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1 stock overlooked by the market

I might be biased. I have held this stock for some time and continue to buy in, which makes me less than perfectly objective but read on and decide what you think for yourself.

Stock picking can be tricky business, particularly when the market is “fully valued.” Foolish investors will know, however, that we’re not interested in short-term fluctuations or whether or not QE tapering happens in December, January or on a Wednesday or Thursday. We are being optimistic about the future and finding ways we can make it profitable. Our job as savvy long-term investors is to find stocks that the market has, to put it bluntly, got wrong.

According to this excellent article written by Motley Fool Investment Advisor Scott Phillips, there are a number of certainties as we look forward:

  1. Companies listed on the ASX will make more profit
  2. Dividends will be higher
  3. We will be healthier
  4. We’ll live longer

One company likely to increase profits and dividends in FY14 and that I am certain that will benefit from numbers 3 and 4 above, is Challenger (ASX: CGF).

Challenger is Australia’s number 1 annuities provider to retirees. An annuity is essentially a contract for reliable income. A customer pays a premium to the company, and the company will invest the money and return regular payments to them for a specified period of time. Sounds boring right? Exactly.

Annuities are, for the most part, designed for low-risk investors who want the same amount of money entering their bank accounts each month regardless of financial and property market performance.

As you can imagine, it’s a difficult business to operate and is heavily regulated by APRA. However Challenger’s ‘Life’ division receives an ‘A’ credit rating from ratings agency Standard and Poor’s and for five years running has been voted annuity provider of the year by the Association of Financial Advisors.

Challenger’s annuity sales are growing and in 2013 grew by 18% to $3.1 billion, taking Life’s total investment assets to $10.8 billion. What’s more, Australian retirement income is expected to grow strongly in the next 20 years. The baby boomers control one third of the country’s superannuation, and they are about to hit retirement.

Australia’s superannuation nest egg is expected to grow from $1.5 trillion to $6 trillion before 2030. Life’s annuity sales for the quarter to September 30, 2013 were $732 million, and included a 48% increase of retail sales.

This could partly be attributed to sub-par returns from other investments classes that rely on interest rates, such as term deposits or interest bearing accounts.

Challenger’s record annuity sales throughout 2013 are notable because it performed well despite the rise in share markets. This highlights many investors’ post-GFC predisposition away from ‘risky’ asset classes. Since 2009, annuity sales have increased by a compound growth rate of 43% each year.

CEO Brian Benari said, “The demand for any fixed income investment will respond appropriately to market falls and ongoing volatility, but we remain firmly of the view that the trend to longer-term and lifetime annuities is sustainable.”

Funds management

Challenger’s Funds Management division represents around 16% of revenues but it is one of the fastest growing investment managers in Australia. As an example, two years ago the company was the 19th biggest funds manager in Australia, it’s now seventh.

Funds management is divided into two groups. Fidante Partners is a multi-boutique platform group with a number of separately branded investment managers, and Aligned Investments manages Life’s assets as well as those of a number of third-party clients.

In 2013, Funds Management generated $7.0 billion of net flows, up from $4.2 billion in 2012. This highlights the strong investment performance of the managers as well as Challenger’s unique model. Its flagship funds have outperformed their benchmarks over a five-year period. Aligned investments includes ASX-listed Challenger Diversified Property Group (ASX: CDI).

Challenger’s total funds under management (FUM) were $46.1 billion at 30 September 2013, up 31% year-on-year and 3% for the quarter. Challenger’s FUM will likely increase through FY14 as a result of the bullish sharemarket and low interest rates.

Cash position, valuation and dividends

Challenger has to conform to strict capital requirements, similar to banks and other general insurers. However, Challenger Life held $897 million of surplus capital above APRA’s regulatory requirements and the group held $177 million of cash. Challenger has no outstanding group debt.

In FY14, management is expecting to raise the dividend payout ratio to between 35% and 40% of earnings, which means the 20 cent full-year dividend will increase. It will also be partially franked. Challenger Life is expected to produce cash operating earnings between $465 million and $475 million in 2014 and, as seen above, Funds Management is increasing strongly.

Challenger, unlike its Australian rivals, trades cheap – on current earnings around 10. It has a 10-year average annual PE of 10.8. Platinum Asset Management (ASX: PTM) trades on 24 times current earnings and Magellan Financial Group (ASX: MFG) trades on 26 times earnings.

Foolish takeaway

Investors should expect modest earnings growth from Challenger in coming years, but it will be sustainable. The company has recently released new products that have been very well received by the market. However, I’ll finish off by repeating what Mr Benari said in his opening line of the company’s FY13 CEO report: “There is a saying that we overestimate what we can achieve in one year, but underestimate what we can achieve in 10.” In my view, Challenger is a 10-year stock.

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Motley Fool contributor Owen Raszkiewicz owns shares in Challenger. 

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