As an investor, you have to be aware of risks that could hurt the stocks you own. One risk investors have had to deal with this year is inflation.
The U.S. Bureau of Labor Statistics released its monthly consumer price index (CPI) numbers on Dec. 10. The CPI increased 6.8% year over year, the highest reading since 1982. As a result, the Federal Reserve has responded by speeding up the end of its bond-buying program, which it used to combat the COVID-19 economic slowdown. On top of that, Bank of America economists expect the Fed to raise rates twice in 2022 and three times in 2023.
When the Fed reins in monetary policy it can affect markets and make them more volatile. If Fed tightening results in a market sell-off, there's one stock I'm certainly not selling -- Progressive (NYSE:PGR).
Why insurance companies can perform during a sell-off
Insurance stocks like Progressive can perform well no matter what the market does. That's because insurance is always in demand. Consumer are always going to need insurance on cars and homes, and businesses will always require insurance as well. As a result, insurance companies can provide a steady cash flow stream for investors.
Insurance companies can react well to inflationary pressures, too. Although insurance companies might feel pain in the short term from rising prices, they can raise premiums and get back to their profitable ways in the long run.
Beyond that, insurance companies tend to be considered value stocks, good investments to hold in times of rising prices. According to research by Bank of America, since 1940, value stocks have outperformed the broader market during inflationary periods, returning an average of 9.2% versus the broader market's return of just 2%. Progressive now trades at a price-to-earnings (P/E) ratio of 13.8, near the lower end of its range during the past five years and just below its 10-year average. In other words, the shares are relatively cheap.
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Generating cash flow is key to beating inflation
Insurance is a cash flow machine. Since 2014, Progressive has seen cash flow from operations grow 26% annually, from $1.7 billion to $6.9 billion through 2020. Operating cash flow is the money a company makes from operations minus operating expenses; it is a good measure of how effectively a business can generate cash.
Not only that, but insurance companies can also adapt when prices are rising, as in these inflationary times. For example, Progressive has seen larger claims this year, and a lot of that is due to the higher costs of automotive repairs, parts, and new and used vehicles. As a result, settling customer claims this year is more expensive. Progressive had catastrophe losses of $1.3 billion through the first nine months this year, up 67% from the comparable period last year.
So what does Progressive do about this? The insurer can quickly adjust and raise prices on customers to offset higher claims costs. It has already begun doing this. According to Chief Executive Officer Tricia Griffith, the company has increased rates in 20 states during the third quarter, with rates up 6% on average. The company has also reduced its exposure to higher-risk locations in the U.S. after large claims tied to Hurricane Ida and other weather-related catastrophes in 2021.
Progressive's profitability is at the top of its industry
Progressive has a solid 23.2% return on equity, and by this benchmark it is consistently one of the top companies in the insurance industry. Return on equity is a good measure of management efficiency and the underlying strength of the business. A higher ROE means a company is more effective at using shareholders' capital. Given Progressive's history, I believe it will raise prices appropriately and will continue to post stellar profitability ratios.
Source: Ycharts.
The company has also controlled losses and expenses over the years. One metric that can tell you how well it managed these costs is the combined ratio. Combined ratio is a key metric insurance companies use that measures the losses plus expenses divided by the total premiums earned by the company. Ideally, a company will report a figure below 100%, which means it is generating an underwriting profit.
Despite having elevated claims this year, Progressive had a combined ratio of 95.6% through the first three quarters. Not only that, but Progressive hasn't seen its annual combined ratio tick above 96% since 2000. The company has excelled at underwriting profitable policies for decades now and should continue firing on all cylinders -- which is why I'm not selling this stock even if the market sells off.
