Get Some Dividend Insurance With This Stock

Insurance companies make money in two basic ways: prudent underwriting and investment income.

As premiums come in, investment companies hold that money until claims are paid out. If the insurance company pays out less than it takes in, that's an underwriting profit. In addition, as the money is waiting to be paid out, insurance companies have the advantage of being able to invest those funds. Often these investments are in fixed income securities in an effort to match assets and liabilities.

As rates have remained stubbornly low for years, fixed income investing has become more and more difficult. However, this may not always be the case. If rates were to rise in the future, insurance companies could see a boost to investment income. In the meantime, many insurers trade at a reasonable valuation and offer a high dividend yield. A company that fits this description is Mercury General (MCY) .

Founded in 1961, Mercury General is an insurance company for automobile owners, homeowners, renters and businesses. Personal automobile insurance is the most important business unit for Mercury General. The company is active in 11 states. California is its most important market. It sells its insurance primarily through about 10,000 independent agents.

2020 Earnings: Mercury's Rising

Mercury last month reported its fourth quarter and full year 2020 results for the period ending Dec. 31. For the quarter, the company reported revenue of $1.1 billion, which was up 8% compared to the previous year. Net premiums written declined -0.1% year-over-year, to $900 million. The fact that net written premiums were down year-over-year will likely mean that earned premiums could be under pressure during coming quarters.

Mercury General's investment income and investment gains improved during the quarter, as net realized investment gains rose to $90 million for the quarter, up more than three-fold year-over-year. Net investment income totaled $34 million during the third quarter, down marginally compared to the previous year's period, due to a decline in the average yield on investments.

Adjusted earnings per share totaled $1.38 during the fourth quarter, beating the analyst consensus estimate. The adjusted result backs out one-time accounting items. The COVID-19 pandemic hasn't had a meaningful impact on Mercury General's profitability so far. Last year was a strong year for Mercury, as EPS were a record at $5.54, compared to $1.80 and $2.60 in 2018 and 2019.

Mercury General has had difficulty generating growth over the past decade, but is finally starting to turn the corner. From 2009 to 2018, the company's earnings-per-share actually declined, with 2016 and 2017 being two especially harsh years, primarily due to unusually high costs for catastrophes such as the California wildfires during the summer of 2017. During 2019 Mercury's earnings-per-share recovered, due to lower catastrophe losses.

Profits increased dramatically in 2020, partially due to below-average catastrophe losses. The pandemic did not hurt the company's results, and the same can be expected for the current year, but higher losses for Mercury's ordinary business are expected.

Moving forward, the company should be able to increase its profits slightly, although there will likely be significant swings on a year-over-year basis. These cyclical results, caused by one-time impacts such as wildfires or hurricanes, are not unusual for insurance companies with a regional focus.

We are forecasting 1.5% EPS growth from this point. Based on the expectation for $4.70 in earnings-per-share for 2021, this would imply the potential for $5.06 in earnings-per-share in the next five years.

Insurance Against a Recessionary Declines

During the last financial crisis, Mercury General posted EPS of $2.12, $3.23, $2.09 and $2.79 in the 2008 through 2011 stretch. In addition, the dividend continued to increase throughout this period.

This resilient performance can be explained by two key factors. First, even during times when the economy is weak, people still need insurance for their cars, property, and other belongings. Demand for Mercury's offerings is thus not overly dependent upon the economy.

Second, Mercury did not invest in high-risk assets prior to the financial crisis, and therefore was able to avoid the huge losses many other financial corporations had to report. Mercury overall is recession resistant, which is a plus. However, the company is significantly impacted by catastrophes that affect its operations directly, such as 2017's huge California wildfires.

Mercury General has not only paid, but also increased its dividend for over three decades. The company has paid out more than 100% of its reported net earnings throughout most of the last decade. The company nevertheless managed to increase its dividend payout throughout the years, although the dividend growth rate was quite low in recent years, at less than 1% annually.

Mercury General had a dividend payout ratio below 50% in 2020, a very comfortable level that indicates the dividend has plenty of room for continued increases. The payout ratio now sits at around 54% of expected 2021 profits, again implying a highly secure payout. Moving forward we would anticipate for the payout to continue to increase each year.

What to Expect Next

Based on a current share price near $60, a $0.6325 quarterly dividend and $4.70 in expected EPS this year, Mercury General is presently trading hands with a 4.2% dividend yield, 12.8 price-to-earnings ratio and a around a 54% payout ratio. These present a compelling case of value and high yield for Mercury General stock.

As noted above, if earnings were to grow by 1.5% annually, you would expect Mercury General to earn $5.06 or so after five years. Against 15-times earnings, this would imply a future share price of around $76.

If the dividend were to grow by a penny each year, you would anticipate collecting around $12.80 in cash payment over the next half decade. Adding together the potential share price and dividends, you come to a collective value of just under about $89, keeping in mind that this is merely one possibility out of many.

Against the current share near $60, this works out to the possibility for around 8% to 9% annual returns in the coming five years.

Given strong expected earnings in the short-term and the potential for higher rates in the future, Mercury General is offering investors a solid starting yield for income investors.

At the time of publication, Ciura had no position in any security mentioned.