Cincinnati Financial’s Unique Investment Portfolio Makes It A Mini-Berkshire Hathaway

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Shares of Cincinnati Financial (NASDAQ:CINF) have underperformed this year as underwriting missteps and the equity market decline have weighed on results. CINF is relatively unique in the insurance industry as its investment portfolio is highly geared towards equities, which create significant volatility in reported results. In some ways, CINF is like a much smaller version of Berkshire Hathaway (BRK.A)(BRK.B), using its insurance premiums to build a growing equity portfolio that drives shareholder value over time. While this makes CINF’s share price more cyclically exposed than other insurers, I believe it makes CINF a good investment.

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Cincinnati is a property and casualty insurer, which is on track to write about $7 billion in policies this year from $6.5 billion last year. As you can see below, it is primarily a commercial provider, though it has a substantial personal line of business. Its greatest exposure is to the auto sector at about 23% across consumer and commercial.

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Cincinnati Financial

In the company’s second quarter, it lost $5.06 a share due to a $928 million decline in the value of its equity portfolio. Operating income, which looks through this mark to market volatility, fell 64% to $104 million or $0.65 per share. Ultimately when it comes to evaluating results on a quarterly basis, it is better to focus on operating results, and then we can look at the investment portfolio separately. As you can see, net income per share swings massively as the market goes up or down, but operating income provides a much steadier picture.

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Cincinnati Financial

This quarter, the operating results were disappointing. The company’s combined ratio rose to 103.2% from 85.5% a year ago. This measures the insurance losses relative to premiums. A level of 100% means losses are equal to premiums, so at 103.2%, CINF lost $3.2 for every $100 in policies. This elevated ratio came across essentially all of the business due to an 8.5% increase in catastrophe losses. The commercial combined ratio was 106.3% from 84.2%, and personal lines went from 112.1% from 92.7%–in part because loss expenses rose 8.2%.

Aside from the tick-up in catastrophes, CINF was hurt by inflation. An insurer may have to replace your car or building when it is damaged, and the cost of both have risen dramatically, as you can see below. In a sense, Cincinnati was “short” inflation as the elevated losses forced it to replace products at prices higher than it expected when it wrote the policies. This misstep hurt results.

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St. Louis Federal Reserve

On the bright side, it appears that inflation in cars, commodities, and construction is past its peak, so this headwind should be moderating. In response to inflation, CINF has also raised its premiums. In the quarter, earned premiums jumped 11% to $1.77 billion due in part to price hikes. This should improve underwriting results going forward, and combined ratios could improve nicely if car and construction costs fall as these higher premiums are likely to be relatively stickier.

I would also note that CINF has a history of solid underwriting results relative to the industry, so management has earned the benefit of the doubt in my view that one quarter’s issue can be fixed and is not necessarily an ongoing problem.

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Cincinnati Financial

Outside of the underwriting results, the company reported a big loss in investments from unrealized losses on its stock holdings. Cincinnati’s investment portfolio has $9.1 billion in stocks, $400 million in preferred stocks, and $11.9 billion in bonds. That 42% weighting to stocks is much higher than most insurance companies. For perspective, MetLife (MET) has a $448 billion portfolio and just $1.1 billion in equities.

CINF has sized its fixed income portfolio to provide 111% coverage of its insurance risk. That means if losses come in, it can sell bonds to meet them, so that in theory, it will never be a forced seller of equities at the lows. Instead, it can continue to build its equity portfolio as reinvests dividends and underwriting income.

As a consequence, it manages the bond portfolio conservatively. Of its fixed income portfolio, only 5% is rated below investment grade with a 5.1-year average duration. No issuer is over 0.8% of the portfolio. About one-third of the portfolios is comprised of municipal debt with an average AA rating. Given that relatively short duration, it has a constant flow of maturities, which it can redeploy at today’s higher interests to generate more income.

Its equity portfolio is broadly diversified among mostly large cap companies, and its top five holdings are Apple (AAPL) (7.3% weight), Microsoft (MSFT), UnitedHealth (UNH), AbbVie (ABBV) and Accenture (ACN).

Because the company’s earned premiums have exceeded losses year to date as it grows, the company generates cash flow, which has enabled it to deploy another $280 million into its investment portfolio year to date, taking advantage of declining markets.

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Cincinnati Financial

This has proven to be a recipe of success over time as the company has raised its dividend for 61 years, including a 10% increase this past year to $0.69. As a share of cash from operations, CINF’s dividend remains well covered by cash flow, which means that dividend streak should be able to continue well into the future.

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Cincinnati Financial

Given this fundamental analysis, what is the fair value of CINF stock? I like to look at it as a sum of the parts analysis. The S&P has lost about 4% of its value since Q3, so if we assume given its large cap bias, the CINF portfolio performed similarly, it would be worth about $8.8 billion today. Then, there is the 11% surplus of its fixed income portfolio vs expected losses, which is worth about $1.3 billion. So, its portfolio is worth about $10.1 billion for shareholders.

If we assume CINF can bring its combined ratio down to a more normal 92.5% over time, on a $7 billion run rate of premiums, that is $500 million of earnings power.

The stock trades with a $15 billion market capitalization today, so it is valuing the insurance underwriting entity at 10x earnings ($5 billion), a fairly attractive multiple. I would also note this is conservative as CINF has been able to grow its float historically over time by increasing premium income more than it has paid out in losses. As a consequence, it is not as though its ~$10 billion in fixed income that covers 100% of its future losses will be paid out tomorrow. Until they are paid out, CINF earns interest on those assets. With a pre-tax yield of 4%, these holdings contribute another ~$300 million in after-tax net income. Valuing this income stream at 10x is an incremental $3 billion of value. That would imply fair value on the stock of about $117-120 at a 3620 S&P 500 level. Holding all else constant, each 1% move in the stock market is worth about $0.60 to CINF’s fair value. If the company succeeds in continuing to grow its float, it will continue to generate more investment income on the interest and dividends it receives.

Unlike other insurers that don’t own equities in material size, CINF share price will be more correlated with the stock market. In the long run, assuming you believe equities will outperform bonds as they historically have, this can enable CINF to create more shareholder value. Shares are trading at about a 20% to fair value using a conservative 10x multiple on earnings combined with the surplus value of its portfolio. This makes CINF an attractive investment that also should generate steadily increasing dividend income.

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