Follow Fairholme Into AIG

| About: American International (AIG)
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Noted investor Bruce Berkowitz has reopened his Fairholme Fund to new investors because he sees several deep value situations, notably the preferred shares of Fannie Mae and Freddie Mac. Most interesting to me, over half of Fairholme is invested in American International Group (NYSE:AIG), a total that exceeds $4.4 billion. Personally, I believe it is important to maintain a very well diversified portfolio. Even with positions I feel extremely confident, I never let one stock exceed 20% the value of my portfolio. To me given his massive allocations, I would be hesitant to invest in Fairholme. However, I do think it can be wise to look at what stocks smart investors own to see if the thesis makes sense. Given this, I would encourage you to look at AIG, which looks absurdly cheap to me.

Currently, AIG trades at only 74% of book value. For comparison, its major competitors trade far closer to book. Metlife (NYSE:MET) is 90% of book, Prudential (NYSE:PRU) is 103% of book, and Allstate (NYSE:ALL) trades at 115% of book value. Why is AIG trading at such a steep discount? I looked towards its balance sheet to see if there were major non-liquid assets. For instance, many companies have massive goodwill accounts that make their stated book value somewhat questionable from a valuation perspective.

AIG has no such intangibles. The only asset that could be argued over is the deferred tax asset of $26 billion. Obviously during the crisis, AIG had massive losses. These losses can be used in future years to cancel out profits, negating a company's tax burden. With $9-11 billion in earnings power, the company will be able to recoup this tax asset over several years in my opinion. This year alone the company will save upwards of $3 billion in taxes thanks to this asset. Even if you wrote off half of the tax asset, which I believe is unreasonable, AIG would be trading at 84% of book, still a notable discount to its peers.

I think AIG is still suffering a "crisis discount." Many investors still associate the company with its excessive risk taking from the financial crisis that resulted in collapse, requiring a massive government bailout. AIG is no longer that company, shedding over $300 billion in its riskiest assets. The company has transformed into a more "vanilla" insurer. Given this, the company won't be as profitable as it was in 2004-2007 because it has so much less risk. Besides, those profits proved to be completely temporary. AIG is more like MET and PRU now, a typical lower-risk life and PC insurer. It should be valued as such. This crisis discount is no longer merited.

My optimism in AIG is buoyed by my optimism for the insurance industry as whole. On the property-casualty side, rates in critical areas like NYC post-Sandy have risen noticeably, which should buoy the bottom line. Equally important, hedge funds have poured into the reinsurance space as a way to build permanent capital. The growing number of reinsurance firm have pushed rates to a point where primary insurers can sell their risk at a profit, further strengthening the business.

AIG's life business also benefits from rising interest rates. AIG currently holds about $300 billion in bonds, so at first glance, you might think rising yields hurts the business because the value of these bonds fall as yields rise. True, but most long term bonds are held to maturity because they are matched against long-term liabilities. As long as borrowers pay interest and principal, AIG doesn't care about the day to day fluctuation in bond prices. As yields rise, AIG gets to invest premiums and interest at a higher rate while its liabilities remain fixed, increasing its effective yield on its long term insurance policy. I believe another 1% increase in the 10 year yield will increase AIG's EPS by about $1.00-$1.25.

Last, the company is cheap on an earnings basis, not just on book value. I believe AIG has core earnings power at current interest rates of $4.50-$5.00 implying a 10x multiple, which for a company trading only 74% of book, is just absurd. AIG is by far the cheapest insurer around, especially with PC looking favorable and rates poised for a continued rise over 24 months. The company has also been buying back shares at less than book value, which boosts book value per share, making the stock even more deeply discounted to its fair value. When a stock trades at book value, return on equity can be used to project long-term returns. For a company trading at book, return on equity will be the return on your investment over the long term. With a Super Storm that resulted in serious catastrophe losses, the company still maintained an 11% ROE over the past two years. Since the company is trading at a discount to book, the effective ROE is 15%, and by growing earnings of 10%, your actual return can be higher.

AIG is steeply undervalued as investors are still scarred from the AIG of the past. This AIG is a new, more traditional insurer with vibrant, growing businesses thanks to attractive pricing and yields. Its discount to peers is unjustifiable. AIG should trade within 5% of book value, which represents 28% upside from here. With a strong and growing earnings yield, I believe AIG could be headed even higher than that over the coming 24 months.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.