Argo Group Is A Confounding, But Potentially Undervalued, Stock

By Stephen D. Simpson, CFA | June 12, 2012 AAA

The world of insurance stocks can be simultaneously quite simple and quite complex. Actuarial science is by no means easy, and it can be difficult-to-impossible to really evaluate a company's underwriting risks or investment strategy from outside of the company. On the other hand, watching metrics like book value growth, return on equity, premium growth, combined ratio and prior year development can usually point investors towards successful insurance stock picks.

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Argo Group (Nasdaq:AGII) stands out as something of a challenging case. Book value growth and return on equity have both been unimpressive, but the company's low valuation may represent a real bargain if the company can improve its operating results.

Not a Bad Market ... When the Models Are Right
Companies as diverse as W.R. Berkley (NYSE:WRB), XL Group (NYSE:XL) and Berkshire Hathaway (NYSE:BRK.A, BRK.B ) have shown that there's money to be made in markets like excess and surplus, specialty commercial and reinsurance. In excess, for instance, companies can benefit from relatively less competition and less regulatory burden, which can allow for stronger pricing.

In the case of Argo, though, the book-value growth has not been so impressive, and underwriting performance has been pretty iffy. The company's loss ratio has simply been too high in recent years, and one and two-year development for business written in recent years has been decidedly less favorable than in years past.

SEE: The Myth Of Profit/Loss Ratios

Simply put, this just has to get better for this stock to work. Companies like W.R. Berkley, Arch Capital (Nasdaq:ACGL) and Berkshire have thrived in large part because of superior underwriting. The ability to evaluate, and price, risk better than the competition is a key differentiating factor in the insurance business, and I'm not sure Argo is good enough at it.

Investment Returns Certainly not Helping
An under-appreciated reality of the insurance business is that there are a lot of companies out there that, more or less, break even on underwriting and make most of the earnings from the investment portfolios. That can be especially common with companies (like Argo) that tend more towards long-tail exposure--that is, policies where the incurred loss and payout may come many years after the policy is written.

SEE: Equity Valuation In Good Times And Bad

That the investment environment is not great is hardly news. Every investor knows that interest rates are low and that the yield on bonds (the primary investment vehicle for the overwhelming majority of the insurance industry) is likewise not very good. This has left companies like Argo with few good choices--either take the low yields offered today, or take on more risk (whether that's credit risk, liquidity risk, duration risk or so on) in pursuit of higher returns.

The Bottom Line
Figuring out a fair value on Argo is a tricky exercise. An excess returns model (that is, a model that projects future returns on equity) doesn't offer up a very bright picture. Even if the company can lift its return on equity to about 7 or 8% by 2017 (a big improvement from recent years, though still weak on a peer basis), the suggested fair value is still below today's price.

SEE: Investment Valuation Ratios: Introduction

On the other hand, insurance companies are often evaluated on the basis of price/book, and that is where this stock is more interesting. Argo trades at about half of its stated book value and about 60% of its tangible book value. That's an uncommonly low valuation, but it must be said that Argo's return on equity is quite low as well. Even still, it's hard to see that Argo fully deserves that low valuation and if management can start delivering better loss ratios, the stock could definitely outperform.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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