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Buy/Sell Recommendations
Morgan Stanley (New York)
Farmers
Group: The Network Strikes Back
As Associate Editor for Morgan Stanley Research in New York from 1980-1983, I edited literally hundreds of earnings reports, industry trend analyses, and purchase recommendations of the department's industry analysts. Every piece had to conform to Morgan Stanley 's strict editorial guidelines and standards. I scrupulously checked each figure in the report for reasonableness and consistency. This purchase recommendation of Farmers Group is an example.
Summary and Investment
Conclusion (1983)
Farmers Group holds a particular fascination for many insurance stock investors by virtue of its unique structure. Farmers manages a trio of reciprocal exchanges and one mutual company from which it earns fees based on a stipulated percentage of their premium earned. These managed companies wrote in excess of $2.8 billion of premiums in 1982, approximately 70% of which were for private passenger automobile insurance, making Farmers Insurance Group the third-largest auto insurer in the nation. Another 17% of the Group's premium volume came from homeowners insurance. Farmers boasts an exclusive agency force of 13,700 men and women that services a base of over 10 million policies in force, concentrated in California, Texas, and eight other states in the West and Midwest. It also owns outright three life insurance companies, which, taken together, would have ranked forty-eighth among U.S. life insurers in 1981 when measured by premium income.
As a result of its property casualty insurance company management operations, Farmers Group's shareholders participate in the dynamics of premium volume growth inherent in this business but avoid the exposure to its traditional cyclicality caused by fluctuating underwriting results and catastrophic loss. Farmers's insurance company management business over the past five years has experienced moderate-to-rapid annual revenue growth (14.6%), high profit margins (21.4%) and returns on equity (25.1%), and, until a few years ago, low capital intensity. The Company's life insurance business, established in 1954, has enjoyed revenue growth rates (12.1%), profit margins (19.2%), and returns on equity (12.4%) of more modest proportions, although, in our opinion, this has not detracted (at least until recently) from investors' perceptions that Farmers's consolidated earnings stream is one of exceptional stability and predictability.
While Farmers Group's earnings per share have grown at an average annual rate of 17% over the past decade, profit performance in recent years has been substantially below this norm. For the three years ended in 1982, it appears that the Company's annual earnings growth averaged a lackluster 6.5% to 7.0%. Our long-dormant interest in Farmers Group has been rekindled recently, however, through a continuing search for investment ideas -- both old and new -- capable of yielding above-average returns. In October 1982, our colleague Norm Rosenthal recommended the purchase of GEICO -- a direct writer of private passenger automobile insurance -- based in part on our shared view that personal auto insurance is one of the few industry segments currently experiencing an mprovement in pricing trends and, in some cases, better underwriting results.
Certainly, Farmers Group -- with its enormous stake in protecting drivers, their families, cars, and homes from financial disaster -- fits nicely into this concept. In addition, we think that the Company stands to win in two ways from a consumer-led economic recovery: premium volume growth in the reciprocal exchanges should benefit from a surge of new car buying by the American public, while life insurance sales, persistency, and profit trends are likely to improve owing to the lower interest rates and higher per capita income that should follow the recession's passing.
During our recent investigation of the Company's prospects, we spent a lot of time poring over its financial results for the past five years. This analysis persuaded us that a major factor in the management company's sluggish profit performance since 1980 has been a level of "investment spending" unparalleled within recent memory. By year-end 1982, capital expenditures devoted to expanding the Company's regional offices reached nearly $200 million -- a sum slightly smaller than the Firm's reported earnings for the seven most recent quarters.
We also found exciting the giant leap forward Farmers Group is taking in creating an on-line, real-time, data processing system linking its agency force with its regional offices, as well as other computer based initiatives now under way in the claims area. The "Network," as the system is called, strikes us as a cunning stratagem to maintain and enhance the competitive edge of Farmer's agency force -- largely a group of small businessmen and women trying to cope with the needs of their clients in a highly competitive environment -- as well as to improve its productivity.
As we see it, then, the investment case for Farmers Group has at least three dimensions: a play on higher auto insurance prices; a call on economic recovery and lower interest rates; and a kicker from the Company's participation in the computer revolution.
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