What's Happening With QBE ?

Certainly, I have been as surprised as many among you by QBE Insurance's ((QBE)) stellar share price performance this month. As at Friday's closing price, the shares are up by 25% in March in an overall flat market, of which circa 22% has been achieved over the past two weeks alone. If we go back to that cloudy day in January when management under departing CEO Frank O'Halloran had to issue an embarrassing profit warning that caused the share price to temporarily sink below $10, then the rebound has been an impressive 40%-plus.

The gains have not gone unnoticed and FNArena has been receiving an ever increasing number of enquiries about QBE. Time for an explanation thus. What the hell is going on with QBE's share price?

Let me first point out it has been an absolutely horrendous experience for long term investors who've held on to their shares since the peak at $35 in late 2007. The share price declined to below $25 in 2009, then below $20 in 2010, then below $15 in 2011 and eventually below $10 in January this year. Even Telstra ((TLS)), which after all has been one of the most efficient killers of shareholders capital since listing, has never been able to match what QBE "achieved" in the 4.5 years prior to this month's revival.

The story of QBE, in my view, provides an excellent example of "reversion to the mean" and why investors should pay attention to excessive profit margins. In QBE's case, post the 9/11 tragedy in 2002 the insurance margin had expanded to triple the margin leading into the event, see the excellent chart from Macquarie analysts below. What transpired next is comparable as to what happened after Woolworths' ((WOW)) Price-Earnings ratio hit an excessive 27 that same year: the normalisation process that followed was always going to make it difficult for the share price to not disappoint in the years thereafter.

Equally important is the observation that 2007 also marked the high point in QBE's investment yield. Insurers such as QBE collect a lot of money in advance which they park in relatively low risk assets such as government bonds. A prudent QBE parks most of the funds it collects in the US market in US yield assets to avoid extra risk from currency movements. Alas, with the Federal Reserve keeping bond yields depressed since 2009 to help stimulate economic growth and support banks' margins, this has had a depressing impact on QBE's investment returns.

As I have tirelessly explained over the past three years, QBE is partially the victim of monetary policies in the US. Owning the shares should therefore come with a personal view on US interest rates. Once interest rates start moving up, QBE is probably the highest leveraged exposure available in the Australian share market. Earlier calculations I made in the past had shown QBE's share price could easily rally by 30% and more from the moment US bond yields were on a sustainable path higher and those calculations were made from a much higher share price.

So how come I still wasn't prepared for this month's jump in the QBE share price?

I guess I was wrong-footed by yet another profit warning which led me to think that, following five years of continuous disappointment for loyal shareholders, investors would put the stock in the doghouse for longer, especially with questions remaining as to the company's adequate financial reserves and the industry's sustainable prospects in the face of changing weather patterns. In addition, the Fed's promise to keep US interest rates low until late 2014 didn't seem to leave much room for surprise either, in particular since I remain of the view that US economic growth is not as firm/solid as other commentators and economists believe it is. (QE3 is not yet off the table thus)

What I did not anticipate was that US bonds, which had risen significantly in the face of European threats to global growth, had simply risen too high and a "correction" had thus become inevitable. That correction has occurred over the past months with the yield on 10 year US government bonds reversing from below 1.7% last year to above 2.30% this month. While this doesn't seem much, such reversal in yield requires quite a big sell-off from bond investors and traders. Compare it to a sharp fall in the share price of a dividend paying stock. Add the fact that many an equities bull has grasped the opportunity to announce the start of a bear market for government bonds, UBS included, and it is all of a sudden not difficult to see as to why hedge funds and traders have been quick to jump on the beaten down QBE share price.

International research from investment bankers and brokers shows (general) insurers and banks are the main beneficiaries from rising bond yields, so no guessing as to why Australian banks also seem to have rediscovered some of their mojo this month. This apart from the fact the sector usually enjoys buying support when dividend payouts are on the agenda. Plus the fact that recent research by Societe Generale and Deutsche Bank suggests an improvement for the sector's margins from a relaxation in funding pressures.

The recent re-adjustment in bond yields (Australian 10 years rose from below 4% to 4.2%) also offers a stern warning to investors seeking yield and safety in government bonds. Timing in the bond market is as important as it is in the equities market and with global bonds offering historically low yields it is but a genuine threat that returns from bonds this year might turn out negative. This would be a fait accompli if bond prices would move even lower (yields higher) as most experts now seem to be predicting.

Problem number one with bond markets in the US, Europe and Japan is that central bankers have manipulated yields to much lower levels than would otherwise have been the case. So how high yields (how low prices) can re-adjust before these central bankers move in is anybody's guess. Some experts estimate that even on "normalisation" US 10 year bond yields might well rise to 2.75% - that would mark a further significant sell-off and guaranteed negative returns for the year ahead for investors holding on to these bonds.

Imagine what could possibly happen to QBE's share price were this to occur?

As I explained on Switzer TV on Thursday last week, I fully agree with the fact that yields on government bonds in most developed countries have probably seen their lows for this cycle, hence why the bull market in bonds should be over. The fact that total returns on bonds have now beaten equities over the past 30 years supports this thesis as such event is truly rare in history. However, the transition to higher yields, I believe, will be gradual and slow, once we're past this sharp re-adjustment phase. This because economic growth in those countries is more likely to remain sub-par, plus governments have too much debt to deal with. Thus central bankers will aim to keep yields on bonds depressed for many more years into the future.

For speculators in QBE this means the sharp rally we've seen this month may have further to run still, but only if US bond yields break out to the upside. The 40%-plus bounce from the lows in January has now pushed the share price well beyond price targets set by most stockbrokers covering the insurer. This suggests that, unless we see profit taking pulling the price down, these stockbrokers will start issuing downgrades for the stock.

I can probably safely assume that most analysts have been equally left surprised by the sudden adjustment in US bond yields. Some adjustments to forward financials for QBE might thus become necessary. Regardless, I don't think the share price has much further to run in the near term without support from US and European bond markets. Note that market expectations already assume QBE will more than double its earnings per share this year after the dramatic fall in EPS for the year to December 2011. After that, to date most analysts have penciled in low growth only.

Other positives that could work in QBE's favour include new management now that CEO Frank O'Halloran has announced his departure in August, a sustainable recovery in insurance margins, a 6% dividend yield and a strengthening US dollar. But nothing can match the potential boost from US bond yields for the insurer. This month's share price performance has given everybody a taste of just what can happen from the moment US bond yields will really embark on a sustainable path to higher yields.

By Rudi Filapek-Vandyck,
Editor FNArena