Premium risk at Prudential

 
A glance at the above chart of the FTSE 100 shows that it has been a relatively cautious week, as the market consolidated the recent gains.

Equities marked the one year anniversary of the bear market low this week, with the best 12 month performance since the 1930’s. The S&P rose by an outstanding 67% and the FTSE 100 increased by 63% from last years lows.

Accommodative conditions combined with an improving economy have helped drive the gains, although it is worth noting that historically equities have tended to do less well in the second year after hitting a cyclical low.

The Vix volatility index, a key gauge of risk aversion, continued to hover around January’s 22 month low, which indicates that investors are growing more confident of a continued economic recovery.

Global economic data has remained mixed, with British manufacturing output falling by 0.9% in January, which put a dent in hopes that the economic recovery might have gained a bit more speed in the first quarter of the year. Conversely, strong Chinese trade data fuelled the bulls, but also raised concerns over monetary tightening, which weighed on commodity prices.

Sovereign default risk continues to linger in the background in spite of the recent action taken by Greek authorities. Portugal reappeared on investor’s radar screens, as Fitch Ratings Services said it still had a negative credit rating on the country’s debt and critisised the latest austerity measures announced by Lisbon on Monday.

Technical analysis highlights the sharp move experienced on the FTSE 100 in recent weeks, with the blue chips gaining over 12% since early February. The index now appears to be trying to consolidate around resistance at 5600 and the average daily volume traded on the FTSE 100 has been well below the daily average over the past week, as investors weigh up the recent moves.

The oscillators are in overbought territory, with the relative strength index (RSI) and stochastic trading at the peak of their respective trading ranges. Interestingly, both appear to be flattening out, which could signal the early stages of a change in trend.

In summary, it has been an impressive run for equities over recent weeks and the economic backdrop is clearly improving. However, many headwinds remain, with unimpressive UK economic data, imminent fiscal and monetary tightening and a general election to name but a few. In light of these and the overbought technical conditions, I am inclined to suggest the FTSE may move lower over coming weeks.

Insurance giant Prudential (Epic: PRU) has stolen the headlines this week, after their decision to buy AIA, the Asian life business of US insurer AIG, has attracted a mixed response from shareholders.

Prudential already has a substantial exposure to Asia and the shares have been a strong performer in equity markets over the last year, with the shares rising over 150% during this time.

Recent results on the 1st March showed a convincing return to profitability, with the previous year’s £2.07 billion loss transformed into a pretax profit of £1.56 billion for the year ended 31st December 2009. Reduced write downs produced a strong reversal in their investment performance and new business sales rose 11% to £2.89 billion on an annual premium equivalent basis.

AIA looks like an impressive business, with a 19% market share of the fast growing Chinese insurance market, versus Prudential’s 10%. It is also the only non-domestic insurer to own an outright insurance license to operate in China. Cost savings are likely to be significant, with obvious synergies from merging back-office and sales operations.

However, investors are concerned about the $35.5 billion (£23 billion) price that Prudential have agreed to pay for AIA. It certainly looks rich against the $20 billion price tag mentioned when AIG first suggested a sale of AIA in 2008. Analysts also argue that paying around 1.6 times embedded value is expensive, considering that most UK life insurers trade around one times.

Prudential will part fund the deal with the largest rights issue in the UK’s corporate history. The $20 billion (£13.4 billion) plus that is being contemplated will contribute alongside another £7 billion of new shares being granted to AIG and the balance made up by more than £3 billion of new debt.

The total figure of £23 billion being paid from a £12.5 billion market capitalisation looks a big gamble. The shares were 600p before the news was announced and even if they could raise the required cash at 600p, they would have to offer one new share for every existing share. To the extent that the fund raising will be deeply discounted, it is clear that a much larger number of shares will need to be issued in order to raise the cash required to fund the deal. Accordingly, the market for Prudential shares is uncertain, as we await the mechanics of the rights issue.

Takeovers historically have a poor record in creating shareholder value and there is likely to be a considerable amount of time before any value from the deal is recognized. Sterling’s recent weakness will only add to the cost.



It is worth noting that technical analysis is largely irrelevant while the company is in the process of a corporate action, such as a rights issue.

The above chart of Prudential shows the shares lost around 75% of their value from the 2007 highs, as the financial crisis gathered steam. Following the market low in March of last year the shares gained over 200% and were 600p before the rights issue was announced. Since the rights issue was announced the shares initially fell to 476p, before rising back up to 545.5p, which is only 9% below the original 600p level.

This is an opportunistic short term trading opportunity, as the period ahead of a rights issue tends to be one of weakness and in light of our earlier analysis of the FTSE 100, it is a very uncertain environment for the biggest ever UK fund-raising.

At the time of writing the share price is 545.5p and I believe the share price will fall in the short term. Near term targets are seen at 511p, 493.5p and 467p, with a stop loss at 584.5p.

This report was written by Mark Allen – Head of derivatives at Simple Investments Stockbrokers. The writer does not hold a position in Prudential, but client accounts may. The material in this report has come from Simply Charts and Prudential’s corporate website.