Principal Financial: Update For An Overvalued Insurance Stock

Dear readers/followers,

Since I last wrote about Principal Financial Group (NASDAQ:PFG), the company has outperformed the market by around 20%. This means that my position of “HOLD” was “wrong” – at least if you bought at the time and sold today. That’s not how most investments go, but still.

However, I have been following this company and similar businesses for several years, and I stick to my targets due to multi-year trends, not momentary ups and downs. A few years ago I made the very conscious decision to not allow fear of missing out to dictate my investment decision in either direction.

That’s why I sold out of what remained in my PFG position when the company hit $90/share, which was the highest I could justify holding this A-rated company at. I now have no position in PFG, and no plan to initiate one.

Here is why.

Principal Financial Group – An update

I’ve been writing about PFG all the way back since 2019 when I was one of the few contributors following the business and calling for it to be a “BUY” in the wake of incredible undervaluation. The same thing was true during 2020, and most of 2021, all the way until the end of the year. When you look at the company’s share price trends, apply valuation logic, and use a great tool, whether it be excel spreadsheets or something like F.A.S.T. Graphs, you can quickly tell where the company tends to go and where it doesn’t tend to go for very long.

Principal Financial Group is a great business. The company has been around for roughly 140 years and has been offering insurance for most of that time. It’s been through several depressions, and many financial waves of panic, and was around when the US banking system did not have its current banking system. The company is a storied survivor, and such companies make for great investments, provided you can get them at a great price.

The current company segments can be summarized into three things: Global Asset Management, Retirement, and Benefits/Protection.

Moving into more granularity, we find this.

So it’s an interesting mix that requires understanding what these various businesses do, and what affects their P&Ls over time.

On a high level, PFG is a shop with $1.4T in AUM and is the Top-3 retirement provider in all of the United States. It’s a leader in benefits and protection for small/medium-sized businesses, with a modern platform targeting customers across the nation and across the world.

Its operating income is over 55% fee-based, with another 18% in risk (straight insurance, in the form of life/specialty) and 26% spread from RIS. It’s made the journey from more traditional, into a leading financial services company, and this is exactly what I want to see from companies such as this. Specialization, and going from A into B, streamlining and focusing on what they’re good at.

PFG has a world-class management team, where the C-suite and the CEO specifically have over 38 years of experience at PFG – meaning he’s been at PFG since he started working. The same is true for several of the presidents, executives, and others. Management quality here is top tier.

What’s also top tier is the company credit rating.

…and we can’t forget the way the company leads the market not only in the US but in attractive growth areas that are likely to contribute to longer-term performance.

The company’s transformation has been a story of 10 years, ever since acquiring Claritas, Cuprum, and First Dental – and is a story that I have studied since starting to cover the company. It “closed” the books by divesting its Indian asset management arm, the Mexico life segment, and some unattractive blocks in life during 2022, leading to the current fundamentals, expectations, and where the company currently “is”.

The company’s results for 2022 and for 3Q22 specifically were “so-so”. Operating earnings are down around 7%, and EPS is flat. This hasn’t impacted the fundamentals – 22.3% debt to cap and plenty of liquidity at Holdco and subsidiaries, with an attractive and stable dividend. My yield here was once over 6% – it’s now barely 3%, which is the first “strike” in terms of valuation here.

Still, the company has deployed its capital effectively during the year, paying dividends and buying back shares, albeit at not that attractive levels if we look at historicals. The company’s long-term targets include a 9-12% annual EPS growth, an RoE target of 15%+, and FCF conversion of 75-85%. The company is very unlikely to achieve this for this fiscal, with current estimates at a negative 4.5% for the year, followed by around 8% in 2023 and double-digits in 2024.

Don’t get me wrong – there are no “worries” in the quarterly results, not as such. The negative op. earnings and flat EPS is expected in today’s volatile market, and investment performance hasn’t really been stellar – but the company’s funds still have mostly a 4-5 star rating from Morningstar.

Also, the company’s efficiency targets are working – which is a good thing, because this is a time where revenue is actually down in several segments, even if recurring deposits in RIS are up 10%. There were significant variances in RIS in 3Q22 YoY, meaning without these variances, the company’s RIS income is down almost 10%. Similar trends are true for the Global investor segment…

Again, when the market is down, most people are unhappy. It means lower performance fees, lower management fees, and other performance-related earnings that have been mostly growing for the past few years.

The company’s balanced portfolio and overall broad offerings make it a prime choice for many businesses as well as for many individuals – and I want to emphasize again – market leadership.

