The latest teaser for Divide.com’s Premium service ($149/yr) had a headline that caught my eye: “Discover How Our Latest Best Dividend Pick in Insurance Space Is Thriving in the Pandemic”
Who wouldn’t be interested in that, right? The insurance business is under scrutiny and pressure to some degree because of coverage (or lack thereof) for lost business due to pandemic shutdowns, but in general has been strong for years and earned its title as “best business in the world”… and, of course, good ol’ Warren Buffett is the poster child for “insurance wealth.”
Here’s a little more from the ad:
“People forget that Berkshire Hathaway is actually an insurance company. That’s because we often focus on its mix of stocks, businesses and other assets. But the reason why Warren Buffett loves the structure and why Berkshire is able to buy all those stocks comes down to float. Insurance companies are forced to place paid premiums into various assets to cover potential claims. These assets earn interest and insurance companies can do whatever they want with that interest and some of the premium funds. This is called float and makes for a free stream of money for shareholders. It’s what has helped Berkshire build a huge empire.
“It’s also helped our latest Best Dividend Stocks List pick win as well.”
Aha! So what is that latest addition to the “Best Dividend Stocks” list? We get a few clues…
“Our new pick is a global leader in the insurance and risk management sector, operating in more than 150 countries worldwide. This focus on underwriting, insurance brokerage and similar products for wholesale and retail clients has continued to build up an impressive empire.”
OK, so that clears it up that we are really talking about a company in the insurance business… and if it’s in 150 countries it has to be one of the larger firms… but that’s not enough, how about more clues?
“Our pick has been able to raise its payout by over 40% since the end of the Great Recession….
“Healthy payout ratio of 42% and growing yield of 1.70%.”
OK, so a decent and easily supported dividend. “Payout ratio” just refers to how much of the income is paid out in the form of a dividend — companies always need capital to grow and reinvest in the business, so you don’t want a payout ratio too high. 42% is quite low, which means the dividend should be very safe.
Then we get a little more info on what kind of company this is…
“One of the largest insurance brokerage firms, and pulling in more than $5 billion in sales last year.”
Hmmm, so that makes this a little odd — and somewhat like Dan Ferris’ pitch last week, in that it’s implying that an insurance broker has “float” and underwriting income. That’s technically true, I guess, brokers often share a little bit in underwriting profit, that’s one of the ways they are incentivized to bring profitable business to insurers, but the vast majority of the revenue at a brokerage firm comes in the form of commissions from insurance companies for selling policies. Brokers are middlemen, traditionally, they just take a bite off the top before passing the money along to the insurance company… it’s the actual insurer that profits from float and a huge investment portfolio.
Some more detail about this secret company? I thought you’d never ask! More from the Dividend.com spiel…
“… our selection is focused on several high-growth areas, including diving head first into higher-margined consulting business lines as well as owning renewable energy assets with its float. Those clean energy assets are providing plenty of tax savings and boosting profits even further. Bolt-on M&A in the insurance brokerage business is also helping assert our pick’s dominance in the sector.”
And since this is Dividend.com, they focus a lot on that payout — the final clue is that they’ve increased the dividend for ten years straight, with the last increase being “nearly 5%”
So what’s our secret stock? This is, sez the Thinkolator, huge multinational insurance broker Arthur J. Gallagher (AJG), which I also own a few shares of personally. And yes, they are ex-dividend today — the current dividend is 45 cents a share, but you had to own the stock as of yesterday to get that payment. If you’re excited about this one primarily for the dividend, you’ll have to wait a few months for the next one (not a big deal — the stock routinely moves by a dollar or two in any given day and the dividend is fairly small, so being patient about a buy point is more important than getting in before a particular dividend payment).
