Note: topics under case studies are for illustration purposes only. They are not investment recommendations. We may or may not maintain active holding at time of publishing and we will make decisions about the investments involved solely on their merits from value investing perspective without any prior updates to this post.
Note: our hearts and prayers go to all those who were impacted in the hurricane. We will donate and offer any help we can to contribute to rebuilding process. The discussion below is from pure investment point of view.
Ticket: HRTG
Category: Short term value play
Position Opened on:
- Sep 5, 2017 at $10.24
- Sep 6, 2017 at $9.25
- Sep 7, 2017 at $9.5
- Sep 7, 2017 at $9.25
- Sep 8, 2017 at $8.99
Position Exited on:
Sep 11, 2017 at $10.82
Return: approximately pre-tax 17% for one week
Background:
Hurricane Irma was projected to make landfall at Florida as a Category-5 Hurricane. It was expected to cause catastrophic damages to the state. (Our hearts and thoughts go to those affected). Starting from September 5th, various insurance companies with exposures to Florida began the decline due to the concerns around losses from Hurricane Irma. HRTG shares declined to $10.25 at one point on Tuesday and went as low as $9.35, from $11.2/share on previous Friday.
Value:
HRTG has comprehensive reinsurance coverage. Their exposure was also reduced recently thanks to management’s prudent underwriting practice. At the maximum damage, barring a major reinsurance company’s bankruptcy, HRTG was standing to lose $20m retained risks and nothing more, unless Irma is 3 times as bad as Hurricane Andrew.
At $20m most likely worst-case scenario, HRTG will lose 0.67/share, since they have approximately 30 million shares outstanding at the time.
At initial purchase price of $10.24, we left $0.35/share margin in our calculations in case there is miscellaneous losses of another $10m on top of HRTG’s contractual $20m retention.
Subsequently, Hurricane Irma strengthened and stayed as Category-5 for a good part of the week and Media/Government, for various purposes, mostly well-intentioned, to highlight the potential damages from this Hurricane to order evacuation or other preparations. Such 24/7 coverage brought the irrational fear into the market, causing the insurance companies with Florida exposures to be sold off further during the week. For the case of HRTG, it made a low of $8.89 on Thursday Sep 8th.
All these fear and irrational selling provided an excellent entry point for us. Upon carefully verifying our calculations and assessing our risks, we continued buying HRTG through the week, using our pyramid purchase structure, with the largest and final position taken on Sep 8th at $8.99/share
The weighted cost of entire position was $9.25, which is full $2/share from previous Friday’s closing and “Mr. Market’s” assessment to how Hurricane Irma will impact HRTG, when only 1/3 of that decline was justified. Should Hurricane Irma become the Category-5 Hurricane and made a landfall at Miami as the market feared, HRTG, when all diets are settled, will pay out 67 cents per share.
Risks:
There are a few main considerations in this play:
- Assumptions that the maximum loss on the part of HRTG may not hold
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- In case of a collective default on various re-insurers that HRTG had contractual relationships with, HRTG’s equity will be wiped out if such defaults exceed $300m
- If there are certain category of coverage that was not property covered under reinsurance agreements, and the Hurricane Irma was worse than expected, the resulting losses may cause larger negative impact on HRTG’s balance sheet
- If there is certain near-term liquidity failure due to improper management of various claims and payouts, HRTG may fail
- It may take “Mr. Market” longer to properly reflect the mis-pricing on HRTG, up to months, should the Hurricane Irma turned out to be worse than expected. At that time, a few other factors may impede our ability to realize the expected pricing gap
- Improper positioning may cause the Portfolio to show large unrealized losses in HRTG position before the event is over. (Although we had high conviction, our investment discipline limited our position to HRTG to 15% of entire portfolio)
- The overall market sentiment may turn so negative because the damage from Hurricane Irma that it takes long time before HRTG’s valuation return to proper level
- This transaction is near term in nature, therefore it is not tax efficient.
It is an unfortunate event for anyone whose life was seriously disrupted in these Hurricane events. We look for every way possible to help with the rebuilding process. However, from the pure purpose of value arbitrage discussion, we witnessed the fear brought by Mr. Market, induced by a natural disaster and we witnessed the irrationality of pricing happened in such situations. Relying on your own disciplined thinking process and carefully position will bring significant outperformance in short order.