I’m Putting Real Money on AIG

On the next market day my Special Situations portfolio will buy shares of AIG (NYSE: AIG  ) . After years of government ownership, this troubled insurer is back on its feet and has cleaned up its operations substantially under CEO Robert Benmoshe. But it has a valuation – around 0.54 times book value -- that more nearly matches the status of a troubled insurer. With this kind of discount, the nearly complete exit of the government from ownership, and the company's stock buyback, this stock looks poised for above-market returns for several years.

What's the special situation?
AIG is the epitome of reputational risk. Everyone knows, just knows, that it's a terrible investment after its massive fall from grace in 2008. It's so ridiculously tainted that most investors wouldn't even think of buying it, let alone actually buy it. But that's exactly what gives investors this opportunity.

AIG is a fundamentally different company from what it was pre-crisis. One of the biggest changes is its severe reduction in derivatives exposure -- down 95% since the go-go days. The remaining derivatives are in run-off mode. Also AIG has shed units and is left with two solid insurance businesses, an aircraft leasing operation, and a 13.7% stake in AIA, its non-core Asian life insurance business.

The company appears primed to refocus on its insurance business and free up excess capital. Its stake in AIA should be free of a lock-up provision in December, allowing AIG to divest the stake and realize a value of around $6 billion. Also a possibility is the sale or spin of the aircraft-leasing operation, a move that could bring in $5 billion or more. All this would create cash that could be used for accretive buybacks should AIG's stock remain well below book value.

And we have the hallmark of uneconomic selling going on with the company's heretofore largest owner, the U.S. government, unloading shares above its $29 cost basis. It seems most interested in being able to claim (i.e., grandstand politically) that it made a profit on its stake in AIG rather than realize the full value of that stake. Back in June the government still had a 62% stake in the business. Following a couple rounds of divestment, that figure is down to 16% and will shortly be down to 0%.

When the government exits the position, it will remove the overhang on shares. Plus, it allows the company the possibility of starting a dividend and greater operational flexibility -- further catalysts.

Who's buying?
There are several sources of buying; some is even forced buying. For example, the company's index weight would increase as the government sells down its position, meaning that index-related funds are forced to buy AIG in order to maintain proper weighting. Dan Loeb of Third sees value in shares, as does Fairholme's Bruce Berkowitz, who has been a longer-time owner with about 6% of shares.

And while the government unloads its shares, AIG is there to buy them back around half of book value. That offers immediate value creation. The company bought back 15% of its shares at about half of book value, and this isn't book value bloated by goodwill, either. As I suggested above, asset sales could bring in further cash for accretive buybacks.

I expect this company could trade back to book value over the next few years, and more so if the company can make its underwriting operations profitable.

Risks
After years of underperformance, AIG is still having issues getting its underwriting profitable. Its combined ratio still sits above 100%, 102.4% in the second quarter. But that's down markedly from 109% in 2011 and 116.8% in 2010. That's moving in the right direction, but I'd prefer to see profitable underwriting. To help improve these numbers, the company is shifting more business of Chartis, its property and casualty subsidiary, to consumers from commercial operations. It's also moving to shorter policies and internationally.

The risk for any investment is that you buy at too rich a price. At about 54% of book value, that doesn't look like too much of a risk here. Even lackluster performance out of AIG could increase the share price from this point.

Foolish bottom line
AIG has many of the features that I love to see in special situations -- uneconomic sellers, massive discounts, reputational risk, and company buybacks. With all these interesting and positive developments, my Special Situations portfolio will buy $1,000 of AIG shares tomorrow.

Interested in AIG or have another stock to share? Join me on my discussion board and follow me on Twitter (@TMFRoyal).

Jim Royal has no positions in the stocks mentioned above. The Motley Fool owns shares of American International Group and has the following options: long JAN 2014 $25.00 calls on American International Group. Motley Fool newsletter services recommend American International Group. Try any of our Foolish newsletter services free for 30 days.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (12) | Recommend This Article (12)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 15, 2012, at 1:40 PM, Sotograndeman wrote:

    There's nothing new in your article. Bruce Berkowitz has made all of these points and more. You're merely paraphrasing him.

    So if you're saying you're following BB, then fine. Good idea.

  • Report this Comment On October 15, 2012, at 3:42 PM, TMFRoyal wrote:

    In investing you get no style points for originality. (Indeed, the idea of an original idea itself is already flawed.) The only scorecard is money.

