QBE Insurance Group
Recommendation
QBE Insurance’s share price bucked the trend yesterday, falling 5% despite the Reserve Bank cutting the official interest rate by 25 basis points. Lower interest rates in Australia penalise QBE, as they reduce investment returns and increase claims provisions (due to accounting rules). But the large share price fall was more likely a reflection of institutional investors’ fears of another capital raising.
Losses from Hurricane Sandy and the drought in the US amongst other claims have put pressure on the balance sheet, and rumours abound that a capital raising isn’t far away. Recently, in Dear QBE: Cut the bloody dividend!, I argued that cutting the dividend was a better long term option, but this has likely fallen on deaf ears given Australian companies generally try to preserve the dividend at any cost.
We’ll have to judge any capital raising on its merits, but there might be an opportunity to lock in an arbitrage profit, as we discussed in QBE share purchase plan arbitrage from 16 Mar 12 (Buy – $13.00). If it’s in the form of a share purchase plan, it might pay to have your shares invested across various accounts so you can submit several applications if you wanted to top up your shareholding or lock in a potential arbitrage given the number of shares could be scaled back.
If you’re fearful of a capital raising then now is the time to act. And although there’s no guarantee that QBE will raise capital, we've decided to reduce the prices in the recommendation guide by two dollars as a precaution. If it doesn't eventuate, perhaps because profits increase substantially next year, or the capital raising is smaller than we anticipate, then we can simply reverse course. If you don’t already own QBE then it could also pay to wait for an announcement and a lower share price.
Conservative investors should continue to steer clear but for now, with the share price falling 12% since 12 Nov 12 (Buy – $11.83), we’re downgrading a notch to LONG TERM BUY for up to 5% of a well-diversified portfolio, as the company is capable of producing much higher profits than it will this year in a more benign claims environment.
Note: We’re unlikely to upgrade to ‘Strong Buy’ again given the company’s issues are no longer just cyclical. QBE is a turnaround situation, which entails additional risk.
Note: The model Growth and Income portfolio's own shares in QBE Insurance.