With Christmas fast approaching, my best guess for 2011 is that the FTSE 100 will tread water. However, there is an outside chance that there will be an ‘equity melt-up’ and the index will soar. If so, it would be driven up by spooked investors worried about rising inflation. Shareholders would remain largely unscathed, but prudent savers and pensioners would get hammered as the purchasing power of their money diminished. So what to do?
The answer is to bolt some inflation protection onto your portfolio. The cheapest form is large-cap equities, which offer attractive dividend yields and enjoy strong pricing power. Enter Aviva, the world’s sixth-largest insurer. This giant provides 53 million customers with pension and general insurance (such as cover for car products in Europe, North America and Asia). Worldwide revenues were up 5% in the first nine months of this year at £35.9bn. Long-term savings sales were 6% higher, and non-life insurance up by 4%. The firm’s proforma net asset value (NAV) – which reflects the boost from closing its final salary scheme – came in at 497p per share in September, up from June’s 461p.
But even this impressive performance is not good enough for CEO Andrew Moss. He has some radical plans to improve shareholder value. Aviva will shrink its geographical footprint, and concentrate resources in its 12 largest locations. It will dispose of many sub-scale assets, such as those in Taiwan. The criteria for any market staying within the Aviva fold is that either it generates profits of $100m per year and a 12% return on capital, or it must be worth more than $1bn. Better still, Moss is committing to deliver another £400m of cost savings over the next 12 months, as well as producing £1.5bn in cash.
Aviva (LSE: AV), rated a BUY by Oriel Securities
So how much is the firm worth? Well, as an indicator of Aviva’s quality, Royal & Sun Alliance offered £5bn this summer for its general insurance units in the UK, Ireland and Canada. So I would estimate a fair value of about 485p per share – equivalent to 90% of my forecast 2011 NAV. What’s more, the stock offers a tasty 6% yield (twice covered). It also sports a sound balance sheet, with £3.6bn more capital than the minimum regulatory requirement.
True, there are a few potential wild cards. These include the group’s exposure to volatile investment returns, lengthening life expectancies, counter-party risk and the forthcoming proposals to increase capital requirements under Europe’s Solvency II rules. The £3bn pension deficit needs to be watched too, but if there is a surge in inflation then this should become less of an issue over time. However, with the shares trading at a 25% discount to my 2011 NAV figure and on a p/e of less than seven, Aviva rates as a buy. Indeed, if Moss can consistently achieve a return on capital of 12%, then my fair value increases to 550p.
Recommendation: BUY at 378p