A major indicator that the FTSE might plummet again is a strengthening dollar. Over the past month the dollar has broken through two key resistance levels against the euro and sterling. So for now I prefer high-quality firms with sound balance sheets and a cheap share price.
Enter Aviva, the world’s fifth-largest insurer. The firm derives around 70% of its income from outside Britain and so will benefit should the pound lurch down again. The group’s main activities are long-term savings (80% of sales) and general insurance (20%). These are all made under the Aviva brand name after the firm ditched smaller ones, such as Norwich Union, last year.
Unlike some rivals, Aviva did not have to resort to a rights issue to boost its capital base during the credit crunch. It started 2009 with £2bn more capital than the minimum regulatory requirement. By December that had been boosted to a hefty £4.5bn, thanks to a bounce in corporate bonds, the disposal of its Australian life business for £450m and the flotation of Delta Lloyd (58% owned) for gross proceeds of £1.03bn. Moreover, there is another £1.1bn stashed away as a rainy-day fund in the form of a default provision against its UK annuity book.
Aviva (LSE: AV), rated OUTPERFORM by Keefe, Bruyette & Woods
Aviva’s CEO, Andrew Moss, updated the City last week, saying that fourth-quarter 2009 life and pension sales had jumped an impressive 21% over the previous quarter. Despite being hit by £100m of losses from the autumn flooding, I estimate the firm’s year-end embedded value (the main measure of profitability across the industry because it adjusts net assets for the expected long-term returns on policies already written) to be about 530p a share. After being cut by a third, the dividend should come in at 21.7p. That offers income-seekers a 5.5% yield.
Aviva plans to exploit its immense scale by cross-selling products in different territories and by closing offices and making redundancies in order to reduce its overheads by another £261m a year. Reassuringly, Moss said that he is “cautiously optimistic” that the worst is behind Aviva, which “starts 2010 in a strong position”. Analysts have pencilled in 2010 and 2011 underlying earnings per share (EPS) of 66.0p and 72.5p. This puts the stock on a price/earnings (p/e) ratio of less than six.
There are potential potholes ahead. These include the group’s exposure to investment portfolio volatility; life expectancy assumptions; counterparty risk and the forthcoming proposals to increase capital requirements under Europe’s Solvency II rules.
However, with the stock already trading at a 30% discount to embedded value, these concerns are more than priced in. Indeed, if the markets dive again, I could even see the group benefiting as institutional investors scale back risk, dump hedge funds and migrate to cheaper, less volatile and more transparent fund managers. Keefe, Bruyette & Woods has a target price of £6.28 with preliminary results due out on 4 March.
Recommendation: BUY at 361p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments