This is Part 6 of a series of articles discussing the returns on common stock and TARP warrants for a few financial institutions relative to the institution's book value. Part I, on AIG, is located here. Part 2, on Bank of America (BAC), is located here. Part 3, on Citigroup (C) is located here. Part 4, on Wells Fargo (WFC) is located here, and Part 5, on JP Morgan (JPM) is located here.
As a result of the financial crisis and the aid the received from the government, warrants on The Hartford Group (HIG) were created and later sold to the public. Some general information on warrants can be found here. The Hartford warrants expire June 29, 2019 so the warrants provide a great way to gain exposure to the company until then. Also, the stated strike price is $9.79, which is well below the current share price so the volatility of these warrants will be lower than warrants in other companies that are out-of-the-money. Here's the prospectus.
With the performance of the stock over the past year, it is good to put the current price into prospective relative to historical valuations. HIG still trades at roughly half of book value. Before the financial crisis, large insurance companies traded at roughly 1.4x book value. The Hartford warrants have around six years until expiration, so these instruments have a long enough life that they should see the company return to more normal valuations of at least book value but possibly as high as the historical 1.4x book value.
All TARP warrants have dividend protection, but the Hartford warrants have great dividend protection based on the adjustment threshold. As the quarterly dividend rises above $0.05, the strike price of the warrant is adjusted down by the amount above that level.
HIG currently pays a quarterly dividend of $0.10 and has since Q1 2011, so the strike price of the warrants has already dropped by $0.45 to $9.34.
To keep the analysis conservative, I'm assuming the company increases the dividend each year for the Q1 payment by 10% over the previous year starting in 2014 (rounded to nearest penny). Given that dividend increase rate, the warrant strike price will be adjusted down by a total of $2.49 through expiration. Thus, the final warrant strike price will be $7.30.
In the table below, I list the relevant information about the warrants including the final strike, the current stock price, the current stated book value (from the latest company reports), and returns for the warrant and stock based on price relative to future book values (both 1x and 1.4x). I assume book value grows at 3.5% per year from current levels. This is a low growth rate to keep the analysis conservative. The returns for the stock include all dividends paid out between now and expiration.
Given the assumptions I used, both Hartford stock and warrants look like compelling investments. Keep in mind that while I use conservative estimates for growth, I assume constant growth. A single year of contracting book value significantly reduces the expected returns.
The average volume in the warrants is over 80,000 which should provide ample liquidity for individual investors but if any large institutions buy or sell the instrument, the share price will move significantly. On the chart of HIG vs. HIG warrants, there are several days where the correlation between the two has broken down. This is probably due to a large investor buying or selling the warrants. This is especially common around earnings reports and times of significant volatility.
After the big run that the whole finance sector has had, I believe Hartford is undervalued from a long-term prospective but probably overextended shorter term. As a result, it makes sense to buy a partial position now and wait for the market to fall to purchase the rest of the position. Since the warrants use leverage, they will be more volatile than the underlying stock. Any drop in stock and warrant prices should provide a great entry point for investors who can handle volatility to achieve long-term gains.