We first purchased AIG for our fund in 2010 and started to pitch AIG (AIG) alongside Goldman Sachs (GS), Bank of America (BAC) and Citigroup (C) as our favorite positions on our long side. Our main investment proposition has been, that investors will get most of AIG's mortgage portfolio for free and future growth at a discounted price. Since then, the government has exited its AIG investment, the company has been restructured operationally and financially, and it has re-branded its operations, and all the while the underlying insurance subsidiaries have been profitable.
We are significantly invested in AIG, both in terms of common stocks and warrants, as we have been since 2010, a short time after Berkowitz announced his bet on the insurance company. Since then we have gradually increased our holdings in AIG, mainly through long-dated warrants, as the stock declined to the mid-twenties. We also continue to believe in the resurgence of AIG going forward when the economy picks up steam and cyclical companies are sought after as institutional investors increase their risk appetite and retail investors start buying again.
We believe the reason for AIG's mispricing can be attributed to emotional factors rather than rational ones. In the case of AIG, we believe investors are overly exhibiting recency bias. This bias stipulates that investors assign too much value to past events that can readily be recalled and expect those events to continue. In essence, they extrapolate past negative performance into the future even though a company might have already reached a turning point. AIG and other financial stocks that got hit in the financial crisis do surely fall in this category. Every value investor would likely agree that a company with solid insurance subsidiaries and decent cash flow generation that quotes at a 35% discount to book value is an interesting long candidate.
Recent catalysts were significant and positive in nature: Forced selling of AIG common stock by the Treasury, divestment of non-core assets and accretive stock-buybacks at half book value. All those points would have justified an increase in AIG's stock price. Additionally, the smart money is invested in AIG, and we do not only mean big names such as Fairholme, ThirdPoint and Eminence. Large amounts of turnaround and distressed equity investment blogs hold AIG in their portfolios as well. Fact is, AIG is well-known to offer a very attractive risk-reward ratio. So why is the stock price not catching up to its intrinsic value?
We believe a large part of the current mispricing can be attributed to willful ignorance by the general public (read: mainstream institutional investors and retail) which is being turned-off by the history of AIG and its bailout. Fund managers either got burned by owning AIG pre-crisis, are having difficulties to pitch AIG to their respective investment committees or perceive the company as too risky. Furthermore, investors seem to pay too much attention to short-term headlines (such as the ILFC sale). Ironically, investors can still find great value in those firms and their stocks.
We believe the market misprices AIG for the following reasons:
- AIG trades at a discount of around 30-35% to book value while many of its peers trade closer to 1x book value. At the same time, AIG's book value is stable and growing.
- AIG has historically traded above 1x book value in up-markets supported by improving industry conditions and strong cyclical momentum.
- On a forward P/E basis, the company only has a multiple of 11x earnings, equivalent to an annualized earnings yield of 9%, and is about to start paying a dividend to shareholders. Book value accretive share buybacks are going to supplement the dividend.
- We believe we are in the early stages of a prolonged bull-market, which favors cyclical, financial companies going forward.
- We predict that P&C industry ROEs will peak around 2016/2017, which should support an investment in AIG and other insurance companies including Hartford (HIG) as well as mortgage companies Radian (RDN) and MGIC (MTG).
- AIG is a market leading company with an extensive international footprint and strong pricing power going forward, especially in the commercial line of business.
- We also believe that investors falsely focus on short-term events such as the ILFC sale. AIG could always have pursued alternative options regarding the sale of ILFC, such as an IPO.
- Top class management which has got things done in the past, put AIG on a new course and injects confidence in the company and its future.
- In addition, we believe a focus on an underlying combined ratio of around 95% will appease investors to increase buying activity.
Risks factors include the mispricing persisting for a longer period of time. Future cat. losses also play a factor in industry profitability; natural catastrophes such as floods, storms, earthquakes etc. are likely to adversely impact AIG's profitability and might delay its capital return plans.
Both investment climate and economic indicators should favor an investment in a profitable insurance company with significant cash flow generation. Trading at 30-35% discount from book, investors also get future growth, multiple expansion and a dividend for free while risks are limited. While we see the discount from book value as a great margin of safety, our investment thesis is largely centered on future EPS and dividend growth and an increase in AIG's return on equity.
Risk-seeking investors might consider the warrants with an expiry date in 2021 which should offer an even more attractive risk-reward ratio. We hold a $75 price target on the stock by 2014, indicating about 60% upside potential with the possibility of strong outperformance due to share buybacks and increasing risk appetite for cyclical companies.