The following commentary is taken from the Coho Capital  letter for Q2 2013.

We are always on the lookout for pockets of market inefficiency that offer superior returns to those who are willing to undertake intensive research efforts. One such area that has proven to be a fertile hunting ground as of late has been the unique securities created through the Troubled Asset Relief Program (TARP).

The TARP program was initiated by the US government in the fall of 2008 to stem the US credit crisis and included $700 million of investments and loans to companies with “troubled assets.” Companies selling assets to TARP were often required to issue warrants, a security that allows the holder to purchase shares at a specified price up until a fixed period in time. Essentially, warrants are a form of long-dated options. We are not a fan of options as they require one to not only be right about their investment thesis but correct in their timing as well. TARP warrants, however, do not suffer from this problem as they have an expiration date between 2018 and 2021, providing the holder ample time for the markets to fully realize intrinsic value.

Hartford Insurance Warrants

Apart from their long-term time horizon, some of the TARP warrants feature additional investor friendly attributes such as dividend protection. That is, if the dividend rises above a certain threshold, the strike price of the warrant is adjusted downward. For example, if the quarterly dividend on Hartford Insurance (HIG) rises above $0.05, the strike price of the warrant is adjusted downward by the same amount. Unlike an option, the holder of a HIG warrant accrues the benefit of dividends. Even assuming zero growth in HIG’s dividend, the strike price of the company’s warrants would adjust downward by $0.40 a year. This is the equivalent of collecting a dividend of 4.2% a year that grows every year due to the downward adjustment on the HIG warrant strike price.

Hartford’s warrants are “deep-in-the-money” meaning their exercise price of $9.56 is well below the stock price of $30.86. Thus, HIG warrants possess similar levels of volatility as the underlying stock. In other words, HIG warrants offer similar levels of risk as the common stock on permanent loss but provide asymmetric return potential on a rise in stock price. A 10% increase in book value per share through 2019, coupled with an industry property and casualty multiple of 1.3x would result in a HIG stock price of $89. The return on HIG stock in such a scenario would be 188% whereas a holder of HIG warrants would earn a return of 372%. Remarkably, HIG warrants only trade at a 3% premium to the stock price.

The dynamics of TARP warrant pricing are clearly inefficient. Nonetheless, if we are not acquiring a quality business then our return potential is moot. Let’s take a look at Hartford and why we think it’s a good business.

Hartford insurance has been around for over 200 years and as a result has one of the best distribution platforms in the world. For example, Hartford has had an exclusive partnership with the AARP for 28 years. Its two centuries of experience are illustrated in the company’s superb underwriting capabilities. HIG has averaged a combined ratio of 94% over the last ten years, compared to an industry average of 101% a ratio under 100 indicates profitability.

Historically, HIG was an odd hybrid of property and casualty insurance, life insurance and mutual funds. Life insurance is a second-rate business with few companies possessing the ability to earn profits on insurance underwriting alone. This leads to volatile results and a focus on juicing returns through investments. Like many life insurance companies over the last decade, Hartford decided that annuities, with their promise of steady income to retirees, could bolster growth. Indeed they did. As long as markets are rising, the annuity business works well with higher asset values providing the capital needed to fund annuity payments. However, in market downdrafts the capital required for annuity payments dries up. Remarkably, HIG, like most annuity providers, did not hedge its investment portfolios. As a result, when markets dropped sharply in 2008 the company was forced to request bailout funds from TARP, issue equity and sell various business units in order to stay afloat.

Under new CEO, Liam McGee, who took the reins at the height of the credit crisis in March of 2009, HIG set about de-risking its portfolio. McGee divested HIG’s life insurance business and wisely placed its annuity block of business into run-off. Buyouts of annuity contracts have depressed near-term earnings but they place HIG on far sounder footing going forward. The troubles in HIG’s life insurance business have obscured the attractive attributes of the company’s prime positioning within the property and casualty market.

At a current price to book multiple of 0.8, HIG trades well below property and casualty peers at 1.3. We expect to see an expansion in HIG’s multiple as capital is returned from a wind- down of legacy operations. On its most recent conference call, McGee highlighted his company’s plan for returning capital to shareholders, “our repurchase activity will be about $200 million per quarter through the end of 2014.” That would result in retiring 10% of shares outstanding at current levels. We expect a full wind-down of the annuity business by 2015 to result in an additional $500 million in free cash to be used for share buybacks and dividends. Share buybacks will be meaningfully accretive to book value and earnings per share, and together with a reappraisal of HIG’s property and casualty business, should lead to a transformation in market value.

Not Your Grandfather’s GM

General Motors (GM) was also a beneficiary of TARP with the company receiving $50 billion dollars from US tax payers in exchange for a 61% stake and a government engineered bankruptcy. Not surprisingly, GM’s bailout did not go over well with the public and few were eager to own shares upon the company’s 2010 IPO.

