With the stock market rising to new all-time highs with regularity, investors have to dig deeper to find bargains. The financial industry is rich with opportunity, in my view, as shares of WisdomTree Investments (NASDAQ:WETF) and American International Group (NYSE:AIG) offer up fat pitches to profit from a depressed consensus view of their earnings power.
Here's why I think these two companies are great comeback stocks for 2018 and beyond.
The fastest-growing business in finance
Though it may be well off its lows, exchange-traded fund (ETF) manager WisdomTree Investments is even further from its highs. The ETF industry is growing like gangbusters, as investors swap high-cost, actively-managed mutual funds for low-cost index funds and ETFs. WisdomTree is a great way to play the trend of a shift from active to passive funds.
So-called "plain-vanilla" ETFs that track well-known indexes like the S&P 500 or the Russell 2000 are winning the lion's share of investors' cash. But because there is little differentiation between fund choices, assets largely flow into the lowest-fee funds, most of which are managed by the ETF industry's "Big Three" -- Vanguard, BlackRock (iShares), and State Street.
I suspect simple index ETFs will be better for their investors than fund managers. That's because Vanguard, which is a major player in plain-vanilla funds, has no profit motive and every incentive to drive down fees over time. Therefore, the real money in managing ETFs isn't in the hyper-competitive corners of the ETF world, but in niche markets, where fees are higher and differentiation matters. It's in these niches that WisdomTree generates the bulk of its AUM, recurring fee revenue, and, of course, profits.
WisdomTree's biggest ETFs offer access to more complex, difficult-to-replicate investing strategies, including ETFs that invest in European stocks and hedge out the currency fluctuations and ETFs that invest in highest-yielding stocks in emerging markets. You get the idea -- if it's an obscure asset class or strategy, WisdomTree likely has an ETF for it or is dreaming one up.
What the market dislikes about WisdomTree
Niche ETFs are like lottery tickets. Most are worth nothing, but a chosen few catch the attention of the market and lap up enough in assets to cover the losers. This much is apparent from WisdomTree's portfolio of funds. Of the 159 ETFs in WisdomTree's lineup in January 2016, only 20 had more than $500 million of assets under management in January 2018, based on my analysis of AUM data provided on its corporate website.
There's a common link among WisdomTree's biggest ETFs by assets. Most are currency-hedged ETFs, or funds that allow investors to get unique exposure to stocks in foreign markets without worrying how currency fluctuations might affect their returns. These funds are more likely to be used by short-term traders and thus produce volatile management fee revenue, which makes WisdomTree an oddball in the asset management industry, where most companies produce almost annuity-like streams of fee income.
For its part, WisdomTree has taken some steps to diversify its product lineup. It recently announced it would acquire a portfolio of ETF Securities' ETFs, which will reduce its currency-hedged business to 31% of AUM, down from 42%, according to its presentation. The deal is expected to close later in 2018, which will beef up WisdomTree's ETF business in Europe and give it exposure to simple funds where scale matters (one key asset it bought is a European ETF that simply holds gold, for example).
I actually view WisdomTree's exposure to currency-hedged ETFs as a positive in the near term, given the dollar's recent decline against foreign currencies -- the euro in particular. The popular WisdomTree Europe Hedged Equity Fund (NYSEMKT:HEDJ) is the kind of fund you want to own if you expect the dollar to reverse course and gain against the euro. As the chart below shows, this ETF hauls in billions of dollars of assets when the dollar rises against the predominant European currency.
This is a big, needle-moving fund for WisdomTree. Consider that a mere $1 billion of inflow into the fund generates about $5.8 million in advisory fees annually, almost all of which should flow into WisdomTree's pre-tax income. To put that into perspective, WisdomTree generated just $52.5 million in pre-tax income in the first nine months of 2017.
I estimate that every $1 billion that flows into the hedged euro fund will add about $0.035 per share to pre-tax earnings on an annualized basis, based on its pro forma share count after it closes on its deal with ETF Securities. The euro trade alone could be a big boost to the company's earnings power and is the most obvious catalyst to send WisdomTree shares higher this year.
In the long run, I expect that WisdomTree will ultimately sell out to a legacy asset manager eager to buy its way into the business of managing ETFs. I suspect that WisdomTree's days as an independent ETF shop are numbered because after it closes on its acquisition of ETF Securities' funds, it will offer an acquirer a platform of ETFs on which to build and leap into the top 10 ETF managers in Europe, a market where ETFs are only getting started.
Can AIG bounce back?
American International Group has been a "comeback" stock for a long time. Admittedly, the company looked like it was turning in 2014, when AIG announced it would make an insurance outsider, former banker Peter Hancock, its chief executive officer. Hancock laid out goals to cut costs, exit non-core businesses, and send more capital back to shareholders, largely delivering on his promises in the years that followed.
But Hancock couldn't give AIG what it needed most: underwriting discipline. The company's underwriting results never turned and have actually deteriorated, ultimately culminating in a $10 billion deal in which AIG paid Berkshire Hathaway to cap its potential losses and put questions about its portfolio behind it.
Under the heavy hand of activist investor Carl Icahn, Hancock stepped down as CEO in March 2017. Having tried its luck hiring an industry outsider to turn the ship around, AIG instead went a different direction, naming Brian Duperreault as its new chief executive. Duperreault is an insurance industry veteran who got his start in the business working as an actuary at AIG in 1973, later taking the role of CEO at ACE Limited, an insurance company widely regarded as an excellent underwriter and risk manager. (ACE Limited has since merged with Chubb Ltd.)
Rather than grow profits by shrinking the business, Duperreault has put AIG on a new course, laying out a plan to grow the company by acquisition to find niches where AIG can generate higher returns. His first deal was announced earlier in January when AIG announced a plan to acquire Validus Holdings (NYSE:VR) for $5.6 billion in cash, giving AIG a foothold in large crop insurance and reinsurance lines. AIG is also getting a Lloyd's of London syndicate.
What the market dislikes about AIG
Carl Icahn once called AIG "too big to succeed," arguing that the insurer's massive balance sheet and complex organization made it difficult for the company to generate attractive returns for shareholders. He argued that splitting up the company into three smaller pieces would allow it to find new focus, as the pieces would be more nimble than one large insurance giant.
While I share Icahn's concerns about AIG's size, scale is hardly its biggest problem, in my view. The biggest problem is arguably the most obvious, and it starts at the top of the organization.
AIG, like all insurance companies, makes money by adequately pricing insurance policies to cover the risk of loss. Yet, if you go back through its laundry list of leaders, you'll find very little experience in the boring study of actuarial science. Duperreault's experience as an actuary is a massive improvement to AIG already, if only because he actually understands the risks that the company is taking when it writes business in a particular insurance line.
AIG is downright cheap, priced as if it is destined to forever generate low returns on equity and destroy shareholder capital. At a recent price of roughly $63 per share, AIG trades at a 17% discount to its last reported book value at a time when other insurance companies trade for multiples of their book value.
A combination of improved underwriting results and rising interest rates could lift AIG's return on equity above 10%, the point at which its shares could reasonably trade for book value. Investors could earn a total return in excess of 30%, thanks to the powerful combination of a rising valuation on top of retained earnings it builds while Duperreault works to solve AIG's underwriting woes.
Jordan Wathen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool recommends WisdomTree Investments. The Motley Fool has a disclosure policy.