Porter Stansberry: One sector every real investor should be watching

From Porter Stansberry in the S&A Digest: 
In today's Friday Digest, I'm going to share with you a few secrets we've recently discovered... and proved... about insurance stocks.
Now, before I bore you to tears... let me try to explain why I've spent so much time and effort figuring out the insurance sector. Or better yet, let me just show you the picture.
The stock chart below shows you (in black) the total return history of one of our highest-rated property and casualty (P&C) insurance companies. The other line (blue) is the total return history of the S&P 500. The chart assumes all dividends were reinvested, and it goes back about 25 years.
The insurance company has made almost 14% a year on average. The S&P 500 has earned 7.4% a year over the same period. As you can see, nearly doubling the average return on stocks year after year creates an immense financial advantage. The highly rated insurance stock has a 25-year total return of almost 2,500%. The S&P 500, by comparison, has only earned investors 500%...
Over the years, I've told individual investors they really ought to take the time to learn about selling puts, buying corporate bonds, and short-selling stocks. I believe knowing how to put these strategies to work will make it easier for you to be successful as an individual investor. But...

Those are all "advanced" strategies. I'd recommend learning how to use them only after you've mastered basics of asset allocation, valuation, and risk management. In my view, these latter strategies are requirements for successful investing. Without them, it's very unlikely you'll be successful.

Understanding the insurance sector is definitely an advanced tool. You don't need to ever own an insurance stock to be a successful investor. But I'm willing to bet, if you'll take a moment today to learn just a little about it, you'll figure out pretty quickly that insurance stocks are one of the easiest ways to safely make a lot of money in the stock market.

One word of warning, however. As we both know, there's no such thing as teaching... only learning.

I'll do my best to explain what we've figured out below. But if you hope to profit from this information, you're going to have to read carefully and think. I know most people would rather do anything than think.

And in this case, refusing to think could be very dangerous to your wealth. While it is possible to make a lot of money with insurance stocks, this is also an area of the market that can wipe you out overnight if you're not thinking. So... with that in mind... let's get started.

Investors make a killing with insurance stocks because of something called "float." Float is free money. Sometimes float is even better than free. How's that possible? How do insurance companies get all their capital (and more) for free?

A well-run insurance company is the only business in the world that routinely enjoys a positive cost of capital. In every other sector or type of business, the cost of capital is one of the primary business considerations. But a well-run insurance company not only gets all the capital it needs for free... it will actually be paid to take it. After all, clients pay upfront for insurance policies. This capital belongs to the insurance company until legal claims are made upon the policy. All the gains made with that capital before those claims are filed belong to the insurer. And it's not hard to generate huge returns on invested capital when your cost of capital is less than zero.

The trick to understanding which insurance stocks are likely to be the best performers is to first figure out which companies have the largest amount of float – the biggest pools of free capital. Wall Street doesn't make this easy to figure out. You won't find "float" mentioned on any annual reports or other forms filed with the Securities and Exchange Commission. Instead, you have to learn how to calculate it yourself or estimate it by looking at other numbers that are disclosed by the insurance company.

You also have to be able to judge which companies are likely to have the most underwriting discipline – or else, sooner or later, the float is going to leak out the door to pay claims. The insurance sector isn't Lake Woebegone. Not everyone is above average. In fact, the industry as a whole loses money selling policies. Most companies don't charge enough in premiums. Most of these stocks won't provide you with a nearly risk-free way to compound your capital effortlessly.

Now... here's the hard part. Most of the normal ways analysts measure value in publicly traded stocks don't work with insurance companies. The main measure of value for operating companies is the market cap of the stock (all the shares multiplied by the share price) divided by its earnings. Typically, analysts will use the price-to-earnings (P/E) ratio, which uses the income statement (market cap divided by net income). Or analysts will use cash flow (enterprise value divided by cash from operations).

