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AIA Case Study: Don’t Invest Based on Brand Recall Alone

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Editor’s Note: There is a notion on the street that investors can simply pick stocks they know and love and expect to perform well. Seasoned investors know this to be false after the failings of many such larger companies – blue chip or otherwise.

Certainly, size and brand recall play a part in a company’s strengths and offers investors a siloed path towards finding investment ideas. But that alone does not qualify a company for investing. The fundamentals of a company, whether well-known or unheard of must be solid and the investment thesis grounded in logic prior to buying in. Further, different companies require different valuation styles and this complicates the process for retail investors on the street.

In this article, we talk about AIA. And we walk through the process for how we value it and our perspective on it so that hopefully, you can avoid future mistakes that cost you dearly in dollars.

Even if you are not familiar with the insurance sector, you would probably have heard of AIA Group (HKG: 1299) before as one of the most prominent players in the insurance space.

AIA recently delivered its first half 2019 earnings where it reported strong growth in new business and operating profits, leading to a higher interim dividend. Let’s have a closer look at the company’s position in the market and whether it is a good dividend growth stock.

Introduction

 If you can still recall, AIA Group was actually a subsidiary of American International Group (AIG), before subsequently being divested in late 2009 as a public listed company. Since then, the company has grown by leaps and bounds and is now one of the largest independent publicly listed pan-Asian life insurance group.

Today, AIA serves individuals and businesses in 18 markets around the Asia-Pacific region. In addition to life insurance, AIA also offers other insurance products and provides financial services like retirement planning and wealth management.

Since its public listing in 2010, AIA has gone on to become the second-largest constituent of the Hang Seng Index. The insurance group has the largest number of policies in Hong Kong, serving over 3 million customers.

On the flip side, AIA’s strong growth may come to a halt due to the tumultuous Hong Kong protests which are unlikely to abate anytime soon.

With that in mind, investors keen in AIA group may want to take another look at whether such headwinds will act as an impediment to the share price or whether these factors have already been priced in.

Below, we will evaluate the attractiveness of AIA’s shares using our Dividend Growth strategy.

  1. What is AIA’s Gross Profitability?
  2. Determine the attractiveness of its Dividend Yield
  3. Determine the sustainability of Dividends
  4. Conclusion: Is the Stock worth Buying?

The Dividend Growth Strategy is a quantitative approach to analyze stocks based on its numbers and proven to bring you market-beating returns. You can read more about the strategy at our Factor-Based Investing Guide.


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1. AIA’s Gross Profitability

Robert Novy-Marx, a Rochester University professor, discovered that the Gross Profitability ratio offers an accurate way of determining future investment returns. His empirical studies proved that stocks with high Gross Profitability can have equally impressive returns as with value stocks and documented his research in The Other Side of Value: The Gross Profitability Premium.

Gross Profitability = Gross Profit/Total Assets

According to his research, companies that use fewer assets to produce higher Gross Profits are generally considered to be more productive and offer more quality than their competitors.

To aid our analysis, we’ve compared AIA with two of the leading players in the global life insurance industry, US-based MetLife and French business AXA. We will see which company provides investors a better return on assets.

Gross Profit (‘millions)

Financial Year 2018 AIA MetLife AXA
Gross Profit 7,565 13,730 19,840
Total Assets 229,806 687,538 930,695
Gross Profitability (%) 3.3% 2.0% 2.1%

AIA and MetLife figures are in USD while AXA is in EUR.

From the analysis above, we can observe that AIA is the most effective among the trio in terms of utilizing its assets to generate profit.

That being said, each company’s gross profitability is extremely low at 2 to 3%, albeit this is typical for the insurance industry where they have to consider the policies as assets they have and also deduct off significant expenses relating to insurance and investment contracts.

Next, we shall evaluate the attractiveness of AIA’s dividend yield.

2. How attractive is AIA’s Dividend Yield?

Insurance companies are generally viewed by investors as an attractive proposition for their dividends given their relatively fool-proof business model (as long as their underwriting is done right).

We have examined each company’s dividend yields based on FY2018 dividends’ distribution. You can determine the historical dividend yield by taking:

Historical Dividend Yield = Dividend distributed in previous year / Current Share Price

FY2018 AIA MetLife AXA
Dividend Yield 1.6% 3.5% 5.6%

The table above shows that AIA has the lowest dividend yield of 1.6% among its peers. In fact, it’s a far cry from AXA’s dividend yield of 5.6%.

That said, we saw that AIA has been growing their dividends year after year and will continue to do so, albeit a low dividend yield currently.

In any case, we’ll also dig deeper into whether the dividends are sustainable.

3. Can AIA sustain its dividends moving forward?

The sustainability of a company’s dividend distribution can be measured using two indicators:

  • Average Free Cash Flow Yield
  • Payout Ratio

We can evaluate AIA’s Free Cash Flow Yield by deducting capital expenditure from its Operating Cash Flow. Fortunately for AIA, the business does not incur much capital expenditure as its commitments to new assets is minimal.

