Yesterday I purchased shares of AIG (NYSE:) after its earnings release and tweeted about it. Last year, Barron’s wrote a bullish article on the company and did a good job of explaining why it was too cheap. At my purchase price of $52.50, AIG trades at only 75% of book value (excluding accumulated other comprehensive income). That is a valuation given to companies losing money and with troubled balance sheets. However, AIG is has been profitable the last 4 years and is trading at 10 times this year’s earnings.
The bears would argue that AIG should trade at a depressed valuation because its ROE has been mediocre at only 6% the last 3 years and is so severely regulated that it is essentially a utility. I would agree that utilities are a good comparison since they barely earn 10% ROE, but the market awards them on average a PE multiple of 17 and they trade for an 80% premium to book.
In fact, one of the reasons that made me wait until after the earnings release was to see how aggressively AIG was buying back stock. It turns out when annualized the company bought back 8% of its shares outstanding during Q4. Coupled with the dividend, the company is currently returning all of its profits back to shareholders. So, in effect, the stock has a 10% yield which is much better than utility stocks. Also, when AIG purchases its stock at 75% of book it is increasing ROE.
In addition, I believe there is a possibility ROE can increase without share buybacks. Since AIG is sensitive to economic growth, if the US economy performs as well as I expect, that will help demand for the insurance products that it sells. Moreover, rising interest rates will allow AIG to rollover its maturing fixed income assets into higher yielding bonds than currently available.
Also, AIG is overcapitalized as its assets to equity ratio is 5 to 1 where historically it was 10 to 1. An increase in leverage to 7 or 8 to 1 should push ROE over 10. A higher ROE is likely to be rewarded with higher multiples.
It is also comforting to know that one the largest shareholders of AIG is the highly successful mutual fund manager Bruce Berkowitz. The following is an interview from WealthTrack where he explains his rationale for making AIG comprise almost 50% of his largest fund’s assets.
In my view, AIG is in the sweet spot of having a low valuation coupled with improving fundamentals. I have made it one of my largest positions and will track its performance here.