance.

Unum’s profits rose to $221 million in the September quarter from $108 million a year earlier. Frankly, this surprised me, because traditionally, disability insurers face rising claims during times of recession and high unemployment.

I give Unum credit for navigating a difficult environment. Also, I like its low valuations — eight times earnings and less than book value. However, profits, while improved, still are not robust: Return on stockholders’ equity was only 9.3 percent last quarter.

Arch Capital

At the risk of being top-heavy in insurance, my final choice is Arch Capital Group Ltd., a reinsurer with headquarters in Bermuda. Reinsurance is a tricky, but often profitable, business. Arch and its brethren take on the excess risks that regular insurance companies wish to lay off.

In the September quarter, Arch earned $280 million, up from $33 million a year earlier. Several other measures of profitability are perking up, too. The stock sells for eight times earnings and just over book value.

Disclosure note: I own Merck and Arch Capital shares personally and for clients. I have no long or short positions in the other stocks discussed in this week’s column.

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Tags: Insurance