Questor: a firm that turns away business? It’s actually the route to strong returns. Buy

Richard Evans 20 March 2019 • 5:54am

Lloyd's of London building — Lancashire does some of its business via the Lloyd's of London market Credit: Marina Imperi

Questor share tip: rather than chasing growth, Lancashire, the insurer, refuses to deploy its capital in unprofitable areas – instead it returns excess cash to shareholders

“This company has been shrinking the amount of business it takes on very consciously.” Such an approach may strike readers as a curious way to pursue profits. But Hugo Ure of Troy Asset Management, who said it of Lancashire, the specialist insurer, was making an important point about effective use of a company’s capital.

We should stress that he wasn’t talking about every part of Lancashire’s business. Instead, Ure, who holds the insurer in his Trojan Ethical Income fund, was commending it for its refusal to chase sales in competitive areas in which returns would be squeezed.

“Lancashire is one of the smaller independent insurers and its size actually gives it an advantage relative to its larger peers,” said Ure. “Big insurers are driven by the top line because of their huge cost bases, but smaller firms can step away from business where returns are too low.”

He said this reflected management’s view that their job was to be “custodians of investors’ capital” rather than simply to make the firm bigger. “We try to identity management teams aligned with our principles,” Ure added. “In the areas they operate in, Lancashire’s are absolute experts.”

Those areas include insuring property against catastrophes such as hurricanes, and specialist fields such as marine and aviation cover. The company also operates in the energy industry. It uses several avenues to sell its policies, including via the Lloyd’s and Bermuda insurance markets and via a fund-type structure in which outside investors’ capital, not its own, is at risk.

Catastrophe insurance, by its very nature, offers volatile and unpredictable returns: after several good years, hurricanes, typhoons and wildfires caused big losses in 2017 and 2018. In view of the risk of having to make large payouts, this part of the business requires a lot of capital behind it, but over the long term it tends to make good profits, Ure said.

Specialist areas such as energy and aviation are less volatile, require less capital and diversify risk better. “This is the interesting bit of the business,” he added. “Competition is less broad and Lancashire is writing very particular risks. The cycle here is turning; rates are starting to improve.”

Insurers’ profitability is often measured by the “combined ratio”: 100pc means break even and a figure of more than 100pc signals a loss, while the further below 100pc the number is, the more profitable the company.

Lancashire’s combined ratio has been “outstandingly strong” at less than 70pc for most of the past decade, although 2017 and 2018 were “notable exceptions” thanks to the spate of catastrophes, Ure said. A 70pc ratio is broadly equivalent to a 30pc margin.

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Likewise, returns on equity have normally been healthy in the mid-teens, although they were negative in 2017 and in the low single digits in 2018. While we normally like to give figures for debt and cash conversion too, these measures are almost impossible to state meaningfully in the case of banks and insurers.

Lancashire’s rigorous approach to the deployment of capital and its reluctance to write low-margin business mean that it sometimes finds itself with excess cash, which it hands back to shareholders via special dividends. This can boost the yield, less than 2pc from the ordinary dividend, to about 10pc in some years.

Ure said he valued the company relative to the value of its assets. The current market value of 1.6 times “book” value is roughly in the middle of its historic range, he added, and growth in profits should cause the figure to fall.

He summed up the stock’s appeal as “returns uncorrelated to the broader economic cycle and a disciplined approach to the allocation of capital”.

Questor says: buy

Ticker: LRE

Share price at close: 652.5p

Update: Staffline

Last week, we reported the resumption in trading in the recruiter’s shares. Ken Wotton, of Gresham House, said he intended to keep his positions in Staffline, which “I hold across multiple funds as a core holding”.

He added: “I have confidence in the management team and the long-term prospects for the business. This announcement [of March 12] confirms that the allegations [of accounting malpractice] made in January were largely baseless.”

Questor says: hold

Ticker: STAF

Share price at close: 882p