An out-of-favour ‘bargain’ stock to watch

On Friday we took a look at the dangers of buying ‘bargain’ stocks.

But, of course, we all love a bit of bargain hunting. And I’m certainly not saying that bargain hunting for stocks is necessarily all bad. There are definitely good stocks to be found at bargain prices.

So today we’ll look at one stock that could be a bargain. It has taken quite a fall over the last few weeks and is now trading at the same level as during the depths of the credit crunch. Long-time readers will know this one.

I recommended Amlin back in February. The stock had already started its descent and to me it looked good value, on a price/earnings ratio (PE) of nine and with a 5.5% yield.

Since then the stock has just fallen even more. It’s now down around 20% since I recommended it. I guess it just goes to show the perils of trying to pick up a bargain!

Share price: 304p
Market Cap: £1,533.54m
52 Week High/Low: 427p/295p

Amlin five year performance: 2006 +30.89% | 2007 -9.77% | 2008 +19.97% | 2009 +0.34% | 2010 +13.99% | 2011 (to 30 August) -22.27%

But I’m not worried. I still like Amlin as a business and it’s set to pay a yield of around 8%, with analysts pencilling in even more for 2012.

Is it the right time to buy now? Well, certainly that’s the sort of chart gets bargain hunters interested.

Let’s take a look at the three traps facing bargain hunters and how they relate to Amlin.

What you need to know about PE ratios

Last week, Amlin posted a pre-tax loss of £192.3m for the six months ending 30 June. Catastrophe claims came in at a whopping £314.3m.

That’s much worse than the market (and I) had been expecting. Earthquakes and floods in Australia, New Zealand and Japan have taken their toll. And now it’s hurricane season!

The first half of this year has been awful for Lloyds insurers such as Amlin. And worse, in the words of one analyst, Amlin was hit by some “unusual and likely unrepeatable” losses from its newly acquired European unit.

But let’s not forget, this is the business Amlin is in. These are risks it is paid to cope with. In fact, if history is anything to go by, then future insurance premiums will go up. Future earnings should improve. All these disasters should be good for Amlin a little further down the line.

But what we have to remember about PE ratios is that they are meaningless if a company is making a loss. There are two ways around the problem. First, as I argued back in February, we can use the average earnings over the last ten years to arrive at a PE figure. That’s known as the ‘cyclically adjusted price/earnings’, or CAPE figure.

At the moment Amlin is trading on a CAPE of just over none times earnings. And that looks like good value.

The other way round the problem is to look at next year’s expected earnings figures. For 2012, analysts are pencilling in earnings per share of 51p, giving a prospective PE of around six times.

And if you’re looking for a cheap stock, then anything under ten times earnings is usually worth considering. At a prospective six times earnings, Amlin looks like a steal.

But we need to know more about how business is going.

Amlin has gradually acquired and integrated many smaller insurers as a way of growing and diversifying its business. And the problem seems to be that some of the recently acquired units have underwritten bad risks.

This is certainly a concern. As I said on Friday, one of the worst things bargain hunters can do is to get involved with rubbish companies. What we’re looking at here is a decent company that’s acquired some rubbish.

For the moment, I have faith in Amlin’s management team. I expect them to turn the newly acquired businesses around.

Three signs I want to see before I buy

The bargain hunter is left with a dilemma. Do you buy the stock because it looks cheap, or do you wait until the underlying problems of the business have been dealt with? There are some clues we can use.

First, the directors have signalled their faith in the business by maintaining the dividend payout. And at 8%, it’s a very tasty return.

But what the directors have not done is put their hands in their own pockets and bought stock. Now that the half-year results are out of the way, I expect to see some director purchases coming our way. If they do, it’ll make me more confident.

I also want to see evidence that insurance premiums are on the way up. This is a cyclical business and we need to be sure that we’re in the upswing. Though premiums tend to go up in the years after big payouts, it will be nice to see this in action.

And we need some reassurance that Amlin has got to grips with its newly acquired businesses. They are going to have to prove that they can make these underperforming units pay their way.

I’d love to be able to tell you: “Yes, this is now a bargain… get stuck in!” But that’s frankly not what I see right now, no matter how ‘cheap’ it looks. I want to give you my honest opinion…

And right now, I’m just not excited enough about Amlin to rate it a BUY. But at the same time, I’ve been with it long enough to believe it can turn the corner.

So for now, I rate Amlin as a HOLD. I’ll keep an eye on it and let you know my thoughts in the future.

• This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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