Description

This is a microcap deep value idea suitable for personal accounts, which I think could have asymmetric potential upside of over >800% to a conservative scenario based on current tangible GAAP book value, with the possibility of a intermediate-term sale of the company by a highly motivated and shareholder-aligned Chairman creating a setup for an exceptionally attractive IRR.

Because this would be a small PA position for most VIC members, but could have an extremely attractive expected value and IRR for those interested in adding a potential multibagger stocking stuffer to their Roth IRA, I'll keep this writeup short and to the point, and be realistic about the uncertain odds of this being a zero if there are further adverse developments in HALL's commercial auto binding insurance line currently in runoff. I've written a concise elevator pitch summary below, followed by sections on relevant aspects of the story for those wanting to drill down in more detail.

Executive summary / elevator pitch

HALL is a microcap specialty insurance company currently trading at a fire-sale valuation of 0.14X GAAP tangible book value, due to recent earnings disappointments culminating in a wave of heavy year-end tax-loss selling into an illiquid market. Today's extreme discount to current TBV and prior VIC recommendations of HALL has been prompted by charges in the two latest quarters to strengthen loss reserves for a previous commercial auto contract binding business, which HALL has exited and placed into runoff.

HALL is now trading at a deep discount to its $65.7MM in GAAP tangible book value after including the impact of the recent charges, and an even more extreme discount to BV after adding back $30.4 million in net operating loss tax assets currently excluded from the balance sheet under a valuation reserve.

To further strengthen the balance sheet, HALL recently sold several of its historically highly profitable excess and surplus (E&S) specialty reinsurance businesses to Core Specialty Insurance for a consideration of $59.2 million, alone representing almost six times the current market cap. Importantly, this transaction was finalized after the latest quarter ending on 9/30/22. With this sale taking place on attractive terms due to the attractive historical profitability of its niche E&S lines, the company reported in an 10/07/22 8-K that the transaction increased statutory surplus of the remaining HALL entity by $59.9 million, and as I can determine no gain to equity has been reflected in most recently reported GAAP tangible BV of $65.7MM as of the latest 10-Q for the quarter ending 9/30/22. Taken together, HALL's $65.7MM in MRQ GAAP tangible book value, additional $30.4MM in off-balance-sheet tax assets, and recently reported ~$60MM gain to statutory capital from the Core Specialty transaction, represent a very substantial pool of tangible assets relative to its current $9MM market cap, and could represent enormous upside for current shareholders in almost any scenario where the company is able to avoid massive future impairments.

I want to prominently represent that there are real near-term uncertainties effectively making this a binary option, which I'll expand on below -- specifically, if the exited insurance line experiences yet further adverse development making recently strengthened reserves insufficient, or the company loses a pending arbitration action brought by its reinsurer (a final decision is expected in 1H2023), additional impairments could severely impact the remaining equity and the company's ability to continue as a going concern. The odds of this are impossible to know with certainty -- and uncertainty may well be "the friend of the buyer of long-term values", but it sure as hell doesn't feel good. Faced with this looming uncertainty after two painful quarters of loss reserve charges, an impending 1:10 reverse split, and the entire retail shareholder base sitting on tax losses and trying to simultaneously unload into an illiquid market, there are effectively no market participants currently willing to buy this at almost any price.

However, the undervaluation is now becoming so extreme that HALL is looking exceptionally attractive as an option with asymmetric upside -- with the option being a uniquely undemanding one (delivering multiples of the current price if HALL's long-term equity value represents almost any positive fraction of its current GAAP tangible book value, with a significant additional margin of safety from its off-balance sheet tax assets and substantial boost to statutory surplus from its E&S sale).

Importantly, several near-term hard catalysts should materially resolve the uncertainties currently impacting the share price within the next two to three quarters, creating an attractive and timely setup for value investors willing to buy into current falling knife tax-loss selling at an extreme discount to book. Specifically, reporting of loss reserve development on its exited commercial auto business over the coming 2-3 quarters will reveal if recent loss reserve strengthening will be sufficient (or potentially even a conservative kitchen-sink event), and the outcome of reinsurance mediation expected in the first half of 2023 will resolve remaining uncertainty there. Together, these catalysts are creating an interesting setup for HALL as an exceptionally timely event-driven deep value investment, with fixed downside and an asymmetric upside to GAAP BV.

