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Summary

  • Positive catalysts vastly outweigh potential downside risks.
  • AIG has one of the most appealing risk/reward ratios, not only in the insurance sector but in the entire stock market.
  • AIG's long-term warrants are an interesting alternative to AIG's common stock.

American International Group (NYSE:AIG) has been an outstanding investment over the last five years. After restructuring my investment position and shifting 100% of my AIG funds into AIG's long-term warrants (trading under the ticker AIG.WS), I must say, I feel even better. Rarely have I been as relaxed about an investment as with American International Group.

Powerful catalysts for AIG's stock price

American International Group remains a Strong Buy, despite trading near its 52-week high of $54.03, as it faces a variety of catalysts and tailwinds that should support significantly higher share prices in 2014 and beyond:

Combined ratio improvement. AIG's Property and Casualty combined ratio stood at 101.2 in the first quarter of 2014, compared to 97.3 in the first quarter of 2013. While a combined ratio above 100 signals inferior insurance pricing, it also shows that American International Group has further room to improve its operations. If American International Group can push its combined ratio down to 90-95%, analysts will have to reassess their valuation assumptions.

Capital deployment. I expect AIG to continue to focus on meaningful share buybacks which, at least for now, are accretive. In fact, I believe near-term book value growth will be substantially determined by capital management initiatives.

Underestimated EPS growth. I think many investors and analysts still underestimate the earnings prospects of American International Group a few years down the road. Many sell-side analysts value the company with a focus on short-term earnings, which leads to underweighting of long-term earnings and, therefore, relatively low target prices. Though some analysts are updating their earnings estimates -- AIG was recently upgraded by Goldman Sachs (NYSE:GS) to Buy, with a target price of $63 -- their intrinsic value estimates are still largely below AIG's current book value. This is not rational, in my opinion.

Book value. American International Group presently trades at a 25% discount from book value -- which, in itself, is a conservative value estimate. Furthermore, I think there is a decent chance that AIG can present investors with above-average book value growth in the years ahead -- driven both by ongoing capital management initiatives, a cyclical upswing for financial firms including insurance companies and banks, and, equally important, higher interest rates which should provide a boost to AIG's investment income via higher bond returns.

Higher prospective book value multiple. Many investors seem to forget, given the current market valuations of insurance companies (both Property & Casualty and Life), that insurance business have traded way above 1.5x book value in periods of economic expansions, with some companies even achieving a P/B ratio of more than 2x. While this may not seem too realistic to achieve in the short term, history will surely repeat itself, and a buoyant financial sector will lead to significantly higher book valuations for insurance companies. I personally think that AIG should be able to trade at least at 1.2x book value in the coming years. Remember, The Travelers Companies (NYSE:TRV) presently trades at 1.28x book value and The Allstate Corporation (NYSE:ALL) at 1.24x, even though insurance sector earnings are far from peaking.

Potential billion-dollar windfall. I have argued recently that AIG could expect a billion-dollar windfall from its ILFC deal with AerCap Holdings N.V. (NYSE:AER), giving the insurance company additional funds to deploy for the benefit of shareholders (funds are likely to be at least partly used for share buybacks).

Mortgage Guaranty. Often overlooked, but AIG's mortgage unit could become seriously more profitable in the coming years. Its first-quarter 2014 combined ratio stood at 80.8 vs. 96.4 in the first quarter of 2013, and its pre-tax operating income soared 85% y-o-y to $76 million. A booming housing market surely should provide further tailwinds.

Dividend hikes. One of the reasons investors could be drawn to AIG in the future might relate to higher prospective dividends. AIG now has a dividend yield of 1%, and I can see a yield of 2-3% once higher cyclical earnings will be reported. Mutual funds and other institutional investors will likely be drawn to higher-yielding insurance equities. All to the benefit of shareholders who are already invested.

Another reason why I have allocated a big chunk of my funds to AIG is because the amount and quality of positive catalysts severely outweigh AIG's downside risks. Catastrophe losses, ongoing difficulties with pushing the combined ratio to the low 90s and uncertainty regarding Benmosche's succession are notable downside risks for AIG shareholders.

Conclusion

With a 25% discount to book value, billions of dollars in funds available for share repurchases and much more potential to improve its operating metrics, AIG is one of the most interesting investments in the equity markets today. AIG is a "get it and forget it" story -- Buy and Hold. AIG faces a set of convincing tailwinds that should work out to the benefit of shareholders. Though I clearly like the stock, the risk/reward ratio with AIG's long-term warrants is even better. Strong, long-term BUY for both the common stock and the warrants.

Source: American International Group: Laughing All The Way To The Bank?