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Buying Goldman Sachs (NYSE: $GS)

Financial stocks have been hit hard in recent days due to concerns about an economic recession and declining interest rates. Financials are leveraged to the economy so it is no surprise that they are underperforming the market. Since I do not believe that the global slowdown will infect the US, I am taking advantage of the recent decline in equity prices to buy high-quality names. One attractive opportunity that I am taking advantage of is buying Goldman Sachs ($NYSE).

Goldman Sachs is an incredibly well-run investment bank, as is evident in its ability to navigate through two recessions and be profitable every year since its IPO in 1999. Prior to the financial crisis, Goldman’s stock traded above 2x tangible book value (TBV).  However, in recent years its valuation has wavered between a slight discount to TBV and 1.5x TBV.

Goldman Sachs Tangible Book Value

Bears on the stock justify a low valuation by pointing out that the large banks are under enormous regulatory scrutiny which requires them to hold unnecessarily high levels of capital that impedes their ability to earn a high return on equity. I would counter that the requirements for high levels of capital make them safer and better able to weather a downturn. Therefore, their utility-like returns are deserving of a utility-like valuation of 2x TBV. I believe that the steady  profits that the banks earn over time will eventually cause the markets to revalue them.

In the meantime, Goldman Sachs offers a 1.5% dividend and is buying back 5% of its outstanding shares each year for a total cash return yield exceeding 6%. Moreover, by buying Goldman at TBV, investors can get the Goldman Sachs brand name and the intellectual capital of the smartest minds on Wall Street for free. I will track GS here with an initial price equal to Wednesday’s close of $159.00.

The Return of the ’97/’98 Playbook

My long-term bullish outlook on US stocks is predicated on a US economy that continues to strengthen in the face of a global slowdown. This has happened before. FT Alphaville compares the current period to 1997/1998:

Recall what things were like in those heady bygone days:

  • Oil prices had plunged by nearly 60 per cent from the start of 1997 through the end of 1998
  • Spreads on high-yield bonds had widened by about 4 percentage points in 1998, while spreads on the junkiest junk debt had widened around 6 percentage points
  • Currency crises and deep downturns were afflicting poorer countries from Latin America to Russia to Asia
  • The US dollar had rocketed up more than 20 per cent from the start of 1997 through the end of August, 1998
  • Core inflation had slowed from an annual rate of 2.0 per cent in June, 1997 to just 1.0 per cent by June, 1998 — the slowest rate ever recorded until 2010
  • America’s unemployment rate had dropped by a percentage point to levels not experienced since March, 1970

Now compare to what we have now:

  • Oil prices are down about 65 per cent since mid-2014
  • Spreads on high-yield bonds are up around 3 percentage points since the start of 2014, while the spreads on debts rated CCC or lower have widened by nearly 9 percentage points
  • Many large emerging markets, including Brazil, Russia, Turkey, and China, are either shrinking or slowing down sharply
  • The dollar is up nearly 20 per cent since the summer of 2014
  • Core inflation slowed from an annual rate of 1.7 per cent in July, 2014, to 1.3 per cent ever since the start of 2015
  • America’s unemployment rate has dropped by a whopping 1.6 percentage points since the start of 2014

As it pertains to stocks, there are a couple of important differences: currently, US economic growth is slower and interest rates are much lower. In my view, both variables cancel each other out in their effects on equity valuations. In 1998 US stocks shook off a 20% correction to go on a parabolic (and unsustainable) run based on earnings growth and multiple expansion. I believe history will repeat itself, although stocks may experience more modest gains and the current bull market will last longer.

With regards to numerous recent predictions about a US recession, it seems that they have mostly been based on the recent weakness in manufacturing activity. But it is important to keep in mind that the US economy is primarily driven by services, while manufacturing’s share is less than 10%.

US Employment by Sector
Source: The Economist

And as reported by the ISM, manufacturing is contracting while services is expanding healthily. If the 1998 playbook is followed, then the manufacturing sector will soon return to growth.