Neither of these measures is very useful for insurance companies because the companies themselves decide how much of their premium revenue to set aside each year in reserve. Insurance companies literally "guess" how much their profits will be each year. Believing management guesses isn't a great way of doing your homework.

These factors make insurance companies both Wall Street's best overall bet for long-term investors... and nearly a closed game. I don't know of any other publicly available research group that's ever published a comprehensive analysis on the entire property and casualty segment. But my new Stansberry Data service (which is available to lifetime, Capital-, and Advanced-level subscribers of my Investment Advisory newsletter) does exactly that – and updates all of the numbers monthly.

We hired an experienced analyst (Bryan Beach) – who worked at a senior level for major accounting firms and has a decade of experience investing in insurance companies – to build out our own insurance company rankings.

We based our rankings on more than a dozen key variables, most of which are unique to the insurance industry. These include things like: the size of a company's float, its underwriting profitability, its investment acumen (how much it earns on its float), and its corporate structure (how much stock do the key decision makers own).

We built out our database and published our first insurance company recommendation based on our proprietary rankings in March 2012. As the companies in the sector have now all published their final results for 2012, we can see exactly how well our model of the industry matched the actual results of these companies.

How did we do? The top 10 companies in our model, on average, increased the size of their float and book value by 13%. (Book value-plus-float is the most important measure of intrinsic value in insurance stocks.) Meanwhile, book value-plus-float actually declined for the rest of the industry (excluding our top 10).

Our top 10 companies also earned an underwriting profit. They posted a "combined ratio" of 98 compared with the rest of the industry's average of 101. The "combined ratio" is a measure of underwriting profitability. A combined ratio of 100 represents breakeven. Anything above 100 represents underwriting losses. Amounts below 100 represent underwriting profits.

If that seems confusing... let me try to simplify it for you. There's no easy way to analyze insurance stocks. So we built a system of data collection and analysis that allows us to see which insurance stocks should produce the best results. Last year, our system proved to be very accurate. Our top 10 insurance stocks were clearly better than the industry as a whole – by a wide margin.

And here's the best part. When we plot the prices of our best insurance stocks (measured by their current price-to-book value ratio) against our proprietary measures of quality, there's clearly no relationship (yet) in the market.

That is, right now, there's no correlation between the price of these insurance companies and their quality according to our model. On the other hand, when we use Wall Street's simple measure of quality (annual return on equity), there's a strong correlation.

That means Wall Street is still valuing these stocks on the basis of their stated return on equity. But remember, that measure of quality depends entirely on the management's own evaluation of its underwriting – on its guesses. Our model, on the other hand, uses actual underwriting profits (or losses) and other tangible measures of quality. In the long run, our model will prove to be a far, far more valuable guide to insurance companies than merely using published return on equity. And that means you still have a huge opportunity in insurance stocks.

Our first recommendation in the sector using our new model was W.R. Berkley (WRB). We're up 28% in about a year. As we grew more comfortable with our model's predictive power, we recommended five more insurance companies last fall. So far, our average return is about 17% – and all of these recommendations have been profitable. These gains, while impressive, are only the beginning. Insurance stocks have rarely been cheaper, and I believe our model provides us with a unique advantage in the sector. This advantage is not yet priced into these stocks.

If you're a subscriber... I strongly encourage you to read this week's Stansberry Data (April 2) update, which is focused exclusively on the insurance sector. It's available on our website, and it's free to all Advanced- and Capital-level subscribers to my Investment Advisory (as well as lifetime members).

While I wouldn't suggest that anyone invest only in insurance stocks, I'd wager that if you limited yourself to only buying the highest-quality insurance stocks, when they traded at attractive prices, you'd earn around 12%-14% annually over time. It's hard to make more than this being a buy-and-hold investor in safe securities. And that's why, if you're not following the sector yet, I'd urge you to.

Crux Note: Could Barack Obama's entire presidency be ruined by a single upcoming event? Porter says YES. To learn when it's likely to happen –  and what it could mean for you and your family – click here.
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