Fifteen months ago, I offered up my favorite kind of investment idea.
It was an asymmetric investment opportunity, or a trade heavily skewed in favor of upside with a minimized chance of downside.
In an ideal world, my entire portfolio would be built of asymmetric opportunities like this one… This particular asymmetric opportunity I identified last August was in the insurance sector.
A business that is, for the most part, beautifully boring.
What attracted me to insurance stocks last August was their valuations – most of the entire sector was absurdly cheap.
Perhaps cheaper than it had ever been before.
Three world-class insurance companies caught my eye. This trio consisted of American International Group (NYSE: AIG), MetLife (NYSE: MET) and Prudential Financial (NYSE: PRU).
All three of these rock-solid businesses were trading for less than 0.5 times book value, as you can see below.
Historically, these companies have traded at or above full book value.
To get back to normal historical valuations, this group of blue chip insurers would have had to double.
That was our upside potential.
More importantly, with these stocks trading at historic lows, like $0.50 on the dollar, it seemed to me that their long-term downside risk to investors was almost nonexistent.
Whenever an asymmetric opportunity like this exists, it is important to ask yourself why.
Why would a group of solid companies be priced so cheaply relative to historical norms?
In this case, the earnings of the insurance sector were deeply depressed by the astoundingly low interest rates in effect in August 2020.
Insurance companies make money investing the cash that they receive from premiums.
Since most of those investment dollars have to go into fixed-income securities, low interest rates are a terrible drag on earnings.
By valuing these insurance stocks at less than 0.5 times book value, the market was telling me that it didn’t think interest rates were going to rise anytime soon.
While I didn’t know when interest rates might start rising, I noted two important factors working in our favor:
- It was virtually impossible for interest rates to go any lower, so again our downside was limited.
- With central banks around the world printing money like never before, the chances of interest rates soaring was high.
The degree of risk was skewed in our favor.
Since then, interest rates have had a big move higher.
For example, the 10-year Treasury rate has tripled from its August 2020 reading.
Rising rates mean rising earnings for the investment income generated by insurance companies.
Rising earnings drive stock prices higher.
The average increase in the stock price of these three insurance companies since last August is 75%. That return is 32 percentage points better than the 43% return of the S&P 500 since I recommended this group.
With the significant rise in the share prices of these companies, I no longer see the same kind of asymmetric opportunity that these stocks presented 15 months ago.
They aren’t nearly as cheap.
These companies’ price-to-book ratios – or the ratio for price per share divided by book value per share (balance sheet asset value minus select liabilities) – have risen from about 0.5 to around 0.7.
But in spite of the rise in prices, these stocks aren’t expensive yet.
I think there’s still upside here if interest rates keep moving higher, which seems almost certain with ongoing inflation at concerning levels.
I could see this group continuing to move higher, and I would target full book value as an exit valuation point for the group.
Historically, I have been guilty of not letting my winners run for long enough, and I don’t want to make that mistake here.
We are up 75% so far on this trade, and I think we could get a full double out of it as interest rates trend higher in the coming months.
Low risk, high reward.
Tick this trade off as one that worked out perfectly.