GM was in need of reform long before the credit crisis hit. A bloated cost structure and a reputation for shoddy quality across a mishmash of eight different brands left the company ill-equipped for global competition. The company’s trip through Chapter 11, however, has proved cathartic. GM has reduced its North American fixed cost base from $35 billion per year pre-crisis to $25 billion currently. It has reduced its brand nameplates from eight to four, right sized its dealer network, reduced headcount and renegotiated onerous union contracts. The end result has been a radical transformation with significantly lower fixed costs, structurally higher margins and a focus on profitability and quality over market share.

GM will trot out model replacements for 79% of its vehicles over the next three years, more than any other automaker. A refreshed auto lineup will transition GM’s fleet from one of the oldest in the industry to one of the newest. GM’s increased product cadence should drive showroom traffic and build additional brand buzz for the company.

New product introductions have demonstrated GM’s new found penchant for rigorous quality control. GM recently supplanted Toyota in JD Power and Associates annual Initial Quality Study. Vice President of global vehicle research at JD Power, David Sargent, commented on GM’s quality in a recent interview, “If you were to ask me the question, what corporation has the best quality in the entire industry; the answer would be General Motors.” GM has also won plaudits from Consumer Reports, which ranked Chevrolet’s 2014 Impala as its top ranked sedan, the first time in two decades that an American brand has rested atop Consumer Reports’ sedan rankings. In fact, Consumer Reports gave the Impala the third highest score it has ever given to any car.

Access to credit is the single largest driver of auto sales. After emerging from bankruptcy, GM was without a captive finance arm, putting the company at a disadvantage in securing loans for potential customers. Over the past few years GM has reconstituted its finance subsidiary, acquiring auto credit specialist AmeriCredit in 2010 and Ally Financial’s (formerly GMAC) international automotive financing operations in late 2012. These acquisitions enable GM to offer financing at more competitive rates which should increase the company’s market share while lowering the company’s cost of capital. GM believes it will regain its investment grade credit rating later this year which will enable the company to re-enter the prime lending market. We think GM’s efforts to rebuild its captive finance arm are an underappreciated growth engine. We expect financing to contribute over $1 billion in non-automobile earnings per year.

We also expect GM to benefit from a cyclical recovery in auto demand. In 2012, US auto sales were 14.4 million. This compares to an annualized pace of 16 million per year prior to the credit crisis. According to automotive research firm, Polk, The average age of vehicles on the road is a record eleven years. This bodes well for replacement demand. As the economy continues to improve we expect some of this pent-up demand to buoy auto sales.

GM should also be a beneficiary of the recovery in housing. US Truck sales have a 95% correlation to housing starts. As of June 2013, housing starts were at an annualized rate of 911k per year. This compares to a long-term average since 1959 of 1,475k per year. A ramp in housing starts will be a boon to new truck sales, which carry higher operating margins than other vehicles within GM’s product lineup. Shale production of oil and gas could also have a stimulative impact on sales.

For all its domestic problems, GM is perceived far differently in emerging markets, where its growth prospects remain tantalizing. GM has spent years building up its presence in Brazil and is the second best-selling brand in China with a 15% market share. The China market is the world’s largest auto market but remains significantly under-penetrated at 85 cars per 1,000 people, compared to 812 per 1,000 in the US.

Brazil is the world’s fifth largest market and GM has a 19% market share. Transaction prices for a batch of new Brazilian models are 20% higher than previous models and have helped GM gain share. In short, GM is well positioned in two of the world’s fastest growing auto markets and has a long runway for growth for many years to come.

Despite significant improvements in its business model, GM trades just 10% above its IPO price of 2010. The company trades for a 25% discount to peers on a PE basis and 50-60% discount on an EV/EBITDA basis. These measures alone, however, understate how cheap GM is relative to competitors as they fail to take into account GM’s $70 billion in tax shields and lack of mandatory pension contributions until 2019. These two measures create additional free cash flow every year which can be used to pay down debt and buy back shares.

We elected to take advantage of GM’s warrant pricing, rather than purchase shares, as warrants were only priced at a 4% premium to the stock at our time of purchase. While the GM warrants do not carry dividend protection, they are long-dated, expiring in July of 2019. Similar to the HIG warrants, they are deep in-the-money with an exercise price of $18.33 compared to a stock price of $36.47. So again we get similar levels of volatility but enhanced exposure to higher prices.

We think auto sales are still early in a cyclical upswing and believe the market has not yet recognized the earnings potential of the new GM. A strong product cycle, improved quality, a rehabilitated balance sheet and hidden free cash flow have yet to be appreciated and offer multiple pathways to value creation.

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