Here’s how the company describes itself:
“Arthur J. Gallagher & Co. an international service provider plans, designs, and administers a full array of customized, cost-effective property/casualty insurance and risk management programs. The company also furnishes a broad range of risk management services including claims and information management, risk control consulting and appraisals to help corporations and institutions reduce their cost of risk. In addition, the company assists clients in all areas of their employee health/welfare and retirement plans, including plan design, funding and administration.”
And, to further match those clues…
“Gallagher has operations in 49 countries and, through a network of correspondent brokers and consultants, Gallagher offers client-service capabilities in more than 150 countries around the world. Some of the company’s offices are fully staffed with sales, marketing, claims, loss control and other specialists; some function as servicing offices for the various divisions.”Are you getting our free Daily Update
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So why look at this one today? Well, mostly just because I’m finding this to be an interesting trend… growing interest in insurance brokers, including some slightly inappropriate comparisons to actual insurance companies (both Dan Ferris in his pitch of Brown & Brown and Dividend.com with this pitch of A.J. Gallagher imply that these companies share that “float” feature of insurance companies that makes them one of the best businesses on earth… and they don’t, not in any really meaningful way, though brokers and agents are certainly important players in the insurance business).
But, yes, it’s probably also because I’m subconsciously biased and my eye tends to be drawn to stocks and sectors I have researched before or own — and that’s the case with both AJG and BRO, both of which I have been gradually buying in small chunks for about three months now. I shared a lot more of my thinking on the value of agencies in the insurance business last week when I wrote a lot about BRO, AJG and some of their competitors for that Ferris pitch, and before that in missives for the Irregulars, so I won’t repeat all of that here… but this is what I said about AJG when I first started buying it in June:
“… as we approach what will probably be a very ‘hard’ market again (‘hard’ just means rising insurance premiums), but insurance companies at the same time face a year or two of possible claims and heavy litigation expenses as a result of the coronavirus, I see more of an opportunity (and less of a risk) in the agencies at current prices.
“And the two that are reasonably-priced strong businesses with long and stable operating histories, who also settle into the ‘sweet spot’ when it comes to size (big enough to be pretty stable) and growth potential (small enough to still grow a lot over time) are Brown & Brown and A.J. Gallagher (AJG), so I’d like to start a position in one of the two — but which one?
“My inclination is to lean toward BRO, given the fact that they’ve closed the gap on valuation with AJG a bit but are still a little cheaper and significantly smaller, and I remain encouraged by what I’ve read about their strong culture and family ownership. The Brown family started with a single insurance agency in Florida in the 1930s, and began to grow and acquire agencies in the 1960s under Hyatt Brown, the co-founder’s son, grooming third-generation CEO Powell Brown to take his place about a decade ago, and they have now acquired well over 500 businesses in just the last 30 years.
“A.J. Gallagher has a somewhat similar history as a small insurance agency that became an acquirer, with a member of the founding family still at the helm, though unlike the situation with Brown & Brown the founding Gallagher family is not a major shareholder — J. Patrick Gallagher, of the third generation of Gallaghers to work in the company since it was founded by his grandfather, owns about 1.1 million shares (about 0.5%) and is the only meaningful family shareholder, whereas J. Powell Brown, current Brown & Brown CEO, holds about 1.1% of BRO shares and his father, J. Hyatt Brown, continues to control more than 14% of the company’s shares (and continues to serve as Chairman of the Board).
“This will probably not be an exciting business, but I expect that their revenues and cash flow will be steadier than most through this recession… and could surprise nicely if people and businesses are able to pay their (likely higher) insurance premiums in the coming year. There will certainly be some relatively weak periods if the recession deepens and demand for insurance falls, or if there are fewer homes and businesses to insure, but there’s very little real underwriting exposure in the event of catastrophes….”
