Tom A's Stock Picks

Hartford Financial 3Q 2008 Earnings

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Hartford Financial Group (HIG) recently reported 3Q 2008 earnings, a loss of 8.74, driven by investment losses, catastrophe loss in the P&C business, and a DAC (Deferred Compensation) unlock in the Life business. The stock, which had already been severely punished after their pre-announcement, has been as low as 12.50, a big comedown for a company that has traded as high as 98.07 within the past year.

Looking at the conference call transcript here on Seeking-Alpha, the analysts homed in on the potential need for more capital. Hartford has already received a 2.5 billion infusion from Allianz, which diluted existing shareholders, and if more capital needs to be raised under today's conditions serious harm would be done to shareholder value. Accurately predicting an outcome requires the ability to predict the course of the S&P 500 as well as the changing assumptions of the credit rating agencies, specifically Moody's (MCO), which has Hartford under a negative outlook.

I believe the S&P 500 will rally in due course. No realistic person will attempt to predict what Moody's will do next.

As usual when updating my files, I recomputed HIG's book value. With earnings so badly influenced by the performance of the stock and bond markets, I tend to look to book value for financial companies. Hartford posts a quarterly supplement on its website, and discloses a GAAP BV/Share of 41.80, and a nonGAAP BV (excluding AOCI) of 55.13. AOCI is accumulated other comprehensive income and holds unrealized losses (mostly on investments) that have not been passed through the Income Statement. The last time I looked at this issue, I felt that the company was able and willing to hold the affected bonds to maturity and accordingly the proper metric was nonGAAP.

However, Hartford will now be reducing the risk inherent in their investment portfolio, which will involve realizing some losses on Alt-A and Sub-prime RMBS. Under the circumstances, I will now use GAAP BV, and adjust that for dilution from the Allianz infusion. Part of the Allianz deal involved warrants exercisable at 25.32. Because this is less than GAAP Book Value, I expect that the warrants will be exercised in due course and included their effect in computing dilution. Book value per share, for my purposes, is now 30.78.

Believing the share price will eventually recover to 1.5 X Book, I see a target of 45 per share, within 2 to 3 years. If the unrealized investment losses can be salvaged, that figure would be 60. On the other hand, if a worst case combination of adverse market developments, short-selling, and forced capital raises can be precipitated, a very poor outcome is possible. I have been operating under the assumption that intelligent regulatory intervention and the normal actions of legitimate investors could prevent these outcomes: however, that assumption has been expensive, to date.

I see some positives here. Hartford's P&C business, looking past the catastrophe claims, has a very respectable 90.1 combined ratio. Because many market participants have had bruising investment losses, the industry will probably start pricing to an underwriting profit. Reduced mileage due to gas prices and the economic slow-down should help Personal Auto results.

It is still early in the 4th quarter, and if Treasury can get the TARP program going on the Asset purchases, and stabilize MBS values, much of the pressure would come off Hartford's investment portfolio.

With these thoughts in mind, I am holding my long position in HIG. When averaging down in financials, my procedure is to spend equal sums of money at successive fractions of my metric - in this case, my estimate of book value including future dilution. Working off 30.78, shares are already less than ½. My next buy point would be 1/3, or 10.26. After that would come ¼, or 7.69.

Now would be a good time to talk about the problems I have experienced as a value investor drawn to financials. Fundamentally, these stocks have been attractive based on book value and the expectation that the housing market, and with it capital and credit market conditions, will eventually recover and return to normal. As the situation has developed, book values have become very soft - there are ongoing write-downs of assets, at some point capital is required due to regulatory or rating agency concerns, and then short-selling sets in. Frequently viable companies are cut off from access to the capital markets. Private Equity, or other smart money, has come in repetitiously, but the smart money gets burned too.

Drivers have included the CDS spreads, which I believe are subject to manipulation, and mark to market accounting, which is idiocy. The rating agencies have become intimidated by their inability to predict the sudden demise of previously highly rated companies, and have been down-grading in self-defense. Collateral requirements, based on credit ratings, have created liquidity problems.

A number of observers have suggested that there was a panic on the way down, and there will be a panic on the way back up. I believe this will happen soon. Mark to market will eventually exhaust the available distortions, or be abandoned. When that occurs, those who saw mark to market as idiocy will seem to have been prescient, clairvoyant, perspicacious, etc. The CDS market will be brought out into the daylight, and intelligent decisions will be made about insurable interest requirements. Going forward, no sane manager will expose his company to the vicissitudes of rating downgrades, and eventually the damage caused by collateral requirements and rating agency downgrades will burn through the last of the vulnerable companies. Smart money will come in again, and be rewarded.

In the meantime, I will hold, and add if HIG goes down to my next buy point.