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Assured Guaranty: Deep Value, Improving Prognosis

|Includes: Assured Guaranty Ltd. (AGO), AIG, AMBC, MBI
As the market begins to show strength and both investors and traders begin putting capital back to work, I'm finding opportunity on two different fronts.

1) Speculative positions which are heavily leveraged toward an economic rebound can get juiced higher quickly as institutional managers scramble to add beta to their portfolio.

2) Value equities which have healthy long-term businesses but have become depressed after falling out of favor can also show tremendous short-term performance along with the potential to become longer-term core investments.

As swing traders, we often focus on the more speculative positions that are quick to move (higher or lower) when market dynamics change.  But today I want to take a closer look at a stock that is trading at an exceptional value due to institutional investor's aversion to the industry this company operates in.

Financial Insurers

The names MBIA Inc. (NYSE:MBI) or Ambac Financial Group (ABK) bring back some pretty ugly memories for the LOLO (Leveraged Outright Long Only) investors - most of whom took a bath when these insurers hit the skids.

The business model seemed pretty sound.  Just like any other insurance companies, financial insurers took in a regular premium to insure investors against losses.  In this case, the potential losses were from investments - usually fixed income products - and to a large degree these companies insured what we now know to be very risky Mortgage Backed Securities.

To make a long (and painful) story short, stocks like AIG, MBI and ABK were trashed when the securities they insured took on water and the companies were saddled with huge losses.  In order to pay the claims, these companies had to raise additional capital and still don't have the balance sheet strength to underwrite new insurance business.

But one company in the business managed to survive with its business intact - and today looks like an attractive trading and investment opportunity...

Assured Guaranty - A Cut Above the Competition

When competitors like AIG were making a mint collecting premiums for insuring toxic waste, Assured Guaranty (NYSE:AGO) was ridiculed for passing up the easy profits.  Management simply wouldn't play the mortgage insurance game because they believed the premiums charged by the industry didn't match with the risk insurers were taking...  Of course we know how the story ended.

And so when most in the industry were teetering on the verge of bankruptcy, Assured Guaranty had plenty of capital to take advantage of the situation.  Ironically, AGO entered the mortgage insurance market at the bottom of the cycle, purchasing a struggling competitor and emerging as the only major insurer actually underwriting new business.

At this point, the risks in mortgage securities are well known.  And since AGO is basically setting the price at which it is willing to take on risk, the company is being well compensated for its risk - and appears to have plenty of capital set aside for potential losses.

Municipal Bond Risk

Since AGO was not very involved in the mortgage security market, the company developed a specialty insuring Municipal Bonds - which has recently become a concern for investors.  Of course we know that states like Illinois and California are in deep trouble and may have a significantly hard time meeting their obligations.

If states or other municipalities begin defaulting on their debt, AGO will likely have to step up and fulfill the obligations. Investors have liquidated positions due to this risk, pushing the stock down nearly 50% from the April high to the low point less than 2 months later.  Clearly the risks have been considered and at this point it looks like the fear has likely been overdone.

Recent comments out of Washington indicate that there will likely be federal assistance for struggling states, and at the same time, many of the municipal obligations insured by AGO are misunderstood by the investing public...

There are a number of municipal bonds insured by AGO which are characterized as "revenue bonds."  These bonds are used for very specific purposes such as building water treatment plants, and the bonds are backed by the water and sewer revenue from the municipality.  Of course this revenue stream is not immune to economic ebbs and flows, but at the same time citizens are more likely to pay their water or electric bill to keep the lights on - even if it means defaulting on the mortgage.

AGO's risk with these bonds does not appear to be nearly as dangerous as traders believe, and now that we are seeing signs of a recovery - however weak that recovery may be - that risk is becoming less of an issue.

Compelling Value and Attractive Trade

Analysts (who you remember are pre-disposed to be overly conservative in this industry) are forecasting earnings for AGO of $2.76 per share this year and $3.89 for 2011.  Based just on this year's expected earnings, the stock is currently trading at less than six times earnings.  If you use 2011 earnings as a baseline, the stock becomes even less expensive at just over four times earnings.

There is a significant argument to be made both for increased earnings estimates as well as multiple expansion.

Of course, as Mercenary Traders we are looking for evidence of positive price action before committing our capital.
AGO has participated in the July rally - gaining 18% during the month and tacking on additional gains so far in August.

The stock is now above the 50 EMA and appears to be gaining institutional support.  The company announces earnings Thursday after the close and will host their conference call on Friday morning.  I'm expecting management to offer more evidence of their risk management skills and may look to use any volatility around the earnings report to work into a long position.

Initially, I will want to use the price action to take a shorter-term swing trade position.  However with AGO representing a deep value and if the business dynamics continue to be healthy,
I would consider maintaining a longer-term position, establishing more of an investment approach while still managing risk carefully.

Disclosure: no positions