The Allstate Corporation's (ALL 0.20%) stock has held up nicely over the last couple weeks: While equity markets were broadly in retreat, and sectors from basic materials to financials got hammered, Allstate's stock lost just 2% since mid-September -- a sign of extraordinary resilience in a weak trading environment.
Year to date, Allstate's stock is up more than 14%. While other insurance companies can now be bought significantly cheaper than just three weeks ago, Allstate still trades close to its latest 52-week high at $62.59. So, should it still be considered buy?
Cyclical insurance investments
Property and casualty insurance companies like Allstate should prove to be excellent bets in a scenario of stronger U.S. economic growth, as well as higher interest rates. Since interest rates have nowhere else to go but up, insurance companies should experience tailwinds for their investment income as the Federal Reserve scales back its mortgage and Treasury securities' purchases.
Source: The Allstate Corporation investor presentation
If the U.S. economy continues to recover, unemployment continues to go down, and median wages increase, there is a good chance that Allstate will benefit from further revenue and premium momentum -- a key value driver for any insurance company.
Over the last couple of quarters, investors in Allstate have already seen some decent premium momentum: Allstate's property liability net written premiums rose by at least 4.2% year over year in any quarter over the last five consecutive quarters.
Written premium growth stood at a solid 5.5% in the second quarter of fiscal 2014, and the trend in premium growth suggests that momentum could very well continue in the short-term -- to the benefit of both Allstate and its shareholders.
Strong (and improving) returns on equity
Premium and cost trends are not the only thing that are important for an insurance company in order to convince investors of a purchase.
Source: The Allstate Corporation investor presentation
Return measures such as the return on equity (and sometimes the return on assets) are equally important yard sticks in order to gauge an insurance company's ability to translate premium growth into rising company profitability.
So far, Allstate has a good record of increasing profitability: Its return on equity increased, on average, 38 basis points per quarter since Q1 2013 and was reported at 9.8% in the most recent quarter.
Going forward, two themes could further provide tailwinds for Allstate's profitability: Higher interest rates, which would likely have a positive impact on Allstate's net investment income. Secondly, continued cost improvements and low combined ratios could fuel Allstate's earnings growth.
In the second quarter of 2014, Allstate reported a property-liability underlying combined ratio -- an insurance metric to determine the profitability of its policy underwriting -- of 84.7%, which is quite a solid cost ratio. If Allstate manages to keep it that low in the coming quarters, investors could reward Allstate's underwriting discipline with even higher book value multiples.
Valuation upside
One of the most important aspects for investors who are deciding about a potential stock purchase relates to a company's capital appreciation potential. If investors looked at Allstate's premium book valuation right now, some would think that Allstate's stock does not retain significant upside potential.
Though Allstate does trade at a nearly 26% premium to its book value, which makes the insurance company stand out in a sector that largely sees discounts to book values for its constituents, investors also need to put Allstate's current valuation into the proper context.
While it is true that Allstate is more expensive than other insurance companies, the premium valuation is the result of strong operating results and investors' confidence in Allstate's earnings prospects. Further, the 26% book value premium pales in comparison to Allstate's historical valuation.
The Foolish bottom line
Insurance company Allstate may trade at a premium to its book value when many other insurance companies don't, but the company deserves it as it has shown some really decent year-over-year premium growth lately, and Allstate appears to be on track of achieving double digit returns on equity this year and/or in 2015. This is even more likely to happen if the U.S. economy provides tailwinds for cyclical insurance operations, and if interest rates increase.
At the same time, Allstate's stock has resisted the general selling pressure in the market, which goes to show that investors perceive Allstate as a fairly resilient and promising insurance bet. Given Allstate's low valuation compared to its own history, the company indeed makes a compelling value proposition.