That was a longish elevator pitch (the Burj Khalifa version). For readers wanting to further dig into other relevant aspects of the thesis, I'll give a more in-depth overview in several areas below.

Corporate history

HALL has been recommended three times on VIC at much higher prices than today's. I like to think that sometimes the fourth time can be the charm, particularly during tax loss season at a point of apparent extreme capitulation. Past VIC recommendations have made valid points about the profitability of several of HALL's other specialty insurance businesses. In particular, the March 2021 writeup by Den1200 rightly identified a structurally attractive feature of HALL - it appears to have owned several niche specialty insurance "good businesses" that have showed very favorable long-term profitability, with the specialty commercial segment writing to an impressive average combined ratio in the low to mid 80s across multiple years, normally deserving of a significant premium to book value. As it turns out, these good businesses have been entirely obscured by two fairly mediocre businesses in HALL's standard commercial and personal lines (combined ratios in the 90s to 100s), and one incredibly atrocious business in the small truck binding business currently in runoff.

Unfortunately, the ultimate loss reserves required for the exited commercial auto line have been much higher than management or any of the past VIC investors anticipated. Den1200's 2021 writeup highlighted that this line alone had been responsible for adverse loss development totaling $8.43 per share - it's incredible to recognize the extent to which much of the equity generated by an otherwise profitable portfolio of specialty insurance lines has been eviscerated by a single monumental bad bet.

"Good business concealed by bad business" has often been a successful strategy for finding uniquely asymmetric deep value opportunities in the past, and value investing in apparently distressed financials at a point of peak pessimism can create some truly remarkable long-term returns - I could of course mention Uncle Warren buying American Express at distressed levels amid investor panic on losses due to the salad oil scandal, and GEICO after plunging to $2-$3 per share after posting a $126 million loss due to loss reserve charges in a "transitory" inflationary enviroment.

In the case of HALL, the outlook is a somewhat different but still interesting and timely setup. Hallmark CEO and Chairman Mark Schwartz is himself a substantial shareholder with a value investing mentality. With HALL having recently sold several of its excess and surplus (E&S) lines for a $60 million gain to statutory surplus, Schwartz is likely laser focused on stabilizing the remaining business and positioning it for sale to maximize value for common shareholders, chiefly including himself.

Management and incentives

Current CEO and Chairman Mark Schwartz, an experienced value investor and operating executive in the specialty insurance space, has accumulated a large position of over 5 million shares or 27.8% of HALL's common stock, originally paying as much as $9 per share on the open market through Newcastle Partners, an LP entity controlled by Schwartz since the 1990s. As the largest shareholder, unlike most salary-driven managers Schwartz will be highly motivated to retain and deliver value for shareholders; in the past, he's shown commitment to returning capital, and delivered significant dividends and accretive buybacks during periods when HALL was not capital constrained.

Schwartz was CEO of HALL from 2003 through 2006, and oversaw a period of profitability and growth in several of HALL's specialty commercial lines. Outside insurance executive Naveen Anand was hired as HALL CEO in 2014, and in an attempt to expand into additional niche specialty lines, oversaw an expansion of premiums written in a commercial auto contract binding business that eventually proved to be a disastrous misstep. When this became apparent, the auto binding business was placed into runoff, Anand was let go, and Schwartz returned as CEO in 2021 to oversee the business directly.

Impact of exited auto binding business

Although profitability in other specialty lines during Schwartz' tenure has been attractive, the long-term impact of ultimate loss reserves for the exited auto binding business has been devastating. As further described in Den1200's 2021 recommendation, after placing the auto binding business into runoff, the company negotiated a loss portfolio transfer (LPT) reinsurance agreement with reinsurer DARAG, under which the companies agreed to cede the initial $151.2MM in liabilities to DARAG Bermuda, with HALL retaining a subsequent corridor of $24.9MM, and DARAG's Bermuda and Guernsey subsidiaries reinsuring a second layer of $63.9MM, up to a total of $240MM.

