Wall Street is all about storylines, while businesses are about creating value for various constituencies, so it is often interesting to see analysts jump off the bandwagon when the storyline loses its initial appeal. In following American International Group (AIG) over the last decade and being heavily invested over the last few years, I've seen that there is very little correlation between Wall Street's interest in the company and the margin of safety or risk-adjusted return potential available in the common stock. This creates a time-arbitrage situation, in which through investing in AIG while it still trades at a substantial discount to intrinsic value, while that intrinsic value is still growing; allowing for very attractive long-term investment returns as the manic moods of Mr. Market once again turn optimistic in relation to the company. I view the recent sell-off in the AIG common stock as a wonderful opportunity to add to the position and to sell cash-secured puts.
To be clear, AIG is not the bargain basement deal that it was when it was trading in the high $20s or low $30s, but the company also has a lot less uncertainty than it had back then. The company was able to completely pay back the government with a solid profit, which to many pessimists seemed nearly impossible back then. In addition, under the strong leadership of Robert Benmosche, the company has improved the results of all of its key businesses. AIG has reduced its financing costs and has invested heavily in its infrastructure, which should augur towards better underwriting margins. Analysts reacted negatively to the fact that the company will no longer provide regular updates on its aspirational 2015 goals, but to me this is little more than semantics. I really wouldn't trust an insurance company that attempts to guide too accurately when results are impossible to predict with precision when you are dealing with things such as natural disasters. Management understands that they will be evaluated on the returns to shareholders and margins on the business lines, so little has changed in my opinion except analysts will actually have to dig a little deeper to come up with their forecasts.
Despite the stock being a bit more expensive, the relative value to the rest of the equity market has become a lot more attractive. Stocks as a whole seem to offer very little margin of safety, so the opportunity to buy a business that will likely see continued earnings growth, at a discount to liquidation value is highly desirable for a long-term value investor. It is much easier to see AIG earnings $7-9 per share in a few years and trading at a 10 multiple, than it is for me to see S&P 500 increasing by 30-50% over the same time period. When you adjust for risk, the opportunity to invest in AIG versus the S&P 500 becomes that much more obvious in that the company is generating excess liquidity, which will ultimately continue to enhance AIG's ability to buy back stock at a discount to tangible book value, likely reducing downside.
On October 31st, AIG reported 3rd quarter net income of $2.2 billion and diluted earnings per share of $1.46. 3rd quarter after-tax operating income attributable to AIG was $1.4 billion, or $0.96 per share. AIG Property Casualty reported after-tax operating income of $1.044 billion, which was up 33% from the same time last year. AIG Life and Retirement reported after-tax operating income of $1.144 billion, which was up 38% from the same time last year. The relatively small Mortgage Guaranty business reported after-tax operating income of $43MM and continues to write attractively priced new business. AIG benefitted from a reduced tax rate due to its net operating loss carry-forwards, which will likely continue to be a recurring theme over the next few years.
Probably the biggest disappointment in the quarter was that AIG Property Casualty recorded a combined ratio of 101.6 and an accident year combined ratio of 98, despite a very mild season for natural catastrophes. In today's exceptionally low interest rate environment, insurance companies that cannot record reasonable underwriting profits are destined to attain low returns on equity due to the anemic investment returns that are available. AIG has been boosting reserves from historical under-reserving and most analysts and investors are anxious for the company to turn the corner in relation to underwriting margins. The company has invested heavily in big data and analytics to improve underwriting results, but while the trends are moving in the right direction, progress is clearly not as rapid as most would like to see. AIG Life and Retirement is benefitting from the returns in the equity and fixed income markets, and seems to be maintaining positive momentum in terms of incoming flows. Normalized pre-tax earnings, for both of these companies, is well in excess of $1 billion per quarter, or $8 billion combined per year.
Book value per share excluding accumulated other comprehensive income (AOCI), increased 8% from year end 2012 to $62.68 and $67.10 on a reported basis. AIG's prior goal was to attain a 10% return on equity by 2015 and I still believe that is a reasonable expectation, which would mean normalized earnings of roughly $6.30 per share. With the company trading around $49 per share, the company is trading at less than 8 times normalized earnings and is getting no credit whatsoever for growth or astute capital allocation. The best thing that AIG can do to create additional value beyond improving underwriting margins is through buying back stock at a discount to book value. The company has picked the easy fruit as far as refinancing their expensive debt to lower rates, which will continue to lead to improved earnings moving forward, but buybacks or even a tender could drastically bolster the intrinsic value of the company.
In addition to buying more of the stock, we at T&T Capital Management (TTCM) have used the selling of cash-secured puts to generate income and to attempt to manufacture an even cheaper entry price into the equity. With the stock trading at $48.72, an investor can sell the January 2015 $50 puts for $6.35 per contract. This would mean that if AIG expires above $50 at expiration, the investor would pocket a 14.5% return in just over a year on the maximum risk of $4,350. If the stock expires below $50, the investor would end up owning 100 shares at $43.50, which is about a 10.7% discount to current prices. This allows the investor the opportunity to potentially double their money over a 3-5 year period as both earnings and book value continue to grow. We tend to own the stock and sell puts at the same time and nothing from the 3rd quarter has given us any pause from this long-term oriented strategy.