So yes, AJG is a beneficiary of rising insurance prices… but not really of “float” or investments, though they do have that oddball “clean energy” business as well — I’m not particularly impressed by that, frankly, but it has been a nice boost to revenues for many years now. Here’s what I noted about that when I started buying shares:
“AJG also has an odd ‘Clean Energy’ investment business that’s helped them get a bit of a profit boost over the past decade, it started out by essentially co-investing in ‘clean coal’ production to generate returns from the federal tax credits. This is declining, and will likely decline further with lower GDP leading to lower energy prices, so if you discount that business or think it will go away that’s about 15% of earnings recently.”
The stock is not exactly cheap, and is not growing super-fast on the top line — revenue will likely actually be down a little bit this year, though higher insurance rates are helping to make up for the loss of “insured units” (like fewer businesses who need insurance, or fewer employees covered by employer-provided insurance plans that AJG helps manage), and their earnings are likely, analysts say, to go from about $4.35 per share this year to $4.83 in 2022, which is only growth of about 5% a year.
Bank of America just downgraded AJG (and competitor March & McLennan (MMC)), by the way, cutting AJG’s price target to $101 because of worries that the “operating margins may be inflated and relative valuations over-extended,” and they’ve got the lowest earnings estimates for AJG among analysts now at $3.90 for next year. So maybe that can be a bit of a counterweight to any over-eager optimism you might feel welling up in your belly.
They might grow a little faster than that if they make good acquisitions along the way, since steadily rolling up more firms and regional businesses is the source of much of their growth, but this won’t ever be a high-growth shocker — it’s a strong company in a steady business that I think is well-situated right now, even if I would still give the edge to Brown & Brown in this sector, and I expect it will generate decent returns for patient investors, but in the short term my expectations for both AJG and BRO are quite muted.
I like these brokers primarily for the exposure they give to higher insurance rates, without any real exposure to underwriting risk or catastrophes, and for their very consistent long-term growth as serial acquirers. Both BRO and AJG trade at historically high valuations when it comes to PE ratios, or Price/Sales, but so does pretty much every other “blue chip” stable business in this low-rate era, and they have generally become more efficient businesses as they’ve grown their top line over time. I’d still take BRO over AJG, by a whisker, but I do like AJG’s international business strength and their much higher dividend, and I’ll likely continue to nibble on both in the months to come… even if I should caution you that the dividend, despite this Dividend.com pitch, is not all that impressive.
A 1.7% dividend and 5% annual dividend growth is going to take a loooong time to really compound into a meaningful shareholder boost from the dividend. Every little bit helps, but compared to the S&P 500 that’s both a below-average yield and a below-average dividend growth rate — you don’t need to be perfect, and compounding your dividends through reinvestment can show really dramatic returns over time from either a high dividend that grows slowly, or a low dividend that grows quickly, but being on the low end of both, like AJG, means you’ll probably have to be patient and it’s better not to consider the dividend to be a big part of your potential return. Over 10 years, it’s likely that dividend reinvestment in a company like this will only boost your annualized return by about half a percent (which would mean, roughly speaking, turning $10,000 into $19,100 over a decade if the stock price and dividend both go up by about 5% a year, instead of $18,400 if you don’t let those dividends compound — worth doing, but don’t send the down payment for that private island just yet).
That’s just what I think, though, and I should only decide how to invest my money — when it comes to your portfolio and your needs, you’re the best judge… so what do you think of Arthur J. Gallagher? Excited about it for the 1.7% dividend and the 4-5% dividend growth, or would you rather wait for a more depressed valuation? Think the brokerate business has long-term appeal, or are you worried about disruptors taking share in insurance? Other thoughts? Let us know with a comment below.
P.S. To be clear, no, these large agencies and brokerage firms do not count as “baby Buffett” investments, at least not in my book. They do grow by compounding, to some degree, but that’s mostly because they use a portion of their commission income to buy more businesses (mostly smaller brokers and agencies), which lets them turn around and write yet more insurance (the rest primarily goes to dividends and buybacks) — they’re really good serial acquirers with an eye on maintaining a high return on shareholder equity, but they’re not getting “free money” from insurance “float” to invest.