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Natural Disasters May Herald a "Hard' Market


AJ Gallagher is the best play in the broker industry...


Editor's Note: This article was published in today's edition of The Financial Times and is reprinted for the 'Ville with permission.

Last year's rendezvous of three witches (Rita, Katrina and Wilma) on the Gulf Coast caused destruction and sucked out capital from the property and casualty insurance industry.

The bad news is: insurance companies lost a lot of money. But the good news is: insurance companies lost a lot of money. Thus we are likely facing a new "hard" market, of increasing prices. If you are an investor in the sector, rather than a buyer of insurance, that is good news - provided the likes of the three witches don't pay the U.S. another visit next year, or the small earthquake California felt in December was not a prelude for a larger one.

There is, however, a good way to participate in the upside of the rising insurance premiums without bearing the risk of a natural disaster - insurance brokers. They are hired by companies (from mom and pops to Fortune 100 companies) to find an appropriate insurance coverage at the best price. Insurance brokers are transaction facilitators, enjoying the upside of rising premiums since their commissions rise with premiums, but at the same time they are not risking their balance sheets, which is the insurance companies' job.

AJ Gallagher (AJG) is the best play in the broker industry: it has the highest dividend yield (3.6 per cent), one of the lowest valuations, virtually no debt, a very respectable 20 per cent return on capital and it is trading at 16 times 2006 earnings, which are likely to be revised upwards as the market hardens. It has a good management team, headed by Pat Gallagher - the third Gallagher to run the company since it started in the suburbs of Chicago 77 years ago - which has shown a commitment to long-term growth even if it means making sacrifices to short-term profitability. This is a rare quality in today's often short-sighted corporate environment.

In the past decade AJG has grown earnings per share at about 14 per cent a year. Long term growth is likely to be somewhat in line with the past, with 7-8 per cent coming from organic growth and the rest from acquisitions, though I expect sales growth over next couple years to be higher, driven by firming (hardening) of the insurance market. I am usually not a big fan of acquisitions as they introduce an execution risk to the business and are often done to build corporate empires, not for the benefit of shareholders. However, that is not the case with AJ Gallagher. It has perfected the art of making small acquisitions that effectively involve hiring an office of insurance agents (usually 10 to 20) that share a similar culture and goals.

A grey cloud in the person of Eliot Spitzer is hovering over insurance brokerage stocks, but that could dissipate soon. All top insurance brokers, including AJ Gallagher, stopped taking contingent commissions (which according to Mr. Spitzer created a conflict of interest for insurance brokers) and paid fines. To offset loss of contingent commissions, insurance brokers are negotiating with insurance companies to raise their normal commission thus making their compensation transparent to their clients.

AJ Gallagher has shown a remarkable ability to create shareholder value, and grow earnings and cash flows in any market environment (hard or soft). Using Warren Buffett's analogy: it is one of those rare stocks that I would feel comfortable holding even if the stock market were closed for the next ten years and I could not sell it.

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