Rising Star Buy: Aflac

Insurance is a tough business. Companies make money by taking on risk, policies for the most part are commodities that compete on price, and companies spend a ton of money trying to build a brand and create perceived differentiation.

But Aflac (NYSE: AFL) has generated wonderful long-term returns for shareholders by developing innovative products its customers want, establishing distribution channels that others were slow to find, and becoming the low-cost provider in its insurance niche. Nevertheless, the market's distaste for risk (insurance is the business of risk, remember), fear of problems in Japan (Aflac gets 79% of its pretax earnings from Japan), and unwillingness to look beyond temporarily slowed earnings growth have beaten shares down 18% since the beginning of the year. I'm scooping up shares (a 5% allocation) for the Un Portfolio while this blue-chip bargain is unloved.

Aflac dominates its niche
Aflac offers insurance policies that cover life's expenses when a policyholder gets sick or hurt. Medical insurance pays the doctor (pay the doctor, boy!) while nonmedical expenses (like the mortgage, groceries, and daycare) are the responsibility of the sick/injured/recovering patient, and often these bills can break an already wounded soul. Aflac's policies help pay those nonmedical expenses.

The company sells its products primarily through worksites -- developing relationships with companies that employ hundreds or thousands is a heck of a lot less costly than finding a way to sell directly to millions of individuals. Aflac is entrenched in human-resources departments in its core markets (Japan and the United States) and is the world's largest underwriter of these types of policies. The company's efficient distribution model and large policyholder base make it the low-cost leader in its niche and allow it to price its policies better than its competitors.

The Big Three reasons I'm buying

1. Products and distribution. Aflac is a product and distribution innovator -- it introduced one of the world's first cancer-expense insurance policies in 1958, and its distribution network has enabled it to insure 50 million people worldwide.

2. Price and quality. Aflac has consistently generated returns that outpace the life and health insurance industry at large. It is an incredibly high-quality company. This is reflected in its historically premium book-value multiple and high return on equity. But Aflac shares are trading at roughly the same discount to their historical price-to-book ratio as the industry, and even lower than the industry on an earnings basis. Given Aflac's superior quality, this simply isn't justified.

Source: Capital IQ, a division of Standard & Poor's.

3. Great stewardship. Aflac is founder- and family-led has a culture of transparency and doing the right thing. It treats its employees well, and it has raised its dividend for 28 straight years.

What's so "Un" about Aflac?
Aflac takes its insurance premiums and invests them in a diverse bond portfolio. Unfortunately, some of its bond holdings are proving risky (namely anything associated with troubled European economies). As a result, Aflac has been "de-risking" its portfolio and selling off higher-risk positions and incurring losses. In the big picture, this is a great move, but until investors are confident that the company's portfolio is pristine and its capital ratios are sufficient, shares will remain under pressure. Couple these dirty bonds with slowing earnings growth (management is expecting just 2%-5% in 2012), and investors have lost interest in Aflac.

That's a buy
I'm confident that Aflac's competitive position is well intact, though. New efforts to bolster the effectiveness and efficiency of its sales force should take hold in the coming years, and with more than 90% of policyholders renewing each year, it has a base of earnings that's incredibly consistent and predictable. With such low expectations built into the current price, Aflac could easily surprise investors.    

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