American International Group: Why The Warrants May be a Better Bet Than The Common Stock

Source: Company

American International Group (NYSE: AIG  ) continues to be one of my favorite investments in the financial sector. While a lot of attention, naturally, focuses on AIG's common stock, there is another instrument with which investors can play a normalization of valuations in the insurance sector: Warrants.

As part of a comprehensive recapitalization initiative, American International Group issued an option dividend in January of 2011 for shareholders on record and distributed 0.533933 warrants for each stock owned at the time under the ticker AIG-WT.

Insurance companies are still cheap, especially AIG
Both American International Group's common stock and the warrants ultimately fell off the cliff in 2011 after the market corrected sharply and uncertainty with respect to AIG's survival prospects remained high.

Valuations of insurance companies largely remain depressed with many companies just managing to trade at book value. AIG continues to trade at a sizable discount of more than 20% to its book value.

Compared against Metlife (NYSE: MET  ) and Prudential (NYSE: PRU  ) , two formidable competitors of American International Group, AIG is actually quite an attractive bet on increasing valuations which should be driven by a combination of operational improvements, share repurchases below book value and capital deployment initiatives within the company.

However, investors can also invest in AIG via long-dated warrants. AIG's warrants (NYSE: AIG-WT) have a couple of benefits that allow those investors wanting to get exposure to an undervalued insurance company with a low book valuation to play their investment thesis with a bit of leverage.

1. Long time-horizon
The first attractive characteristic of American International Group's warrants is that they are long-dated in nature. The warrants issued in 2011 expire on January 19, 2021, giving investors ample time for their investment thesis to play out.

It can't be stressed enough how important this feature is for investments in general.

Long-dated options fit perfectly into the strategy of long-term investors, who want to benefit from a cyclical normalization of equity valuations.

Long-term warrants give investors sufficient time for the market to correct its past excesses and for American International Group to transition to growth.

The recovery of American International Group, especially after the fallout in 2008, took a long time and is likely to take even more time. Long-dated warrants are perfect for this investment thesis.

2. Leverage
Of course, one of the most important characteristics of warrants is the power of leverage, that investors gain by purchasing the warrants instead of the common stock.

American International Group's warrants have an exercise price of $45. With AIG's common stock currently trading around $55 per share, the warrants are about $10 in-the-money.

The warrants currently also trade at about $26 which includes about a $16 time premium. Investors can understand the $16 as a premium they are required to pay in order to get access to the potential benefits of leverage for the remaining warrant term.

AIG warrants allow investors to get access to approximately 2x leverage by investing in American International Group's warrants instead of the common stock, which makes the warrants a potentially highly lucrative investment.

3. Anti-dilution adjustments
Warrents with anti-dilutive features are extremely attractive.

Generally, when a company pays a dividend, the stock price should go down. In theory, the decline in market capitalization of a company that pays a dividend should be equal to the cumulative amount of dividends paid on the shares. This is because dividends are a form of 'value distribution', not 'value generation'.

The value of warrants (or call options), which have anti-dilutive features, will not be affected by dividend payments of the company, which is an important characteristic to level the playing field between the common stock and the warrants.

The Foolish Bottom Line
American International Group's warrants are an interesting alternative to the common stock for investors who want to get more than short-term exposure to one of the leading insurance companies in the country.

AIG's common stock must reach approximately $71 per share in order for warrant holders to break even, but with six and a half years remaining before the warrants expire, there is a good chance the common stock can rise far above this level.

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