The global asset management arm is the icing on the cake, as I see it, with substantial assets under management, adding value through its other businesses by accumulation distribution and other synergistic drivers. It enables the company to expand its relationships with institutional and wealthy investors, increasing its overall market share, and allowing it to capitalize on emerging market investing.

This shop hasn’t seen any serious problems in 3Q either, and a 4-5% drop in EPS isn’t enough for me to call PFG a bad or an uninvestable business.

But when it comes to insurance businesses, what I want is cheap quality. PFG was very cheap quality at one time, but I believe this has somewhat changed today given the state of the company’s valuation.

Here is where that state is currently at.

Principal Financial Group – The Valuation

The market has a strong tendency to undervalue or put a discount on this company in relation to actual earnings potential.

What this means is we need to evaluate the company’s current valuation relative to this discount, as opposed to actual potential, as the stock price is unlikely to stay there (looking at historical values). This goes for upsides as well as downsides and is doubly true when we’re looking at overvaluations to that discount – as we are today.

Here is the valuation as it stands today.

So you can see why my stance at this time is that things have changed, and why I sold out at around $90 with what little remained in my portfolio of the company. The conservatively adjusted upside based on a 10-11x range, which is the very well-established 20-year average for this business, was no longer even positive.

As it stands today, that upside, based on a 10.8x multiple, is around 3% per year, or 5.91% until 2024E.

Could the company climb higher and keep stay there, based on their new fundamentals as a solid financial company?

Yes, of course, it could. There have been periods of several years when the company traded fairly high, over 15x P/E, in terms of multiples, though this was before the financial crisis.

But the problems with that are that it’s a speculative assumption and that there are plenty of high-rated financials available at much lower multiples and better yields while having arguably great overall upsides to go by. So the comparative upside you can get from equally safe – or safer – companies is better than some 3%-yield and 2-5% upside that PFG currently offers.

Valuation is key – especially in a conservative and recession-prone market like the one we’re currently in. That is why I say to you, dear readers, this is not the time to invest in Principal Financial Group.

S&P Global analysts give the company average targets of $78/share, which means that they’re actually agreeing with my stance – which is of course rare. Only one out of 13 analysts currently has a “BUY” rating on PFG, and the overvaluation today is potentially as much as 7% based on these targets. The range goes from $61 up to $90/share at most, and for once I am in almost 100% agreement with the analysts of a company here.

In my previous article, I gave the company a share price of $65/share. In light of today’s market and situation and what we find in terms of attractive companies, this is not a target I am going to be shifting to here.

Rather, I’m repeating and emphasizing it – it’s $65/share.

Historically speaking, these analysts, and that by the way includes me, have been pretty accurate when it comes to the business. I would also argue that the company has a pretty well-established tradition of trading between specific price ranges – and once the price goes above the price range we’re seeing here, then it usually comes back down again fairly quickly.

Because of that, this is my current thesis.

Thesis for the Common

I consider my current thesis on PFG as follows:

• Principal Financial Group is an absolutely solid insurance play that’s generated alpha in my portfolio for many years – and was rotated at a time when it had generated that alpha back around the $70/share mark. I would be happy to buy it back when it’s cheap, but not at over 11X P/E.
• The insurance sector is full of solid, global companies offering a 4%+ yield at excellent credit safeties – and PFG is one of the more expensive ones of the bunch.
• PFG is a “HOLD” here. A price target that I would consider attractive for investment based on my goals would be around $65/share – though every investor of course needs to look at their own targets, goals, and strategies. I would also always consult with a finance professional before making investment decisions such as this.

Remember, I’m all about:

1. Buying undervalued – even if that undervaluation is slight, and not mind-numbingly massive – companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.

2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.

3. If the company doesn’t go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.

4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.

Here are my criteria and how the company fulfills them (italicized).

This company is overall qualitative.

This company is fundamentally safe/conservative & well-run.

This company pays a well-covered dividend. This company is currently cheap.

This company has a realistic upside based on earnings growth or multiple expansion/reversion.

A great company, but it does not fulfill my criteria for investing in terms of valuation.

The options play

In terms of options, the current valuation means that we can’t really put money to work at attractive put options prices. If you’ve elected to hold onto your PFG shares, but have 100+ shares and want to look at a CALL option, I have this to offer you.

This is a long-dated call option with a low Strike, meaning a higher premium. This is what I usually do when I “want” to sell an equity at a specific price. I want the sort of yield that makes it worth not selling straight if the company drops back down. Close to 10% annualized gives that. If I had 100 shares of PFG, this is what I would do.