HCC Insurance: Historically Cheap

by: The Keating Letter

It’s rare that I find a stock in an out-of-favor industry hitting 52 week highs. It’s even more rare when that stock is historically cheap. HCC Insurance (NYSE:HCC-OLD) takes the honors. The company is hanging out around its 52 week highs, but valuations are depressed because the insurance industry is out of favor.

I came across HCC because of its low P/B level relative to its past. It's currently trading at a P/B of 1, when the historical rate is 2.2. Not only that, but it is very close to its 10 year P/B low of .88. For a company this cheap, you’d think business is tough. The opposite is true for HCC. It is doing as well as ever, and book value steadily grew from $15 to $29 over the last five years, not even dipping on a YoY basis through the financial crisis. The stock price is sitting at the same levels it was in December 2006, when book value was only $18. So the company is now worth 60% more, but the stock price reflects none of that.

It may be helpful to look at a few other insurers for comparison that I’ve written about previously. I briefly highlight XL Group (NYSE:XL), Montpelier Re (NYSE:MRH), Partner Re (NYSE:PRE), and Everest Re (NYSE:RE) here: Four Cheap Reinsurers to Research: Historically Low Price to Book. Those four reinsurers all trade for less than .8 times book when the historical multiple is between .85 and 1.6 for the industry. HCC is a little pricier, but is best in class in the industry, whereas the four listed above all have some warts.

HCC isn’t the most well known insurer, so let me give you a little background information on the company. It was founded in 1974 and is based in Houston, Texas, with operations in Bermuda, Spain, and the United Kingdom. The company does life insurance, property-casualty, accident and health, as well as commercial lines dealing with things like directors and officers, employment practices, and errors and omissions liability. They also insure aviation and other specialty underwriting, and provide reinsurance brokerage services throughout the world.

HCC is unique in that its culture focuses on profitability rather than on growth. Most insurers give this lip service, but inherent incentives don’t allow them to actually carry this strategy out. HCC has a long history demonstrating its ability to occasionally pass on the revenue in order to wait for better pricing. The company swoops in when the pricing market has blown up and it doesn't participate in the race to the pricing bottom that is a hallmark of the insurance industry.

There are a few concerns that have dragged down stock prices in the industry. In inflationary times, insurers typically are not the best place to be. I think the valuations across the industry have been depressed specifically because of these fears. HCC has a conservative investment portfolio with a lot of exposure to municipal bonds. It chooses top quality issues and has been decreasing its durations. This isn’t a big concern for me right now. The other inflation problem is if it isn't able to quickly adjust premiums to reflect the higher prices for payouts. If roaring inflation comes, this is going to be a problem for all insurers. A more company-specific concern would be the management changes at HCC. There have been three CEOs in the past five years. Despite these transitions, it appears that the strong culture and emphasis on profit rather than revenue has held firm.

Book value is growing 10% to 15% per year, and if you say that P/B will eventually go back to 1.5 times, then HCC is conservatively undervalued by about 60%. You also collect a 1.9% dividend along the way. For an insurer with comparable ROEs as HCC, P/B has traditionally been between 1.5 and 2, so this valuation is arguably conservative in a normal environment. The historically low P/B should put in a floor for the stock price, and this valuation exercise, as I mentioned, doesn’t take into account the fact that insurers are very much out of favor in the market right now.

Incidentally, the other financial trading at a 10 year historically low P/B is Hudson City Bancorp (NASDAQ:HCBK). I wrote an article recently about the company as it was hitting new 52 week lows. See Hudson City Hits New Lows: Wait to See How Government Deals With GSEs Before Buying. If you compare the two companies, Hudson City has serious challenges going forward that justify its low valuation. HCC Insurance has none of those same headwinds. If you believe in the reversion to the mean idea for P/B for financial companies, HCC Insurance is a compelling stock to look at buying.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.