Can Investors Trust AIG Again?

| About: American International (AIG)

By Jake Mann

One of the world's largest public companies, American International Group (NYSE:AIG), is a multinational insurance provider to customers in over 130 countries. No stranger to economic tribulation, AIG's liquidity shortcomings in 2008 nearly exacerbated the financial crisis to biblical proportions, save for an eleventh-hour government bailout. While this mess shrunk shares of AIG to nearly one-fiftieth of its pre-recession values, the stock has provided double-digit returns in the last six months and is currently trading just north of $30 a share.

Before discussing AIG's fundamentals, it is crucial to understand the company's economic woes during the most recent financial crisis. In the years leading up to what is now termed the Great Recession, the company had written credit default swaps (CDSs) in large quantities. These instruments were a type of financial derivative similar to an insurance policy, which protected any debt-holding company from the risk of default. In AIG's case, they issued $447 billion worth of CDSs on a variety of debt, including subprime mortgages and toxic assets from investment banks. When default rates were low, AIG's earnings were strong, due to the high volume of CDS fees it was able to charge without having to pay for any major default.

By the fall of 2007, the collapsing housing market had triggered most of AIG's anguish, as increased mortgage defaults forced the company to post $18 billion in losses. As a result, AIG was now unable to pay its CDSs, meaning that the firms that held them -- most notably Goldman Sachs, Morgan Stanley, Bank of America and Merrill Lynch -- were exposed to losses. In an effort to prevent further calamity, the Federal Reserve and U.S. Treasury issued a $140 billion bailout package to AIG, while taking majority ownership of the company. As a result, shares of AIG fell from nearly $430 a share to below $10, after already falling from a pre-crisis peak of almost $1,500 a share.

These events have skewed some of the fundamentals that can be used to compare AIG with its competitors. Upon first glance, revenue growth seems splendid -- AIG's three-year average is 110%. Unfortunately, this measure cannot be used because of the company's recession-era losses. Additionally, one of the most popular valuation metrics -- the price-to-earnings ratio -- does not provide an accurate measure of AIG's true value. AIG's current P/E is 3.8 times, which is below the industry average and all of its major competitors, is artificially low.

One thing to look at is how quickly AIG has paid back its bailout loan from the government. Over the last three years, AIG has continually reduced Uncle Sam's ownership by buying back shares in exchange for debt reduction. A large fraction of the $140 billion bailout has been repaid with interest to the point where the company currently owes $9.3 billion to the Fed and $35.8 billion to the Treasury. The most recent deal occurred in early March, when AIG paid down $8.5 billion in debt to the Treasury in exchange for $6 billion worth of stock. Looking toward the future, the new AIG will be a smaller yet safer company. Once it completely repays its debts and has ownership returned to common shareholders, it will refrain from carrying out its risky CDS operations of the past. The company will still be a profitable player in the property, casualty and life insurance area -- last year revenues surpassed $60 billion -- which has been its focus post-recession.

As AIG consistently continues to pay down its bailout, investors remain bullish about the stock. Since the start of this year, reputed fund managers including Bruce Berkowitz have demonstrated faith in the insurance giant and have been rewarded, as the stock has jumped almost 40%. As we mentioned in this article, over a third of Berkowitz's holdings are in AIG, amounting to a value of $2.1 billion. It is abnormal for any manager to have such a high percentage of holdings in one stock, so this is a clear signal that the smart play may be to follow Berkowitz's lead, who has Morningstar's "Stock Manager of the Decade" accolade to his credit. On the whole, hedge fund interest in AIG has been increasing, as 33 funds held bullish positions at the end of 2011, compared to just 18 funds one year earlier. Moreover, insiders share a similar positive sentiment for the stock. Back in February, Director Morris Offit bought 15,000 shares of the company at just over $28 a piece -- a move that more than doubled his total holdings of AIG. A few months earlier, insider T. Laurette Koellner bought 13,500 shares at a price of $21 each. Since these purchases, both men have seen impressive returns of 14% and 52%, respectively, and the lack of selling activity seems to indicate that these AIG insiders believe the stock has more room to run.

Analysis of the company's return on equity (ROE) supports the upward momentum that is oozing from AIG stock. ROE is a measurement of the return a company is generating on shareholders' investments -- insurance industry norms are between 10% and 15%. Over the last year, AIG's ROE was 28.72%, a number significantly stronger than Allstate (NYSE:ALL) at 4.18%, Travelers Companies (NYSE:TRV) at 5.72%, Hartford Financial Services Group (NYSE:HIG) at 2.94%, and Chubb (NYSE:CB) at 10.79%. This measurement, more than anything, explains why insiders and hedge funds have been buying AIG stock. Individual investors may do well by following suit and purchasing American International Group .

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.