Ultimate loss reserve estimates have exceeded even the $240 million ceiling. In the latest quarter ending 9/30/22, ultimate incurred losses from the subject business were $282.8MM, or $42.8MM in excess of the aggregate limit for transfer under the LPT. Although past losses have certainly been disastrous, loss development now that the business is well into runoff should not be infinitely long-tailed. In their 2020 ASM presentation, the company reported it discontinued writing new business on 2/4/20, and had originally projected runoff of the book to be completed by the end of Q3 2021. Now approaching 3 years after entry into runoff, recently updated reserves should begin to bear an increasingly close relationship to losses actually incurred. The latest quarter's ultimate loss reserves should be based on current best actuarial estimates of final losses ultimately incurred, so the strengthened reserves reflected in HALL's GAAP book value should theoretically be sufficient to satisfy future claims, with no further charges expected assuming updated actuarial estimates are appropriate. With the retail investor base having entirely capitulated into tax-loss season, HALL's current share price appears to assign this almost no probability.

DARAG arbitration

After having entered into the reinsurance loss transfer agreement described above (and experiencing more losses than expected), DARAG entered an arbitration case in 2022 claiming misrepresentation by HALL and seeking to retroactively annul the agreement. HALL has stated it believes "any such claims are without factual basis or legal merit and intends to vigorously contest the matter", and is seeking an arbitration award enforcing the terms of the LPT Contract.

HALL carries a $38.6MM reinsurance receivable related to the LPT contract, which will be fully recoverable pending a successful outcome from a letter of credit DARAG was required to post. Because the $92.6MM reinsurance premium plus retained corridor was less than the ultimate incurred loss reserves, an extreme adverse outcome where the LPT is retroactively entirely rescinded would wipe out HALL equity and can be regarded as a binary survival event.

The probability of a successful outcome is hard to determine objectively, adding to the uncertainty that's led to the current capitulation. Without having special insight into insurance arbitration, I think the most reasonable base case is that the reinsurance policy in force will be upheld. As a company in the business of assessing and reinsuring risks, DARAG made an affirmative decision to enter into a reinsurance contract, knowing the binding auto line had incurred significant unexpected losses in the past. DARAG was able to perform any due diligence it believed necessary before deciding to do so, and (barring any blatant and illegal fraud on the part of HALL) should be responsible for performing on the reinsurance contract that it agreed to. Considering that the purpose of reinsurance is to absorb future excess losses if they develop, and ultimate loss reserves are difficult for primary insurers and reinsurers to forecast precisely in many specialty insurance lines, exempting DARAG from performing on the policy it agreed to would set an unusual and perhaps dangerous precedent. (DARAG would have essentially gotten a free option allowing it to pocket a huge reinsurance premium if loss development was similar to or better than its own internal underwriting assumptions, but revoke the coverage it agreed to in arbitration if things went against them.)

Core Specialty E&S sale

Even before the recent extreme selloff, management and the Board were frustrated by HALL's low multiple to tangible BV, and had been exploring a potential spinoff or IPO of its specialty insurance businesses beginning in 2021. Faced with the need to strengthen its capital base (and with Schwartz highly motivated to avoid dilution), HALL recently entered into a sale of several specialty and excess and surplus lines to Core Specialty, booking a $59.9 million increase in statutory capital less transaction and other expenses. In the release announcing the sale, management described HALL will retain "Hallmark’s Standard Commercial and Personal lines, Aerospace & Programs business unit, the exited Binding Primary Auto business, or any business produced by third-party program managers (which includes a senior care and a commercial auto program)".

HALL stock rallied to $1.50 intraday on the announcement, only to give back gains after an AM Best release placing HALL's A- rating under review. The agency stated it "acknowledges the additional influx of capital will be a net positive for policyholders. However, significant execution risk remains related to restoring profitability across Hallmark’s retained lines, particularly standard commercial insurance and personal nonstandard auto, which have had historically high net underwriting loss ratios. The ratings will remain under review (with negative implications) until AM Best can fully assess the impacts of the aforementioned transaction, in addition to the effects of initiatives to improve operating performance and stem further material adverse reserve development."

