In 2005, I believed that AIG’s shares were undeservedly depressed by temporary regulatory issues. In the course to speaking to insurance industry executives about AIG, we repeatedly were told that we should also look at Hartford Financial.  Hartford, according to its competitors and peers, is a particularly strong company that has been superbly managed under the leadership of Ramani Ayer and that has reduced its exposure to cyclic lines and has increased its exposure to some rapidly growing businesses, including retirement products.

 

            At first, I was hesitant to spend time on Hartford.  We had believed that insurance is a competitive, slow growth, low return business.  However, one day I spent some time reviewing Hartford’s history – and, quite frankly, was surprised by the results.  Hartford was spun-off from ITT on December 19, 1995.  In its first full year as a public company, Hartford earned $3.07 per share, a 17.3% return on a year-end book value of $17.72 per share (note – all figures exclude capital gains and are before non-recurring items).  Last year, we believe that Hartford earned just over $9.00 per share, a 15.7% return on an estimated year-end book value of $57.25.  Thus, over a ten year period, the company’s EPS and book value grew at 11.3% and 12.4% annual rates, respectively – and the company earned relatively high returns on its invested capital.  These results triggered our interest in Hartford – and, after subsequent research, we concluded that the company’s long-term growth rate should be in excess of 10% and that the company’s shares should be worth at least a “market multiple”, or at least 15X earnings.  We estimate that Hartford’s 2007 “normalized” EPS is about $9.30 (we believe that the company actually might earn more than $9.30 this year due to the tight P&C market).  Thus, we believe that Hartford’s shares are worth at least $140, or 50% above their present price – and we find it very unusual that such a large, well-managed, well-positioned company is selling at only 10X its current normalized EPS.

 

            In a typical year, about 45% of Hartford’s profits come from property and casualty (“P&C”) insurance and the remaining 55% from various “life” insurance products.  Regarding P&C, over the years, management has pulled back from many of the more cyclic, competitive lines and has purposely concentrated on such less competitive markets as small businesses, specialty lines, and auto insurance sold to AARP.  Similarly, in its life businesses, management has particularly focused on its group disability business (after purchasing CNA’s group disability line several years ago, Hartford became a strong #2 to UNUM in this specialty business) and such retirement products as variable annuities, the management of 401K’s, and mutual funds.  Hartford strongly believes that the transition from defined benefit pension plans to defined contribution plans in our country presents an unusually favorable opportunity for the company to grow quite rapidly by selling a variety of products to the retirement market.

 

            We believe that, in a “normal” year, Hartford earns a ROE of about 15%.  This means that, after paying dividends equal to about 3% of book value, the company’s book value should grow by about 12% annually, before other considerations.  Since the company’s top line is only growing at about 10% per year, the company is generating some excess capital.  Recently, management announced that it would repurchase about $800 million of its stock in order to return to shareholders excess capital that will be generated in the 2006-2007 period.

           

In 2006, Hartford’s EPS were helped by the unusually tight P&C market, but were hurt by a one-time charge for litigation and by the flat yield curve (which materially reduced the demand for the company’s annuity products).  On balance, be believe that the company will report EPS of about $9.00 for 2006, but that it’s normalized EPS were about $8.50.  After a lengthy interview with Ramani Ayer (CEO) and after our own analysis, we have concluded that the company’s normalized EPS will grow at about a 10% annual rate to about $9.30 this year and $10.25 next year.

 

We believe that there are several reasons why Hartford’s shares are deeply undervalued.  One reason is the concern by investors that the P&C market is weakening.  We agree that the market is weakening, but note that the company’s P&C lines tend to be less cyclic and that the company’s annuity lines currently are operating at somewhat depressed levels and should rebound when the yield curve becomes steeper.  Another reason is that hedge funds, which are playing a key role in determining the price of stocks, largely have been ignoring the shares of Hartford and many other high quality, large cap companies (such as GE and 3M) that are not expected to appreciate sharply over the near term as a result of favorable developments or trends.  Thus, in purchasing shares of Hartford, we are treading on a less traveled path, which is where we generally like to be in our investment journeys.