Manufacturing and Services Decoupling

Therefore, if US economic growth continues to chug along and it turns out that investors’ fear about a recession were misplaced, then as in 1998, the maximum possible drawdown that one should expect is limited to around 20% and the bull market will shortly resume.

Buying Alibaba Group Holding via Yahoo (NYSE:YHOO)

During the recent market volatility, I decided to build a position in Alibaba Group Holding (NYSE: BABA). This might be surprising to those who are familiar with my long-standing bearishness on the Chinese economy. Aside from buying one Chinese stock 5 years ago (which turned out to be a fraud), I have always traded China from the short side.

That being said I am always searching for companies having market leading positions in large industries with secular tailwinds and being run by highly successful operators. These companies tend to be easily identified by investors, and consequently trade at rich valuations. However, during market corrections and economic slowdowns, the baby is often thrown out with the bathwater. I believe the recent stock market correction along with an economic slowdown in China has presented a compelling investment opportunity in Alibaba.

Alibaba is synonymous with e-commerce in China. The company’s platform provides the fundamental technology infrastructure and marketing reach to help businesses leverage the power of the Internet to establish an online presence and conduct commerce with consumers and businesses. Given the scale it has been able to achieve, an ecosystem has developed around its platform that consists of buyers, sellers, third-party service providers, strategic alliance partners, and investee companies. Much of Alibaba’s effort is spent on initiatives that are for the greater good of the ecosystem and the various participants in it.

The popularity of Alibaba’s platform has resulted in rapid revenue growth and high profitability as shown in the table below.

BABA Financials

Although China’s economy is facing a significant slowdown, the weakness is likely to be confined to fixed asset investment as investing slows after outpacing the overall economy for the past several decades and being artificially stimulated during the recent global financial crisis in order to revive growth. As shown in the following chart, the growth in retail sales has been fairly stable and now exceeds investment spending.

Chinese Economy Rebalancing

Within China’s retail sector, e-commerce will continue to take a greater share of total retail sales, which is to the benefit of Alibaba.

Ecommerce Growth by Country

E-commerce as a Percent of Total Retail Sales

With 386 million annual active buyers and 346 million monthly active users on mobile, it is inevitable that Alibaba’s China e-commerce growth will slow. However, investors are overlooking some of Alibaba’s other businesses which are experiencing hyper-growth and have the potential to significantly add to the bottom line down the road, while strengthening the company’s platform.

BABA Revenue by Business

Aliyun is Alibaba’s cloud computing unit which was started in 2009. Restrictions on foreigners investing in the online services industry gives Chinese companies a significant advantage when competing against Amazon and Microsoft. Aliyun has become a world-class cloud computing service platform and is the market leader in China. While holding a 23 percent market share in its home market, Alibaba has set its sights on the cloud computing space beyond China, eager to tap into a market that according to researcher IDC could grow into a $100 billion industry by 2017. With only about 10 percent of IT budgets spent on cloud computing in Asia, there is plenty of room for growth outside of China. Cloud Computing can be a highly profitable business as disclosed by Amazon’s AWS unit which had 21% operating margins last quarter. The chart below shows that Aliyun is registering exponential revenue growth.

Alibaba Cloud Computing Revenue

Alibaba is also disrupting the financial services industry in China through its 37.5% ownership of Ant Financial which raised money last year at a $45 billion valuation. Ant Financial’s Alipay platform is China’s largest Internet payments platform.

Alipay Dominance

When it comes to mobile payments, China is years ahead of the rest of the world. Traditional noncash payment methods such as credit cards, debit cards, and personal checks never really caught on in China meaning that until recently cash was king. This has allowed China to leapfrog traditional payment systems. In the US, mobile-payment providers rely on the traditional infrastructure of bank-card numbers. However, in China  Alipay only require user accounts to be linked to a traditional bank account. Alipay charges small merchants just 0.6%, which amounts to very little profit. One way Ant Financial can increase profitability is to cross-sell other financial products, including loans and investments. But new regulations in China make this difficult.

