Financial stocks are probably among the trickiest to analyse due to the extensive room available for potential manipulation by the companies’ management. Their audit reports, therefore, may not always reflect the reality – even if there were issues with a company, its investors would have been kept in the dark until after they eventually imploded.
A bank, for example, may push its non-performing loan (NPL) ratio down by continuing to lend to corporates with financial difficulties to boost their repayment capability.
Another thing investors should be mindful of is the time lag of NPLs. NPLs may be uncommon in the early stages of a loan cycle, such that a bank with a high loan growth rate will also have a lower-than-peers NPL ratio, but a lower NPL ratio is by no means indicative of stronger governance. As loan growth gradually slows, the NPL ratio will likely rise over time when reality kicks in. In relatively mature markets, such as Hong Kong, this is not a regular occurrence, though the same cannot be said about banks in emerging markets.
Even more difficult to dissect than banks are insurance companies, especially lifers. While customers of life insurers pay annual premiums for their policies, the payouts of which upon the insureds’ deaths can take place several decades later, leaving much more room in the annual account reports for even more assumptions on which future expenses are projected, including mortality rates, and the commission plans of insurance agents. The more assumptions there are, the easier it becomes for an insurer’s management to doctor the numbers on its ledger book. Indeed, most of the listed insurance companies run respectable, honest businesses, and the assumptions in their annual reports must have also been the best estimates available. Still, there are blind spots in these numbers that investors should recognise.
How then do we assess the valuations of insurance companies as an investor, and determine their target prices? Given that insurance companies derive parts of their income from investment returns, which are inherently more volatile, valuation metrics using price-to-earnings ratio (P/E ratio), for example, is typically not our preferred methodology for the reason that a low P/E ratio can be indicative of high investment returns in a given year, rather than of good performance in their core businesses.
A more commonly used measure aiming at alienating the volatile effect of investment returns on valuations involves embedded value (EV), which can be divided into net asset value and the present value of projected future profits from in-force policies. Insurance companies would also indicate in their annual reports the value of new business (VONB) to help investors construct a more comprehensive understanding of the company as the value from future new business is excluded from the EV methodology.
While both EV and VONB contain assumptions for future businesses, they can nevertheless serve as a reference for investors. Typically, insurance companies’ annual reports would include a section that details how changes in those assumptions would affect their EV and VONB – it helps inform investors of the economic environment that would give a leg up to their valuations relatively.
The biggest listed insurance company in Hong Kong, for example, indicated that the current economic environment – in which interest rates, risk discount rates, as well as inflation are rising and coinciding with market selloffs plus a strong dollar – will have a negative impact on its EV and VONB.
However, not all insurance companies’ EVs are subject to the effect of rate hikes – given that a considerable amount of in-force policies among some lifers in Japan, South Korea and Taiwan are non-participating life insurance plans that provide guaranteed benefits, for which they had to dig into their own pockets to fulfil in the previous low-rate environment, it would perhaps tip the scale in these insurers’ favour as interest rates look set to rise further.
This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.
Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.
There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.