Here’s a quick look at the last three financial years.

Year (USD million) FY2018 FY2017 FY2016
Operating Cash Flow 2,020 1,451 1,364
Capital Expenditure* 219 235 235
Free Cash Flow 1,801 1,216 1,129

Average Free Cash Flow: US$1,382 million

Average Cash Flow Yield: Average Free Cash Flow/No of Shares = 1,382m/12,021m = 11.5%

The average cash flow yield of AIA across three years is 11.5%. This is much higher than its historical dividend yield of 1.6%, which suggests this dividend is sustainable.

What’s more, the company is actually increasing its operating cash flow year-on-year, while also keeping capital expenditure steady. This may provide AIA with the scope to potentially increase dividends in coming years.

Another test we can look at is the Payout Ratio, where we can analyze the fraction of earnings being paid as dividends. Ideally, a good payout ratio needs to be contained below 1x.

Year (HKD) FY2018 FY2017 FY2016
Total Dividends per Share 1.24 1.00 0.86
Basic Earnings per Share 1.69 4.24 2.73
Dividend Payout Ratio 0.73 0.24 0.32

AIA has managed to retain its payout ratio well below 1x in each of the last three years, thus it passes the Payout Ratio assessment.

Although the dividend payout ratio was much higher at 0.73x, it is actually due to last year’s sharp fall in earnings. According to the company’s statement: “The decrease in net profit at AIA was due to a valuation loss of US$2.06 billion in its equities and real estate investments, compared with a gain of US$2 billion in 2017”.

Hence, FY2018 results can be considered a temporary blip and at the same time, it means there is still moderate scope to support the dividend growth each year.

The Qualitative Side

To provide a comprehensive picture of AIA shares, we will now turn our attention to the following qualitative metrics:

  • Moat (Competition)
  • Ownership

Moat (Competitive Threats)

In my opinion, while there are numerous companies operating in the life insurance and financial services space, AIA has a moderate competitive moat in the Asia-Pacific market.

The company has somewhat achieved a market leading status and strong brand recall on the back of its longstanding history over 100 years from its parent AIG.

In addition, the company is able to leverage economies of scale to diversify across the Asia-Pacific region given its long history decades of operations. This also means it has substantial resources to compete with individual insurance businesses in local markets who lack the same quality of staff and access to assets for investment purposes.

Investors may be worried about the upcoming relaxation of restrictions on foreign insurers in year 2020. However, any new (foreign) insurers would be required to invest a considerable sum to gain a foothold in the market, yet alone before they could start taking any market share.

In this sense, AIA has secured the first mover advantage as one of the largest listed insurers in Hong Kong and establishing a premium positioning in mainland China. As a matter of fact, AIA’s growth in the value of new business was the fastest in China among its other 18 Asia Pacific markets during the first half of 2019.

Ownership

As a general rule, we prefer companies with the directors owning a large chunk of the company’s shares as it will likely lead to more aligned interests.

On the other hand, we do not want the controlling shareholders to own more than 70% of the company because there have been cases where the owner-cum-management shortchanged the minority shareholders by offering a very low price to buy up the remaining shares and delist the company.

The FY2018 annual report above illustrates that AIA’s directors have a small, but relevant interest in the company. Considering the enormous market cap of the business, we think these levels are somewhat appropriate as they are worth millions and more (in Singapore dollars).

When we look at the substantial holders list, we see the presence of several well-known institutional investment firms. Their combined ownership is 37.39%, which is an appropriate structure for investors to consider.

With that said, some of these companies also hold short positions over the stock, or lend out a portion of their shares.

Conclusion

AIA would not necessarily pass as a good dividend growth stock because of its low dividend yield of 1.6%. However, given their steadily increasing dividends track record, it’s highly probable for AIA to pay out higher dividends in future as well.

Moreover, its rising operational cash flow and comfortable payout ratio would provide much more headroom for the dividend to increase going forward.

AIA Group also stands to benefit from a diversified market presence, conducive demographic trends that support demand for its products, as well as a reputable brand positioning in China.

Last but not least, temporary headwinds arising from the Hong Kong unrest and downcast macroeconomic conditions may turn out into being a good opportunity for investors keen to take a position in the company (provided the share price can go down to your buying levels).

We have mentioned in prior articles using the same valuation technique that for growth stocks, we only invest in companies within the top 20% profitability band as defined by this formula.

Gross Profitability = Gross Profit/Total Assets

This is an example of why we don’t use brand recall routinely as part of our investment thesis. Most names often fall short. Trust me. I’ve tried often enough to see if it worked.

As a whole, AIA is a G1 stock, meaning it is in the lowest band of profitability. It does not pass the bar for being stock with top tier profitability. Certainly, it has understated profit since its policies must be counted as an asset. But where uncertain, we must learn to move on. There are always better opportunities elsewhere.

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Alternatively, here’s our full factor-based investing guide. Here are our case studies. You can also join and participate in discussion under our Ask Dr Wealth facebook group and receive live updates on all notable investing ideas/approaches on our telegram group.

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