Shares of American International Group (NYSE:AIG) are beating the S&P 500 to date this year by the narrow score of 8.3% to 7%, respectively. But American International Group Warrants (NYSE:AIG-) have blown both the common stock and the S&P 500 away with a return of over 30%.
So why have the warrants done so well, and does it signal a shift in the market's approach to the insurer?
The power of leverage
The most obvious reason for the warrants' outperformance is that they are leveraged to the common stock and should be expected to show bigger gains and losses depending on the movement of that stock.
Today, with the warrants trading close to $27 and the stock trading near $55, the warrants provide roughly two times leverage on the stock. With the exercise price on the warrants at $45 per share, the warrants carry a time premium of about $17 for this leverage until they expire in January 2021.
At the beginning of the year, the stock traded at roughly $51 per share and the warrants around $20, giving the warrants roughly 2.6 times leverage. But even if we take the higher amount of leverage from the start of 2014 as our example, multiplying AIG's common stock return of 8.3% by 2.6 would only show the warrants gaining 21%. With their actual gain at 34% to this point in 2014, they have far exceeded what would be expected from increased leverage alone.
Warrants share many characteristics with long-dated stock options, one of which is that the market becomes less wiling to pay as much for the time value as the leverage decreases. Given the decrease in the leverage of the warrants this year, one would normally expect the warrants to rise less than a dollar for each dollar of stock price increase.
However, this has not been the case. The warrants have outperformed on a percentage basis and on an absolute basis. From the beginning of Jan. 2 to the close on July 7, AIG warrants gained $6.82 while the stock only managed a gain of $4.50.
Based on the stock performance, leverage comparison, and the dollar-for-dollar performance, something beyond just higher leverage looks to be at play here.
With the significant outperformance not explained by leverage alone, it appears many investors have been favoring the warrants over the stock, causing this difference in year-to-date performance.
Due to their leveraged nature and the fact that they would be worthless if AIG stock is trading below $45 in January 2021, the warrants are a higher-risk, higher-potential reward way to invest in AIG. This increased attention to the warrants shows larger parts of the market are ready to take on more risk for bigger returns with the company.
These investors also must see a large amount of upside to the common stock. At the price of $26.75 per warrant, AIG common shares would need to hit $71.75 by January 2021 for the warrant investor just to break even. Not only that, but shares would have to head even higher for the warrants to beat out the common stock in total return, especially considering that the common stock pays dividends while the warrants can only benefit through a dividend adjustment feature that partially compensates for the absence of a payment.
It's hard to give a definitive reason for what would cause investors to start betting on bigger returns from AIG this year, but here are three possible reasons:
- The expectation that the sale of AIG's aircraft leasing unit, International Lease Finance, would improve stability and raise cash for share buybacks.
- The authorization of more share buybacks in February and June allowing AIG to repurchase shares below book value.
- A fear by some investors of overvalued stocks and a shifting of money to value investments.
What to buy
I've been interested in American International Group for years as it repaid its government bailout funds and bought back shares below book value, all the while keeping a strong insurance company largely intact.
Having taken a long-term bullish view of AIG, my investment is in the warrants. However, more conservative and income investors would probably prefer the stock itself for reduced leverage and quarterly dividends.
Year to date, the market seems to have favored the warrants over the stock; investors in either security should keep an eye on how the relationship in performance between the stock and the warrants continues to play out.
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Alexander MacLennan is long American International Group warrants. This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security. The Motley Fool recommends American International Group. The Motley Fool owns shares of American International Group and has the following options: long January 2016 $30 calls on 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.