On the next market day my Special Situations portfolio will buy shares of AIG (AIG 0.38%). 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.
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.
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.
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