U.S. stocks are lower in late morning trading on Wednesday, with the Dow Jones Industrial Average (^DJI 1.13%) and the S&P 500 (^GSPC 0.41%) both down 0.65% at 12:05 p.m. EST. Shares of mammoth insurer American International Group Inc are outperforming, up 0.33%.
At the end of October, this columnist wrote that it took Carl Icahn to point out the obvious on AIG. In an open letter to the insurer's CEO Peter Hancock, the legendary investor called for two immediate actions in order to enhance shareholder value:
- Implementation of a cost control program.
- AIG should focus on property and casualty insurance, hiving off its life and insurance businesses into two separate publicly traded companies.
AIG's executive management and its board are surely beginning to feel the heat rising beneath their executive chairs. A week ago, the insurer announced that its fourth-quarter results would include "an update on its strategy and its proactive plan to drive shareholder value."
Hancock has little room to maneuver, as it now appears AIG's institutional shareholders privately hold similar views to those the unabashed Icahn states publicly.
In a note published on Tuesday, Sanford C. Bernstein & Co.'s Josh Stirling presented the results of a survey Bernstein conducted across some of its institutional clients. The numbers suggest there is essentially no support for the status, nor any ambivalence regarding the way forward. For example:
- "Only 4% of investors said they support management's current strategy, as it is."
- "Only 9% of the respondents indicated they would support management's directors in their most likely posture -- pursuing the current strategy enhanced by a 'modest acceleration of cost-cutting and small divestitures."
- 86% of respondents want AIG to announce a plan "de-conglomerate and un-lock value by selling businesses and/or spinning divisions."
Bernstein's survey covered over 100 investors that represent more than a third of AIG's shares. Given the level of consensus among the respondents, however, it's unlikely the shareholder base as a whole is satisfied, or feels very differently.
There is quite a bit of research supporting the existence of a diversification (or conglomerate) discount in the financial services sector (see, for example, Laeven & Levine (2005) and Schmid & Walter (2007)).
In other words, companies that diversify across different businesses areas, such as lending and securities underwriting, are valued less highly than those that choose to focus on a single one.
That diversification discount also exists within the insurance industry. The authors of a 2008 paper in The Journal of Risk and Insurance concluded:
Our results indicate that un-diversified insurers consistently outperform diversified insurers. In terms of accounting performance, we find a diversification penalty of at least 1 percent of return on assets or 2 percent of return on equity.
Two percentage points may not seem like much, but in the context of a company that has earned a median annual return on common equity of just 7.3%, it starts to look pretty significant.
Furthermore, at AIG, that conglomerate discount is probably compounded by a size discount because it is one of only three insurers that has been designated as a SIFI (Systemically Important Financial Institution) and will, therefore, almost certainly be required to hold additional capital.
With rival insurer MetLife Inc announcing a breakup plan of its own yesterday that would see it split off a substantial part of its retail segment, AIG had better come up with something big on January 26, failing which, Hancock is not long for his position.
For investors, I believe there is a medium-term opportunity here, with AIG's shares now trading roughly 7% below where they closed on Oct. 28, the day Icahn published his entreaty and announced he owned "a large stake" of the company.