This is a realistic assessment; the remaining insurance businesses are too subscale to justify HALL remaining independent over the long term, and would be worth much more to a larger strategic acquirer (the profitability of standard and E&S personal auto lines in particular would skyrocket if acquired by a larger auto insurer adding repair network economies of scale). The coming quarters will be critical to demonstrating that Schwartz can see through runoff and arbitration without further impairment -- with this accomplished, the fact pattern suggests he will be highly motivated to conclude a sale of the remaining subscale business, with almost any fraction of current GAAP BV representing a home run for shareholders from current levels.

Investment portfolio and benefit of rising rates

In the first half of 2022, the total return on Hallmark’s equity portfolio was -3.2% compared to -20.0% for the S&P500 index. In the next quarter I'd expect some further writedown in the value of HALL's relatively small equity portfolio of $42.8MM given the recent trajectory of the markets. The 1H22 total return on Hallmark’s fixed income portfolio was -1.6% compared to -10.4% for the Bloomberg Aggregate Bond Index. Although you wouldn't know it from HALL's share price, Mark Schwartz and HALL CFO Christopher Kenney have done a very creditable job of positioning HALL's investment portfolio to benefit from today's environment of rising rates. From the 5/12/22 8-K release accompanying HALL's 10-Q:

"Beginning in the second quarter of 2020, following the steep decline in interest rates resulting from COVID-19 stimulus measures, significant restraint was exercised in making new commitments to bond investments. The amount of cash held steadily increased, growing to more than $350 million by 2021 year-end. As interest rates rose significantly in the latter part of the first quarter of 2022, $154 million of cash was deployed into fixed income securities at yields comparable to, or higher than, the average yield of the existing portfolio. During the second quarter of 2022, an additional $92 million was deployed in debt securities of similar or better yields.

These actions had two primary purposes. First, the cash reserves and short duration of debt securities held provided protection to the balance sheet during what has been described as among the worst periods of performance in bond markets in U.S. history – avoiding unrealized losses in longer dated maturities that will likely persist for years. Second, opportunistic reinvestment of large sums of cash into income generating securities with comparatively attractive yields is expected to contribute to an increase in investment income in future periods."

Even this redeployment has been remarkably judicious in avoiding reaching for duration and preserving HALL's ability to benefit substantially from the rising rate environment we're currently experiencing. As of the latest quarter ended 9/30/22, HALL reported its insurance subsidiaries held $129.5 million of unrestricted cash and cash equivalents, as well as $417.1 million in fair value of debt securities with an average modified duration of 1 year.

The liability side of the balance sheet includes $30MM in trust preferred securities (TRUPS) at LIBOR +3.25% and $20MM at LIBOR +2.9%, and $50MM of 6.25% fixed rate senior unsecured notes maturing in Aug 2029. Given the fortuitous decision to underweight long-duration bonds, HALL's fixed income portfolio will begin to generate a substantial increase in net interest income relative to the current market cap. Taking HALL's $546.6M cash and fixed-income securities less $50MM in adjustable-rate TRUPS liabilities for a net exposure of $496.6MM, today's +3.6% YTD increase in 2-year yields would imply an extra $19.7 million in net interest income annually YoY if HALL survives to gradually redeploy its short-term fixed income portfolio at today's higher rates. This would be a very substantial annual tailwind going forward relative to the current market cap of just over $9 million, and is potentially meaningful enough to harvest a large portion of HALL's $30MM in off-balance-sheet tax assets in a scenario where the remaining insurance lines can simply achieve a near-breakeven combined ratio for a short period.

Valuation

To enable rational decision-making under uncertainty, taking a straightforward expected value approach is a reasonable method of quantifying the potential upside represented by HALL's assets and placing this into perspective with various probabilities of a total loss. I've put forward one scenario below that investors can modify as they'd prefer.

