Back in 1950, a young investor by the name of Warren Buffett discovered that his mentor Benjamin Graham was chairman of a company named Government Employees Insurance Company, or GEICO for short. Shortly thereafter, he hopped on a train to go visit the company at its headquarters in Washington D.C.

Following the visit, Buffett quickly became enamored with the way GEICO sold auto insurance. Instead of using agents and having to pay them a sales commission, it marketed directly to consumers. This “direct sales” model gave it a competitive advantage over large insurers that had to charge more for insurance because of the need to compensate sales agents.

#-ad_banner-#The rest is legend. Buffett has since become one of the most successful investors and businessmen of all time. In the process, he bought and continually added to his holding of GEICO, and in August 1995, ended up buying the portion he didn’t own for $2.3 billion.

More than 60 years since Buffett’s meeting, auto insurance firms are still using a direct sales approach to beat more stodgy competitors. Since 2007, GEICO and Progressive Insurance (NYSE: PGR) have steadily increased their market share by avoiding agents to sell auto insurance. As of the end of 2010, the two companies held 8.7% and 7.9% of the $160 billion auto insurance market share, respectively.

State Farm is still the market leader with 18.2% share, but its share has stagnated in recent years because it remains committed to the agent model. Allstate (NYSE: ALL), the second-largest firm, with 10.4% market share, has lost steady share in the past three years. This, combined with losses in its investment portfolio during the credit crisis, has pushed the stock to its lows of the past year. Additionally, the stock has fallen by more than 50% over the past five years.

 

But things are changing at Allstate, and I smell a buying opportunity. The company is still a market leader and has started to address its challenges. Part of this strategy is to obviously embrace the direct-selling model, which Allstate did in May when it announced it was buying online provider Esurance for roughly $1 billion. Also, the executive in charge of the auto insurance unit left in July and is being replaced with outsiders who have a better grip on the current market environment. Last year, the direct sales channel accounted for only 3% of the $26 billion in premiums Allstate collected, so adding Esurance more than doubles its exposure to this sales channel. Expect that number to grow going forward.

Allstate also offers home insurance and is still primarily reliant on the 11,500 agents that exclusively sell Allstate policies. However, more fully embracing the direct selling model will be the primary way to boost total company growth going forward. It has worked wonders for GEICO and Progressive in recent years, and Progressive has a successful balance of using agents and selling directly to consumers.

Allstate also operates a business segment that sells life, accident, health insurance and retirement products such as variable annuities. Last year, it brought in $4.5 billion in premium and fee revenue. Overall, Allstate, like other insurance companies, makes money by paying out less in claims than it collects in premiums. It also earns interest from the bonds in its investment portfolio and makes money from investing wisely. On $31.4 billion in revenue last year, Allstate netted $928 million, or $1.72 per share in earnings. 

Allstate’s businesses and investments on its balance sheet have fully stabilized since the credit crisis. Book value dipped to less than $24 per share but has recovered to $36, or right at pre-crisis levels.  All the firm needs is a slight boost toward growth, which is what the new management team and Esurance acquisition should provide. This should boost revenue growth as well as profitability going forward.
 
Action to Take –> Allstate’s book value (a common metric for valuing insurance companies) is currently right around $36 per share. At the current price, the stock trades at only about 70% of book value. A rule of thumb for the insurance industry is a stock is cheap when it trades below book value. So overall, by this metric, Allstate is extremely cheap. Prior to the credit crisis, Allstate’s price-to-book ratio was 1.5.

Allstate’s return on book value averaged 22% in 2006 and 2007, right before the credit crisis hit. I don’t expect returns to these levels any time soon, but a return on equity (another term for book value) of 10% is quite reasonable. By simple math, this works out to earnings of $3.60 per share ($36 book value x a 10% return). On a price-to-earnings (P/E) basis, Allstate is trading at only seven times this more normalized level of profitability.  

Overall, I see the potential for Allstate’s P/E multiple to expand as the company better grows its business and investors reward the company with a higher stock price. Profit growth of about 10% in the next three years would put earnings close to $5 per share. A multiple of 10 off of these earnings, which I see as reasonable and closer to Alllstate’s historical average, suggests a share price of $50 per share, or double current levels. The dividend yield is also appealing at about 3.3% and well above the market average of 2.2%.

The One Stock to Buy BEFORE President Obama’s Emergency Briefing
A little-known event is about to take place that could be catastrophic to the United States. You’re not hearing about it on CNN or Fox News (yet)… but you will. Don’t be surprised if there’s a briefing from the president himself. The governments of China, India and Russia are all involved… and an estimated 31 million Americans will be impacted. StreetAuthority’s top research analyst has put together his own “emergency briefing” that spells out step-by-step what’s going on. He’s also identified the one stock he predicts could double in a hurry as this situation unravels. Click here to watch the briefing.