A lot of us investors learned about investing by reading the annual letters of Warren Buffett and books written about him. We are all aware of how a few concentrated high conviction investments have created much of Buffett’s enormous wealth.
When it looked like American Express was doomed in 1962 during the Salad Oil scandal Buffett stepped up and put 40% of his hedge fund into American Express shares. The result was a giant homerun for Buffett’s partners. In 1976 with GEICO on the verge of bankruptcy Buffett sucked up his courage and made another major investment. Same result, this time the value accrued to shareholders of Berkshire Hathaway (BRK.A) (BRK.B).
Two giant successes for Buffett. Two companies that everyone else was terrified to touch when Warren was being greedy. In hindsight it looks easy, in real time I’m sure it wasn’t.
I don’t know if you noticed, but the fund manager with the best track record in the industry over the past 10 years has 18% of his fund in one company. That is a pretty high conviction bet. That fund manager is Bruce Berkowitz and his investment is AIG. Here is his most recent report detailing his fund holdings.
I was reading over this report this week when it struck me that today AIG is in the low twenties, while Berkowitz was holding it as high as $60 in the past year. Given how good his track record is. Given that he was still seeing value at $60. And given that he has 18% of his fund in AIG I think it is at least worth considering as an investment.
Has Berkowitz gone mad and put 18% of his investor’s cash into something that he doesn’t understand? Or does he like Buffett did with American Express and GEICO understand something that few others do? My gut tells me it is the latter. The problem is that I like to use my brain to invest, not my gut.
What Berkowitz Has Told Us About His AIG Position
I’d like to try and understand better why one of the elite value investors over the past two decades has put a mind blowing 18% of his fund in one company. I can’t think of any other manager that has taken on that kind of exposure to one company. Fortunately for us Berkowitz speaks quite often publicly which allows us to get a bit of a look into why he is doing what he is doing.
The AIG position was initiated as early as March 2010 when the AIG name still had the full smell of the financial collapse to it. These original purchases were in the $22 to $34 range. Berkowitz looked like a genius for a while riding the stock up to $60. But the stock price has since fallen way back to the low twenties and Berkowitz has used that fall to take this monster position in the company.
Why?
I spent the better part of an afternoon listening to all of the various television interviews Berkowitz has done over the past year since he entered AIG. He speaks in a manner that does not divulge a lot of detail on his investment rationale. I don’t know if it is intentional or not, but his explanations are almost laughably simplistic, often involving only the utterance of a few phrases like “count the cash” or “can’t kill the business.”
The best source for understanding his AIG investment that I have found was his conference call with investors in May of 2011. Below I’ve summarized as best I can his explanation for why AIG is worth risking 18% of his investor’s cash and basically his entire career on at current stock prices:
- AIG is undervalued in relation to its earnings power. The current stock price is in the low twenties. A reasonable earnings power of the core businesses $6 per share. At a conservative 10 multiple that is $60. At a 15 multiple that would reflect the world class nature of these insurance businesses you are talking $90. As AIG works through its remaining issues this $6 in earnings power will emerge. Again, the current stock price is in the low twenties.
- There has been a large overhang created by the government bringing the shares they own to the public at their cost base of $27 to $29 per share. That has depressed the stock price. This price is only 2/3rds of book value, but the government is not in the business of making money so recovering their investment is their foremost concern not the intrinsic value of AIG. I would note that Berkowitz doubled down on his AIG position in the recent quarter after the government released the news that they were selling some of their shares at this low price which depressed the stock.
- The stock market has been so focused on the liabilities of AIG that it has completely forgotten about the valuable assets of the company. The core insurance business assets were not part of and have not been damaged by the mess created by the unit selling the CDS positions. Their value has always been real and continues to exist.
- There is a $23 billion deferred tax asset that is not on the books of AIG. Once the company starts to show consistent profitability that deferred tax asset is an asset that can be recognized.
- The $6 per share of earnings that Berkowitz expects will be tax free for a number of years for AIG so it should command a higher than normal pre-tax multiple.
- The discount on the stock is due to the stigma attached as a result of the 2008 collapse and the uncertainty created by the government involvement. The further we get from the collapse and as the government intentions become clear this discount will be reduced.
Smack Dab in the Middle of His Circle of Competence
The last word I’d like to leave to Berkowitz, from the conference call linked above explaining why we should trust that he knows what he is doing with respect to AIG, Bank of America (BAC) and his portfolio of ugly names.
So let me give you a quick summary. We moved too fast, headed too soon into the financials. We suffered from premature accumulation. Our companies continue to be priced for continuing stress and the price we paid reflects those stresses. And the prices we paid are quite cheap in our opinion compared to how these companies should perform in a more normal environment. Some people think we are spread too thin, we've slipped but I must tell you we are smack dab in the middle of our circle of competence in financial services.
I’m inclined to believe Berkowitz and think that right now we have a tremendous opportunity to take advantage of the discounted ideas in his portfolio. But buying these tainted names is easier said than done. After being involved in AIG for over a year Berkowitz recently upped his fund’s weighting to 18%. That is encouraging as it is likely that after a year of involvement Berkowitz has a large advantage knowledge wise over the rest of the market.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
