Description

Hallmark Financial Services (HALL) is a consistently profitable, growing and well managed insurance company trading at 69% of book value.  The current market cap is less than half of the value of the company's investment portfolio which is comprised mainly of high grade municipal and corporate bonds.  This effectively provides equity holders with a safe low-teens yield and plenty of upside potential given the company's consistent underwriting profits and growth prospects.  HALL is controlled by hedge fund Newcastle Partners, a long-term value investor with a successful track record.  The company is in strong financial condition and is likely to either acquire competitors (as exemplified by its unsuccessful, but still quite profitable, attempt to buy Specialty Underwriters earlier this year) or continue to buy back shares. 

The stock is down -15% this year for what I believe is a purely technical reason - Newcastle had redemption pressures and distributed a portion of its holdings to its own investors earlier this year (they previously owned almost 70% of the shares and are still over 40%).  In my opinion this massive share overhang has created the current opportunity to buy HALL at such an attractive price and has largely ended as hedge fund redemptions have moderated and Newcastle has actually been buying shares in recent weeks on the open market.    

Business Overview/History

Hallmark is a diversified property/casualty company that serves businesses and individuals in specialty and niche markets.  Through five underlying subsidiaries the company focuses on selected markets that are typically low-severity and short-tailed.  The company's stated goal is to earn consistent underwriting profits and build long term shareholder value by focusing on profitability and operating efficiency rather than premium growth.  It has been successful in this goal, earning underwriting profits every year since 2004 with combined ratios between 82-93%.  It's underwriting has also been conservative, with the company making favorable reserve adjustments each year since 2003. 

Newcastle first bought the stock in 2000 when HALL was a small, one dimensional company.  Newcastle founder Mark Schwarz became Chairmen in 2001 and acted as CEO from 2003-2006, transforming the company into a diversified platform of specialty P&C insurance that has generated almost $120 mm of pre-tax profit since 2003.  Schwarz remains Chairman and Newcastle and HALL continue to be closely intertwined.  I believe this close relationship is a positive as Schwarz has a long, successful investment track record and HALL is by far his fund's largest position (40% of his portfolio according to Factset, although this only takes into account public equity positions).

Schwarz founded Dallas-based Newcastle in 1993 with backing from Lamar Hunt's family.  There have been a few media profiles of Schwarz over the years, including a feature in the February 5^th, 2007 edition of "The Deal".  That article cites Newcastle's returns of 24% annualized since 1993, a "hybrid" investment strategy using PE-type involvement with public companies and a value investing approach with influences including Leon Levy, Carl Icahn and Ben Graham.   Given its mostly long portfolio and illiquid positions, Newcastle had a tough 2008.  Sources familiar with the fund indicate that it was down over 40% last year but that its long term track record remains strong, with returns in the low to mid teens since 1993 (the S&P has annualized at 7% by comparison).  The previously mentioned article ends with the following quote, at a time when HALL stock was around $11 and trading at 1.5x book value:

"Hallmark has made huge strides after seven years, but Newcastle aspires to make it a much bigger company.  Schwarz says, 'I'm prepared to hold the Hallmark investment for another seven years, and perhaps another seven after that.'"

Having an intelligent investor so heavily involved is particularly helpful to HALL given its strong financial position and ability to make acquisitions.  Many VIC readers are aware of the situation at Specialty Underwriters and I'd recommend reading Jigsaw777's write-up from last December and the accompanying thread for all of the details.  In short SUAI was a mediocre insurance company (break-even to slightly profitable underwriting) with a rock-solid investment portfolio trading as low as 0.3x book, effectively giving stock holders a 30% pretax yield at the lows.  Hallmark bought 9.9% of the company, made an unsuccessful bid for the entire thing and later launched a proxy battle, trying to replace board members with its own choices.  SUAI was largely successful at fighting off HALL's proxy battle and later announced a sale to Tower Group at close to 80% of book value.  While not the ideal outcome for HALL, it still made money off of the investment and in my opinion it exhibited HALL's shrewdness and ability to take advantage of struggling competitors.  Another example - in 2007 HALL announced a consulting arrangement with industry veteran Stephen Way, the former founder of HCC Insurance who has a long history of successful acquisitions (more on Way: http://www.insurancejournal.com/magazines/southeast/2005/07/04/features/57787.htm). 

Between year-end 2008 and June 30^th 2009 Newcastle, like many other hedge funds, had a large amount of redemption requests from its investors.  Since it held such a huge amount of HALL shares (almost 70%) it appears to have had no choice but to distribute out the shares "in-kind" to redeeming investors.  It distributed 1.8 mm shares to investors at year-end, 1.4 mm at the end of Q1, and 2.7 mm at the end of Q2.  All told this equates to almost 30% of the outstanding shares, a huge amount that represents almost 90 days of trading volume.  While it's impossible to know for sure what redeeming investors have done with the stock, since they were redeeming from Newcastle in the first place it's reasonable to assume they either didn't like the investment anymore or needed the cash.  Thus, many of them likely sold the stock regardless of what the underlying economics would warrant.  Importantly, at the end of Q3 there was no distribution reported and Newcastle has actually been buying shares the past two months, including its largest purchase yet (150,000 shares) two weeks ago.  Hallmark also made its first ever share buy back in September, purchasing 750,000 shares for $7.00 each in a privately negotiated transaction.  This was done at 69% of the most recently reported book value at that time, exactly where the stock is trading today, and the company currently has authorization to buy back 250,000 additional shares.

Investment Portfolio

HALL's investment portfolio is invested in mostly plain vanilla, highly rated fixed income securities.  The company does have some equity exposure as well and has proven astute in recent years at navigating the fixed income markets.  Most notably the company sold most of its 40% exposure to treasuries by the end of 2008 and replaced it with exposure to municipal bonds, whose yields had blown out to all time high spreads relative to treasuries:

HALL has also avoided mortgages and other areas where other insurance companies have gotten into trouble.  The portfolio's weighted average credit rating is "AA" and weighted average duration is 2.9 years.  So overall this is a safe, well managed portfolio that you get $2.24 of exposure to for every $1.00 invested in the stock, or a 13-14% pre-tax yield.     

Valuation/Summary

The absolute valuation of HALL is the key to the story in my opinion.  Buying the stock today I think you get a safe low teens return from buying into a well-managed portfolio of mostly municipal and corporate bonds at 45 cents on the dollar, with profitable underwriting, potential growth, and an intelligent capital allocator thrown in as pure upside.  From a relative standpoint HALL appears cheap as well and has underperformed this year.  Compared to a universe of 30 other insurance companies with a billion or less in market cap:

Risks

• Newcastle redemptions/distributions - while these appear to be done if there was another large wave of hedge fund redemptions Newcastle might have to distribute more shares, causing further forced selling
• Interest rates/inflation - nothing specific to HALL, just always a concern with insurance companies and in today's world in particular
• Concentration in Texas - 44% of HALL's risk is written in the state. This is largely mitigated given the diversified, niche nature of underwriting HALL is involved in
• Acquisitions - there is always the chance that HALL will make bad acquisitions going forward. They are clearly aggressive (as the SUAI situation showed) and want to expand, and intangible assets have grown in recent years because of previous acquisitions (there is around $41 mm of Goodwill currently)

Catalyst