Inside Wall Street: An Insurance Veteran's Tips for Stocks in a Complex Industry

Some stock groups are harder to divine than others, and among those that are tough to figure is the complex insurance industry. Even pros who have been involved in the business for many years concede that insurance stocks aren't easy to grasp. Among the reasons is transparency, which they aren't known for. That's partly because of opaque accounting practices common in an industry that thrives on taking various kinds of risks.

Even Wall Street veterans like Ray Dirks, who was an insurance analyst at Goldman Sachs in the 1960s, admits it's no cakewalk to sort out which insurers -- life or property/casualty -- are sound long-term choices, primarily because of the lack of clarity in their convoluted operations. Among them, according to Dirks, are American International Group (AIG), Conseco (CNO) and Life Partners Holdings (LPHI). Dirks, who now heads his own investment outfit, Ray Dirks Research, has shorted these stocks.

That doesn't imply, however, that he's down on the entire insurance group. In fact, Dirks is bullish on several, led by Aflac (AFL), a major provider of supplemental life and health insurance in the U.S. and Japan, now trading at $56 a share; Hartford Financial Services Group (HIG), one of the largest U.S. multiline insurance companies, currently selling at $28; Progressive (PGR), a large U.S. auto insurer, now at $20; Phoenix (PNX), a major provider of life insurance, annuities and investment products, currently at $2.52; and eHealth (EHTH), a leading online source of health insurance provided by its network of 150 insurers, trading at $13.

Censured, Not Praised

Why should any one pay attention to Dirks? Well, he's probably one of the best insurance analysts around. Dirks's name ended up enshrined in the U.S. law books because of a landmark 1983 decision by the Supreme Court on his expose in 1973 of an insurance fraud committed by a large insurer, Equity Funding. Dirks blew the whistle on Equity's scam, which used fake profits to boost its stock price. The company fooled its auditors, Wall Street analysts and industry watchdogs -- until Dirks, tipped off by a disgruntled insider, exposed the scam. As an analyst, Dirks felt compelled to inform his clients about the fraud.

But instead of praising Dirks, the Securities and Exchange Commission censured him for "tipping nonpublic information" to his clients concerning Equity Funding, in "violation" of federal securities laws. Dirks fought the SEC's action all the way to the Supreme Court, which rendered a decision in his favor after 10 years of trials.

The court ruled Dirks wasn't guilty of insider trading because for a recipient of a tip to be guilty, argued the court, he or she must have sought to profit from the tip. The court found no evidence that Dirks made a dime from his actions. The Supreme Court's decision is now known as the Dirks Law on insider trading, which presumably will be invoked in the huge current insider-trading case against Raj Rajaratnam, the billionaire founder of hedge fund Galleon Group.

That's a lengthy way to introduce Dirks, but it's important to establish his credibility.

Low Double-Digit Growth

On his buy rating on Aflac, Dirks says it's the best time to buy the stock, currently trading at just 11 times his 2011 earnings forecast of $6.35 a share. He sees the company sustaining a yearly growth rate of 13% for the next several years. Aflac earned $4.95 in 2010 on revenues of $20.7 billion. He has a 12-month price target of $78 a share, in part because he sees Aflac as one of the companies benefiting from the changes mandated by the new health care reform law.

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Also bullish on Aflac, Edward A. Spehar of Bank of America Merrill Lynch says that after raising its operating per-share earnings at a 17% rate over the past five years, he expects low double-digit growth to continue for the foreseeable future. Spehar rates Aflac a buy, with a higher 12-month price target of $83 a share.

Hartford Financial, notes Dirks, is one of the traditional insurers with a respected reputation among companies that provide investment, life and property/casualty insurance products. Trading at just seven times his 2011 earnings forecast of $4.05 a share, Dirks figures Hartford could trade at 11 times his 2012 earnings estimate of $4.75 a share, or a price target for next year of $50 a share. Hartford earned $2.48 a share in 2010, on revenues of $22.3 billion.

Progressive, like Aflac, advertises heavily to promote its products, often using humor in its TV commercials to educate the public on how to buy insurance products on autos and other vehicles, including motorcycles, heavy trucks and vans. Dirks figures its stock, up from a 52-week low of $16.95 in early March 2010, to $20 on Mar. 8, 2011, should hit $29 in 12 months. The stock is cheap, says Dirks, trading at 12.5 times his 2011 earnings projection of $1.70 a share. He says Progressive has the capacity to sustain a yearly growth rate of about 12%.

An Internet and China Play

Phoenix, one of the oldest U.S. insurers dating back to 1851 (then named American Temperance Life Insurance), provides its products and services to high-net-worth customers through a network of financial professionals and consultants. Dirks says the price is right for this stock, which struggled after collapsing in 2008 from $14 a share to $1. That was after State Farm Insurance dropped Phoenix from State Farm's list of insurance products marketed by its agents. Phoenix has been in the red since then, but Dirks expects the company's new management team to get back to profitability this year. He forecasts earnings of 60 cents a share for 2011, and sees its stock rising to $4.26 a share in 12 months.

eHealth, a novel kind of an insurer, sells its products, primarily individual and family insurance plans, on the Internet. It also offers policies for small business and short-term health insurance products. The big potential for growth will come from China, says Dirks. That could be a huge market for a small insurer like eHealth, he says. The little known insurer, he figures, is cheap at its current price of $13 a share, down from its 52-week high of $18.98 on May 18, 2010. Dirks has a 12-month target of $18.50, based on his 2011 earnings estimate of 60 cents a share in 2011 and $1 in 2011. It earned 73 cents in 2010.

One bull on eHealth is Bank of America Merrill Lynch, which recommends it as a buy. Its analyst, Nat Schindler, notes that the company faces no direct competition and has strong growth prospects. The stock, he adds, is an investment in the greater use of the Internet for selling products and services, including individual health insurance.

Some large institutional investors are already big stakeholders in this small-cap insurer, including BlackRock Institutional Trust, which owns 7.7%; Wellington Management, which holds 5.9%; and J.P. Morgan Asset Management, with 5.4%.

Although insurers haven't been on top of Wall Street's favored list during the economic downturn, some of them could provide insurance for strong gains during the recovery that's now in an upward swing.