Buying a turnaround stock can often be a profitable move. Certainly, there is a risk that its comeback will falter, but there is also the potential for high capital gains in the long run. Reporting on Thursday was a stock which has already returned to profitability and is now looking ahead to significant growth. As such, now could be the right time to buy it.
A transitional year
The company in question is RSA Insurance(LSE: RSA). Its results for last year show it has become a strong, organic growth play which is delivering much-improved levels of profitability. For example, group operating profit moved 25% higher, while its underwriting profit of £380m was a record level. It completed the disposals of its businesses in Latin America and Russia, which brings it a step closer to its principal disposal programme of achieving a more concentrated strategic focus.
RSA's balance sheet and capital ratios provide further evidence of its return to health. Its solvency II coverage ratio of 158% is at the upper end of its 130-160% target, while its reserve margin was strengthened by 50 basis points to 5.5% during the year. It should be relatively well-insulated from the effects of Brexit, since around 70% of its profit is derived from currencies other than sterling.
Profit growth of 51% is forecast for the current year, while further growth of 18% is expected next year. RSA could even gain a currency boost from weaker sterling during the two-year period, which would lead to an upgrade to its guidance.
However, even if this does not take place the company's price-to-earnings growth (PEG) ratio of 0.7 indicates that there is significant upward rerating potential. Even if its shares were to rise by 30%, it would still be trading on a price-to-earnings (P/E) ratio of 16 by the end of next year. Given its potential for double-digit profit growth in the long run, this would not be a particularly demanding valuation. That's especially the case since RSA is transitioning from a turnaround stock to one which has a sound financial base and a more attractive business model through which to report higher profitability.
This should positively impact on RSA's dividends. It currently yields 3.4%, but with such strong growth potential and a dividend which is covered twice by profit, a significantly higher yield could be on offer in future years.
Insurance sector peer Hiscox(LSE: HSX) trades on a P/E ratio of 16.6 at the present time. This is higher than RSA's rating would be if its shares moved 30% higher and it meets its guidance over the next two years. Even on such a heady P/E ratio, Hiscox does not seem to be overvalued. It is due to report a rise in earnings of 10% in 2018, which puts it on a relatively attractive PEG ratio of 1.6. As such, it appears to be worth buying for the long term.
Hiscox has an excellent track record of growth, with profit rising in each of the last four years. As such, it may be viewed as somewhat lower risk than its sector peer. However, RSA is now a much stronger company than in recent years and seems to have the scope to rise by at least 30%, while offering a yield which is 0.8% higher than that of its sector peer.
Peter Stephens has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.