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  Aegon is cheap

BENJ GALLANDER and BEN STADELMANN

Tuesday June 23, 2015

We occasionally get asked for our opinion on Canadian life insurance companies such as Manulife Financial Corp., Sun Life Financial Inc. and Great-West Lifeco Inc. After all, these are very well established brands with solid earnings power and decent dividend yields. The industry has recovered nicely from the financial crisis and is enjoying the tailwinds from rising equity markets and all those baby boomers topping up their retirement nest eggs.

The problem for contrarian investors is that although none of these are as expensive as they were in 2007, they are not cheap either. Instead, we looked further afield for a candidate in this sector with deeper value credentials. Last December, we settled on Amsterdam-based Aegon NV by purchasing the American depositary receipts (ADRs) at $7.64-$7.76 (U.S.).

The Dutch insurance giant posted pretty good numbers in 2014. Revenue was up 20 percent to 8.8-billion ($12.2-billion (Canadian)) and net income rose 38 percent to 1.2-billion. The main engine of growth was their retirement products, which now boast 9.4 million customers. Aegon scrapped their dividend when they accepted a government bailout during the financial crisis, but with those funds repaid in full, shareholders received 23 euro cents per share last year.

In euro terms, the stock is up 4 percent year to date in Amsterdam, but that translates to a slight loss for the ADRs in New York. The euro has been in a long downtrend against the U.S. dollar and the latest episode of the Greek saga has driven the currency to 10-year lows.

In theory, Aegon should be shielded from the weak euro as the majority of its earnings come from its U.S. Transamerica subsidiary. Unfortunately, that division experienced higher claims than normal in the first quarter, holding net income down to 316-million ($441-million). Sales continued to be very strong, up 32 percent over the corresponding quarter last year.

So why is the stock price mired at less than half book value, far below industry peers? Partly this can be blamed on the possibility of a Greek default. Though the company has very little direct exposure to the country, there are fears that a “Grexit” could destabilize an EU economy that is already less than robust. Meanwhile, restructuring has made for erratic results, with a series of large strategic moves including the recent sale of its Canadian operations to Wilton Re for $600-million (Canadian).

The other culprit here is a new regulatory regime called Solvency II, scheduled to take effect at the end of the year. This is somewhat similar to the Basel accords governing banks, which have tightened rules on capital requirements, governance and risk management.

However, there is also an important difference between these regulatory regimes. Basel III, which is currently slated for implementation in March, 2019, is a global effort, while Solvency II is limited to European firms. This is a major headache for corporations like Aegon that derive the lion's share of their revenue outside of the continent. Transamerica has to compete in a crowded field of American insurers that are not held to the same standards that Solvency II entails.

Stronger regulations are expensive and technically difficult to implement, but in our view reforms to reduce leverage and limit systemic risk are ultimately good for both consumers and the enterprises that provide financial services. True, holding large capital reserves in an era of low interest rates reduces profits, but eventually this cycle will end and insurers will earn more from their non-equity holdings. We also reckon that the euro will not stay low forever. Along with our investment in French telecom operator Orange SA, AEG provides a welcome European contribution to portfolio diversification.


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