Insurance broking as an avenue for recovery

This phenomenon, which saw highly cyclical companies such as those involved in mining services lead the market out of its March slump despite little discernible change in the operating environment, was unflatteringly christened the "Dash for Trash" by fund managers with a taste for rhyme.

The equities strategy team at Macquarie this week nevertheless emphasised "the necessity for investors to quickly add beta to their portfolios to capture the improving investment scene".

According to Macquarie, stronger recent US consumer sentiment and manufacturing data builds upon a smattering of other positive indicators to signal that markets will increasingly support cyclical stocks.

Among the scramble for cyclical stocks, many high-quality, defensive, mid-sized companies are being left behind by the market. Some are starting to look cheap. Good stories can be found in health care, funeral direction and office supplies. A personal favourite is Austbrokers, Australia's leading listed aggregator of insurance brokerages.

Austbrokers is a conservatively managed business with a market capitalisation of just under $200million. The company owns a share in about 40 small to medium-sized insurance broking businesses. Austbrokers typically holds a 50per cent interest in each business, with senior staff owning the remainder. This "owner-driver" model ensures that management is committed to business, while the parent company provides valuable systems and back-office support.

From an investment perspective, insurance broking is a straightforward business. An insurance broker acts as intermediary between underwriter and end customer on commercial insurance transactions. Often operating from suburban offices, an insurance broker works with a customer to understand their insurance requirements before sourcing competitive quotes from underwriters. The broker generates revenue by taking a commission on insurance premiums paid and charging fees to the insured.

The pricing of premiums for commercial insurance is somewhat cyclical, rising in periods where underwriter profitability is under stress due to high claims levels, before falling again when profitability is restored as excess profits are competed away. This pricing dynamic results in huge variation in the profitability of underwriters, but has a more benign impact on the performance of brokers as it is only the commission component of revenue that is affected and also because brokers do not have exposure to the cost of claims, a highly variable expense. For the past six years commercial insurance premiums have been falling or stable, yet Austbrokers has achieved solid profit growth in every year. Austbrokers' investment fundamentals are compelling. The company is trading on a reasonable price/earnings multiple of about 9.5 times Goldman Sachs JB Were's 2010 forecasts and looks set for growth in earnings per share of about 10per cent a year while paying solid dividends. While a large number of companies trade on single-digit price/earnings multiples, few offer as much earnings certainty and scope for profit growth in good times and bad.

Austbrokers' earnings certainty arises from the stability of the sector. Insurance broking customers tend to be sticky, with only a low level of annual "churn". The biggest risk would arise if a severe economic downturn led to a significantly reduced customer base due to businesses failing or electing to self-insure. Any clouds currently on the economic horizon are not that dark.

In the near term, Austbrokers looks set for good earnings growth on an upswing in the pricing of commercial insurance. Recent industry reports suggest that price increases of about 10per cent are likely across a range of commercial insurance lines next month the biggest month for insurance renewals.

Over the medium term, Austbrokers will grow earnings organically and through an acquisition program under which businesses worth about $15million are acquired in a typical year. Even after years of sector consolidation the small end of the insurance broking industry remains fragmented. The proprietors of many of these businesses are approaching retiring age and succession planning is a challenge. Selling a part of the business to Austbrokers is therefore attractive. As there are few other active acquirers in the market, Austbrokers is able to complete acquisition transactions on terms that are fair to vendors and value-creating for shareholders.

While the outlook is strong, Austbrokers' potential is not limitless. A share price a little above $5 a share, a premium of about 35per cent to current pricing, would be a good result in the near term. When combined with low downside risk, this potential is sufficient to attract a Buy recommendation from Carpathia.