* 30% probability that recently updated ultimate loss reserves for the exited binding auto business are still insufficient after the $ increase, requiring further increases to loss reserves that are so substantial as to wipe out the remaining equity, including the recent additional $XX in statutory surplus from HALL's E&S sale.
* 30% probability that DARAG prevails in arbitration, achieving a retroactive cancellation of its liabilities under the LPT sufficient to wipe out remaining equity in HALL

Assigning 30% probabilities to each of the above as independent company-ending events would give a cumulative probability of loss of approximately 50% (a probability of survival of 0.7 * 0.7 = 0.49).

In the event that the company survives, quantifiable sources of equity value for shareholders include the company's $65.7MM in mrq tangible GAAP book value, $30.4MM in additional off-balance-sheet deferred tax assets, and the company's reported $59.9 million increase in statutory capital from its Core Specialty transaction in October - together representing approximately $156MM, over 17 times HALL's current market cap. This is without considering gains to net investment income going forward due to the repricing of HALL's fixed income portfolio. Expected value given the above assumptions would be $78MM or $4.29 per HALL share. From another perspective, expected value would be positive for all survival probabilities greater than 1/17 or 0.0588.

You can play with the above numbers to underwrite the scenario you're most comfortable with - in the end, it's a good example of the Munger homily on not having to know a man's exact weight to know he's fat. The thesis is that accumulating a small position into capitulation tax-loss selling at an extreme discount to tangible net asset value will create an attractive perpetual option with fixed downside and highly asymmetric positive upside.

Conclusion

Considering HALL's current $65.7MM in MRQ tangible GAAP book value, $30.4MM in additional off-balance-sheet deferred tax assets, and the company's recent reported $59.9 million increase in statutory capital from its Core Specialty transaction for an aggregate tangible value of approximately $156MM, potential upside of up to 1700% relative to its current ~$9MM market cap creates a compelling binary option which has positive expected value for scenarios other than a vanishingly small probability of corporate survival. Risks include additional adverse development requiring further strengthening of loss reserves, and/or a potential adverse outcome to HALL's arbitration with DARAG. If the company does survive unimpaired, HALL's tangible assets would represent a multibagger for current shareholders from here, and the company will additionally experience a substantial annual tailwind in net interest income as its short-term fixed income portfolio is reinvested at higher rates.

HALL shareholders will benefit from a value-oriented owner-CEO in Mark Schwartz, who has recently strengthened the balance sheet through a highly antidilutive sale to Core Specialty and will be strongly motivated to stabilize and sell the remaining business. Considering impending catalysts that could act to resolve current uncertainty within the next 2-3 quarters and help Schwartz position the remaining company for a sale, the potential IRR from a small allocation here could be exceptionally attractive.

In a world where specialty insurers like KNSL somehow trade for as much as 10X book, you have to wonder whether something that is nearly one hundred times less expensive may be worth looking into.

Closing and personal note

I've been an individual investor mainly interested in hunting for extreme deep value stocks for the past 25 years, and might actually be one of the longest-serving members of VIC, having joined back in 2003 (I aspire to one day be nearly as ornery as bowd57). Several years ago, while working a demanding day job in a scientific field and not finding value ideas I honestly thought were compelling I let my membership lapse, but have really come to enjoy VIC as a resource and forum for communicating with other value investors, so if you found this idea interesting I'd greatly appreciate if you consider upvoting. Thanks to Reactivation Status I can't see most discussion on previous posts about HALL, but would be especially interested in any thoughts from past/current shareholders.

Thanks very much, and wishing everyone Happy HALLidays and a prosperous New Year!

Catalyst

• Coming quarters and DARAG arbitration outcome in 1H2023 resolve current uncertainty around runoff of binding auto business
• Gains to statutory capital from Core Specialty E&S sale become reflected in BV
• HALL's short-duration fixed-income portfolio reprices at attractive yields and provides substantial earnings tailwind going forward
• Incentivized CEO (and largest HALL shareholder) motivated to stabilize business and sell remaining entity to maximize shareholder value in the intermediate term, creating potential for an extremely attractive IRR