Stephen Dodson of Bretton Fund presented his in-depth investment thesis on Progressive Corporation (US: PGR) at Best Ideas 2020.

Thesis summary:

Progressive is the third-largest auto insurance company in the US, behind State Farm and GEICO (part of Berkshire Hathaway). It is an “old saw” that insurance is sold, not bought, and most insurance companies work with an army of independent agents who go out and find customers. The agents receive a commission (typically 12-15%) for each customer they bring in and continue to clip renewal commissions (typically 5%) for each year a customer stays with a carrier. From the insurance company’s perspective, it is a low-risk way to grow a business; the company only pays for the customers who actually sign up. However, it is an expensive and unwieldy tool for a sticky product like auto insurance, where customers often remain with a carrier for six to eight years. The direct companies — largely GEICO, Progressive, and USAA — pay for their own sales efforts, which requires a greater upfront investment, but then allows the companies to keep more of the lifetime value of the customer relationship. The direct companies have steadily, if slowly, taken share from the companies that use agents.

From a financial perspective, it is helpful to think about Progressive as two different companies: an insurance company that writes policies and pays claims and an investment company that handles the money put up by policyholders.

On the insurance side, Stephen expects Progressive to write ~$35 billion of insurance in 2020. Roughly $25 billion will go back out the door in claims and about $7.5 billion will go toward overhead and marketing, including almost $1 billion to “bombard” TV viewers with “Flo.” That leaves $2.5 billion in underwriting profit, which, adjusted for taxes, equals ~$3 per share net.

On the investment side, Progressive’s $35 billion portfolio is split between ~$27 billion of debt and ~$8 billion of equity. The conservative bond portfolio should yield at least 3.5% for $950 million, and Stephen expects the equity portfolio to earn at least 6% for another $480 million. In total, Stephen expects the investment portfolio to yield about $2 per share after taxes over the medium term. However, accounting rules can introduce tremendous volatility in reported results: e.g., a rise in interest rates is reflected as a sudden loss in the investment portfolio, even though the company benefits from investing new funds at higher rates.

As a combined entity, Stephen looks for Progressive to generate slightly less than $5 per share in earnings in 2020. Progressive has consistently generated double-digit policy, revenue, and earnings growth, and while the top line may slow over time, a slowdown in newer, more expensively acquired customers would increase profitability and earnings.

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About the instructor:

Stephen Dodson founded the Bretton Fund in 2010 and serves as its president and portfolio manager. Prior to founding Bretton, Stephen was with Parnassus Investments, a San Francisco–based investment manager. Stephen was with Parnassus from 2002 to 2008 and served in a number of areas within the firm, including portfolio manager and president. In 2008, Institutional Investor News named him one of the 20 Rising Stars of Mutual Funds. Prior to Parnassus, he worked for the venture capital group of Advent International, a private equity firm, and was an investment banker for Morgan Stanley in New York and Menlo Park. He holds a BS in business administration from the University of California, Berkeley.