Note: Earnings listed are in Canadian dollars. The share price discussed is in US dollars.
For much of the past 18 months, investors have yawned at our caution and reluctance to chase stocks higher. For almost all stocks we talked about, we had a lower purchase price that was much lower than the current price. In the case of Manulife Financial Corporation (New York Stock Exchange: MFC), this perfect entry was less than $17.00 back when we covered it in June 2021. Interestingly, the action’s 52-week low was well below $16.65. Have we been long? We tell you why it dropped sharply and where our buying point is currently.
MFC’s Q1-2022 EPS was 77 cents. That was down 5% from 2021 and missed all estimates that called for at least 80 cents this quarter. Analysts were behind the price curve in Asia’s rapid slowdown towards the end of the quarter and are now busy chopping estimates for the second and third quarters. The lockdowns in China are likely to have a significant impact on sales, but this is likely to defer revenue rather than lose it altogether. Still, given that the news came during the most volatile time in the markets, it may have increased the selloff.
More problematic for MFC, however, was disclosure on IFRS 17. As we’ve discussed in the past, insurance companies have a huge asset base compared to their tiny equity base. These assets are invested to earn returns that help them meet or exceed their commitments (read insurance payments) over time. Valuing this is partly a science, but to some extent it is also an art. Well, we have a new artist in town and her name is IFRS 17.
MFC and other insurers under this standard in Canada, including Sun Life Financial (SLF) and Great-West Lifeco (OTCPK:GWLIF), have been talking about it for some time. Everyone who has followed this industry knew this was coming. Nevertheless, no one knew the exact impact until the individual company clarified it. In the case of MFC, the impact seems to be a little bigger than expected. The key points are below.
The decrease in equity corresponds to the decrease in tangible book value. If you recall, we base a lot of our insurance valuations on tangible book value, so that’s obviously something we need to keep in mind when pricing this. Base profits will also be reduced by 10%. Dividends will not change depending on the company, but of course a higher payout ratio could psychologically make the bullish case less appealing.
Is it bad?
From the point of view of a long-term shareholder, no, this is not bad news at all. Earnings that were recognized in advance must now be recognized over the life of the contract. This standard exists in several forms throughout accounting. Even the distribution is observed, for example, in the linear rents of REITs. The cash flow is lower than the recognized income in the first years and higher than in the following years. Over time, things balance out on both the balance sheet and income statement side.
The biggest concern investors should have is whether the changes would impact all material LICAT ratios as equity is lowered. This answer is no. This will not reduce LICAT ratios.
So little changes here for MFC outside of the traditional tangible book value number.
Evaluation and verdict
MFC is cheap compared to the relative numbers for SLF and GWLIF.
It should be noted here that the LICAT ratio of MFC is higher than that of GWLIF (124%) and almost the same as that of SLF (143%) at 140%. This helps to strengthen the case for MFC, as its price is not lower due to higher relative risk.
On the US side, the benchmarks would likely include Prudential Financial, Inc. (PRU) and American International Group (AIG). MFC once again stands out on the cheap side.
MFC also has the best dividend yield here, although it is close.
So our numbers tell us it’s inexpensive, although we still need to figure out a better way to use the new tangible book value numbers. One thing to consider though is that while all of these examples look cheap, they pose substantial risk in the event of a massive downside stock market reset. There is a built-in yield calculation placed on insurance balance sheets, and earnings are likely to fall on average if equity markets disappoint over the long term. This is precisely our way of thinking (0% total returns of the S&P 500 (SPY) until 2030), and therefore we never got into the name.
Our caution in not pursuing this higher level has paid off for us and our subscribers. We established our long position in January by selling the guaranteed cash put options at $18 for June 2022. At the time, MFC was trading a little higher.
But our options gave us a great risk-adjusted entry and offered a high return if the price didn’t get to us.
We are close to reaching this strike price and it is unclear whether we will land with the stocks or not. In the coming days, we will likely approach these options with an option roll to get more bounties and most likely lock in some gains. We price the stock as a buy and have a price target of $20 on it.
Please note that this is not financial advice. It may seem, seem, but surprisingly, it is not. Investors are required to do their own due diligence and consult a professional who knows their objectives and constraints.