    Jim

  • Report this Comment On October 15, 2012, at 3:50 PM, TheDumbMoney2 wrote:

    Soto, even if the original idea is to follow BB, that's still an original idea. If everyone were doing it, AIG would not be cheap, which in my view too it is.

  • Report this Comment On October 15, 2012, at 5:20 PM, Sotograndeman wrote:

    Jim,

    A bit of honesty would go a long way. All you need to do is title your piece Why Berkowitz Bought AIG. He was on Consuelo Mack just the other day.

    You and others can still make money. In fact you'd get more people interested.

    There may not be such a thing as an entirely new idea, but the way the best investors interpret data and draw conclusions can be distinctly individual and contrarian, and therefore possess a certain novelty and enable advantage. BB has done this with financials - and it matters.

  • Report this Comment On October 15, 2012, at 5:25 PM, Sotograndeman wrote:

    Dumb,

    It's not original to follow BB! It may be against the crowd, but the option to do it is actually obvious - in the sense that everyone knows what he has done and why.

    The reason so many are NOT in AIG is that they do not have the ability to understand BB's rationale -which he has spelled out many times. And also because of that, they're afraid.

    No question AIG (and BAC) is cheap.

  • Report this Comment On October 15, 2012, at 5:58 PM, TheDumbMoney wrote:

    Soto,

    He notes that it's a Bruce Berkowitz investment holding/idea, which is plenty in my view. I think you're being a little nitpicky on that. And given that AIG and BAC dual-handedly nearly blew up Berkowitz' mutual fund in 2011, and did lead to him splitting from his long-time investing partner, I think it's still rather courageous and original to follow him in. (I recognize that Berkowitz is now up something like 30% so far in 2012 and the time to really back the truck up was in December 2011.)

    Best,

    DM

    (DM2 is me, too. DM2 is my CAPS-playing account, and DM is my real money account, which details all of my real money purchases and sales.)

  • Report this Comment On October 16, 2012, at 4:01 AM, Sotograndeman wrote:

    DM,

    It might've looked from the outside as if his fund was blowing up, but BB has been entirely consistent in his belief in the financials. He had no doubts that he saw something which almost no-one else did. In his eyes it was other people who were blind and afraid and pulled money out when things got tough.

    It's not nitpicking on my part but just like to see the real movers and shakers get full credit. In my view it's important to know how and where ideas come from.

    Good luck.

    Soto

  • Report this Comment On October 16, 2012, at 6:41 AM, johndroc8 wrote:

    Notwithstanding any possible merit, in the article, the title "I’m Putting Real Money on AIG" completely goes against the mantra of TMF. As if to say, "I'm putting money on black or I'm putting money on the 5 horse." Investing is not gambling!

  • Report this Comment On October 16, 2012, at 10:00 AM, TheDumbMoney wrote:

    Soto, Berkowitz lost something like 1/3 of his aum, not including the money he actually lost in stock losses, in 2011. I don't know the exact figure, but that is not about how something "looked from the outside", that is objective math.

    By way of reference, Bill Miller of Legg Mason was also "consistent in his belief in the financials" in 2007-2008, and that did not stop his fund from blowing up, and it in fact ended his otherwise legendary career.

    But good luck to you as well.

    Best,

    DM

  • Report this Comment On October 16, 2012, at 11:18 AM, TMFRoyal wrote:

    Hi, Soto,

    I think you're being unfair to suggest that I'm being dishonest in not listing Berkowitz as the source of the idea. I had no idea he was on CNBC the other day (I actually don't own or watch TV), though I did know that he's been in it for some time. Moreover, it would be silly to buy simply because some investor (pick any!) was in the stock. One doesn't know their time frame, thesis, valuation, etc. That's a quick way to get steamrolled.

    Foolish Best,

    Jim

  • Report this Comment On October 22, 2012, at 9:24 PM, TMFDeej wrote:

    Goodness, Jim mentioned Loeb and Berkowitz's ownership right in the article. That's more than most writers do already. To criticize him about not giving credit for the idea is an absurd waste of your and everyone else's time.

    I loooove getting new ideas for investments from others. Why would anyone take the investing test all on their own when it's completely legal and moral to copy form the papers of the smartest kids in the school?

    Loeb's write-ups in his letters to investors are better than Berkowitz's anyhow IMHO.

  • Report this Comment On October 22, 2012, at 9:26 PM, TMFDeej wrote:

    Hmmm typing comments on an iPad doesn't work very well. Anyhow no offense meant Soto but this just seems like a silly discussion to me.

    Have a great evening.

    Deej

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