Why I’m buying QBE Insurance shares next week

For those who hold QBE Insurance, the huge profit warning was as welcome as a January hailstorm. Rather than running for cover, Scott Phillips’ strong belief is that the 2011 profit is likely to be a low point in the company’s performance. He’s buying.

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If a week is a long time in politics, a day can sometimes be a long time for investors.

For entrée, we saw fashion retailer Noni B (ASX: NBL) come out and confound the market – and its retail brethren – with a surprise profit upgrade.

A profit increase of between 40% and 60% is now expected for the first half of the fiscal year. The company reported sales that were around the same level as the prior year, citing cost savings and margin improvements as the causes of the earnings growth.

Noni B’s thinly traded shares jumped 37% on the day, sending the stock to a 5-month high and finally bringing some relief to long-term investors who are down around two-thirds since April 2010.

Insurance indigestion
Unfortunately for those of us who hold QBE Insurance (ASX: QBE) shares, yesterday’s main course wasn’t anywhere near as satisfying.

QBE is facing an unfortunate trifecta of a larger number of so-called catastrophe claims, increasing paper losses on its fixed interest investments and a similar impact from a change in a key number known as the ‘risk free rate’ which insurance companies use to calculate the amount of money they must set aside for claim payments.

The net result was a profit downgrade of between 40% and 50% below the prior year – a very significant haircut in anyone’s language.

A bumpy ride
Insurance by its nature is a tough business. You can statistically estimate the likelihood of catastrophes, but these numbers are only ever ‘best guess’ estimates, and mother nature doesn’t pay much heed to the forecasts of actuaries. As a result, insurance companies get the estimates reasonably right over the medium and long term, but the results on a yearly basis are necessarily lumpy.

Adding to the challenges, insurance is a fairly commoditised product. As a consumer, you pay a premium which is more or less correlated to the value of the home, car or life you are insuring. That shouldn’t come as a surprise – each insurer has a team of people whose sole jobs are to calculate the likelihood of a particular event (car accidents, earthquakes and even death) during a given period, and come up with a premium that covers the risk to the insurance company and leaves a little profit afterwards.

Charge too much, and consumers (and businesses) go elsewhere. Charge too little, and you’ll choke on a large number of unprofitable policies, which will put the company at risk.

But worth the discomfort
The best insurers – a group in which QBE can be comfortably placed – get the balance right, allowing them to make a profit on the policies, while getting to use policy-holders’ money – effectively for free – to earn an investment return.

Given such a lumpy business and adding in the variability of interest rates from year to year, investors shouldn’t be surprised that QBE has great years and terrible years. Extrapolating a fair value for the shares based on one year’s performance is a dangerous game – yet that’s what the market continues to do.

In the last 5 years, QBE shares have traded as high as $35 and as low as $10 (yesterday). 10 years ago, the shares were selling for around $6. The implication is that the company somehow increased in value by 5.8 times between 2002 and 2007, and then dropped almost 70% to today’s price in the period since.

As good as it gets?
The benefit of such a miscalculation is that it gives patient, insightful investors the opportunity to buy low and sell high.

QBE has a top-notch management team, a great collection of businesses, and a very conservative investment strategy. It is in a tough, volatile business. Today’s share price likely reflects to a large degree the reduced 2011 profit result that QBE will turn in. Effectively, Mr. Market is giving us the chance to buy QBE at a price that implies no improvement.

To be honest, I think QBE would still be reasonable, if not outstanding, value even if the profit stayed around these levels, so the downside is probably somewhat – but not entirely – protected.

My strong belief, however, is that the 2011 profit is likely to be a low point in the company’s performance. I don’t know whether 2012 is the beginning of the profit recovery, but I believe it will improve over time.

Foolish take-away
It’s for that reason that I’m going to add to my QBE shareholding next week, taking advantage of the lower price – but only after The Motley Fool’s strict disclosure rules allow me to.

I don’t know if the shares will fall further from here. That’s okay by me – while I’d feel better if the share price improved sooner rather than later, I’m not trying to time the market. I’m instead betting on a solid return with a multi-year time horizon. If I’m right, my patience will deliver market beating returns over that time.

Are you looking for more stock ideas? Motley Fool readers can click here to request a new free report titled The Motley Fool’s Top Stock For 2012.

Scott Phillips is The Motley Fool’s feature columnist. Scott owns shares in QBE and will buy more shares next week, once the Motley Fool’s strict disclosure rules allow. The Motley Fool’s purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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