Berkshire Hathaway (BRK-B) recently initiated a 1.3% stake in Travelers (TRV). Investors should not follow the moves of Warren Buffett blindly, as he may have a different investing horizon or goal from them while he is not infallible.

On the other hand, as investors have a lot to learn from Buffett’s investing wisdom, we should pay attention to his moves and analyze them.

In this article, we will analyze whether investors should follow the Oracle of Omaha in his recent purchase of shares of Travelers.

Business Overview

Travelers is a leading provider of property/casualty (P/C) insurance for auto, home, and business. It is the only P/C insurer of the Dow Jones Industrial Average.

The P/C insurance business is a tricky one and hence investors should be very careful in their stock selections. An insurer may achieve great sales during good years by lowering its prices (premiums), only to incur devastating losses in a tough year, with many natural disasters. In other words, the pricing of the insurer is of paramount importance and investors can evaluate its pricing only in an adverse year. Travelers has always followed a disciplined underwriting policy, which has helped the insurer achieve great long-term growth and decent results in adverse years.

Last year was an adverse year for all the P/C insurers, as it included three major hurricanes. Consequently, the earnings per share of Travelers decreased 28%, from $10.13 to $7.27. However, given the magnitude of the natural disasters, the insurer exhibited great performance. Even better, natural disasters promote the long-term growth of insurers, as the latter implement significant price hikes after such years. Indeed, Travelers is poised to grow its earnings per share by 33% this year, from $7.27 to $9.66, and is expected by analysts to grow its bottom line by another 17% next year, to $11.31.

Growth

There has been a major shift in the business strategy of Travelers since its new CEO took over, three years ago. The former CEO, Jay Fishman, who served as CEO for 12 years, did not pursue high sales growth but achieved extraordinary results thanks to strict underwriting policy and aggressive share repurchases. During the 8-year period 2008-2016, Travelers reduced its share count by 52%. As the stock traded at a cheap valuation throughout that period, those share repurchases greatly enhanced shareholder value. During the above period, the company almost doubled its earnings per share, from $5.24 in 2008 to $10.13 in 2016.

The new CEO, Alan Schnitzer, has reduced the buyback rate, as evidenced by the 3% decrease in the share count this year. On the other hand, he has greatly enhanced the growth rate of sales. While Travelers grew its revenues at a 1.5% average annual rate from 2008 to 2016, it has grown its sales by 4% per year in the last two years. Investors should expect meaningful earnings growth from the acceleration of sales in the upcoming years.

Even more importantly, rising interest rates will be a major growth driver for Travelers in the upcoming years. Due to the record-low interest rates that prevailed for several years, the investment income of Travelers remained suppressed during those years. However, now that interest rates are on the rise, they will significantly boost the investment income of the insurer. This is particularly important, as the investment income comprises about 80% of the total earnings of the company. As the average duration of the fixed-income portfolio of Travelers is approximately 4 years, the company will soon begin to feel the tailwind from rising interest rates.

Given also that share repurchases will continue to provide an approximate 3% boost to the earnings per share, it is reasonable to expect Travelers to grow its earnings per share by at least 6% per year in the upcoming years. This is in line with its growth rate over the last decade.

Valuation

Travelers is currently trading at a price-to-earnings ratio of 12.7. This is a markedly cheap valuation, particularly given the performance record of the company. Nevertheless, as the stock has historically traded at lower price-to-earnings ratios, it is prudent not to expect meaningful gains from the expansion of its valuation level. On the other hand, the cheap valuation greatly enhances the efficiency of share repurchases, as more shares can be retired with a given amount of buybacks.

Dividend

Travelers offers a lackluster 2.5% dividend yield. The insurer has paid uninterrupted dividends for 31 consecutive years and has grown its dividend for 14 consecutive years. While the current dividend yield may not be exciting, investors should note that the company has approximately doubled its dividend every 7 years. It has easily achieved this dividend growth rate partly thanks to its aggressive share repurchases, which have greatly reduced the financial burden of the dividend. For instance, since 2006 the dividend per share has essentially tripled, from $0.26 in 2006 to $0.77 this year, but the total amount spent on dividends has increased only 11% (!), from $724 million in 2006 to $807 million this year.

Moreover, the current payout ratio is only 33% so Travelers can easily continue to raise its dividend at a fast pace. On the other hand, since the new CEO took over, the dividend growth rate has somewhat decelerated, from 10% per year previously to about 7% per year. The latter will most probably be the dividend growth rate going forward.

Final Thoughts

The primary reason for the recent initiation of a stake in Travelers by Buffett is probably the fact that the Oracle expects significant earnings growth thanks to rising interest rates. Thanks to the recent correction of the broad market, investors are given the chance to purchase the stock around the entry point of Buffett. Given the promising growth prospects that result from rising interest rates and the disciplined underwriting policy of Travelers, the stock is likely to reward its shareholders with meaningful returns going forward.