To get around these restrictions, Ant Financial created an online bank, called MYBank, which has a license to provide loans and other financial services, though regulations still limit its scope. It is only a matter of time before restrictions are eased because China desperately needs to reform its banking sector by providing more competition to China’s state-owned banks. The state-owned banks tend to favor state-run firms, while underserving individuals and small businesses. MYBank and other online lenders can fill this void by doing away with brick-and-mortar branches to keep costs low and reach more users. Ant Financial has an advantage over other online banks because it can use its huge trove of user-behavior data from Alipay to  assess creditworthiness.

In addition to cloud computing and financial services, Alibaba is establishing an Internet-based entertainment ecosystem for domestic households by delivering of a variety of video content over the Internet using set-top boxes and online video website Youku Tudou; operating online music platforms that offer music streaming services through websites and mobile apps; and producing films and television programs via Alibaba Pictures.

Alibaba has spent over $6.3 billion on logistics-related deals in the past three years because there are signs that getting packages to consumers quickly and reliably is an increasingly important battleground. JD.com offers same-day and next-day services for over 80 percent of orders it delivers while Alibaba aims to have next-day delivery available in 50 cities by the end of the year.

Another notable investment that Alibaba has made is a minority stake in Didi Dache-Kuaidi Dache, the leading and most widely used mobile taxi booking app provider in China.

In the coming years, I believe Alibaba founder and chairman, Jack Ma, will integrate all these businesses to strengthen Alibaba’s ecosystem resulting in double-digit annual  revenue growth over the next decade. At 29x this year’s EPS and 22x next year’s EPS, I believe BABA is trading at an attractive valuation given its growth prospects. I am adding BABA to my Trades page with an initial price equal to Monday’s closing price of $76.69.

Update (2/3/16)
Due to the significant relative underperformance of YHOO as compared to BABA, I am replacing my holding of BABA with YHOO. Yahoo has become so cheap that if you strip out its holding of BABA (assuming a modest tax hit for selling), Yahoo Japan and cash, the core business is selling for nothing. The core business is on track to generate nearly $1 billion in adjusted EBITDA in 2016 and has 600 million monthly mobile users. The board’s statement that it is willing to sell the core, should unlock several billions of dollars. Therefore, YHOO is a cheaper vehicle for owning BABA. I will adjust up my cost basis on YHOO on the Trades page to reflect that I am currently down around 13% on my BABA long.

Bull Market to Resume in 2016

And now we are behaving hysterically at the prospect of just one? It’s a bit of a joke, really… We might have a wobbly few weeks when they do move, but I’m sure the Fed will stroke us like you wouldn’t believe and the markets will settle down, and most probably go to a new high.
-Jeremy Grantham on the Fed’s eventual first rate hike. (8/6/15) http://on.ft.com/1InJDDg

In May, I wrote that I was looking for a “5-15% multi-month correction to refresh the current bull market”. My cautiousness was based on a bull market that had not experienced at least a 10% correction in 3 years, a corporate earnings recession, excessively bullish sentiment, and deteriorating breadth..

Since then the market finally declined by a meaningful 14%. Also, the current decline in year-over-year S&P 500 earnings (by 14%), which can entirely be traced to both a strong US dollar and a collapse in energy prices, is likely to be the worst that we will see. According to the calculations of Thomas Lee, a Fundstrat Global Advisors LLC stock forecaster, the dollar’s rise this year has subtracted $10 per S&P 500 share. U.S. corporate profits would have grown by 8% without the impact of the strong dollar. Similarly, ex-energy S&P-500 earnings have grown 5% indicating that most US corporations are still prospering.

In fact, the past two years are among only four years out of the last thirty that the US dollar index registered double-digit declines. It would seem highly unlikely that the US dollar will continue to rise without taking a pause. Similarly, if the year ended today the price of light sweet crude oil would have suffered its third worst annual decline after 2008 and 2014 in thirty years. Again, it is highly unlikely for a major asset class to experience a massive move in the same direction for three consecutive years. On the other hand, if the US dollar and oil prices are stable in 2016 then earnings should resume its upward trajectory given the US economy’s decent growth.

US Dollar Index Oil (WTIC)
2014 -13.1% -45.6%
2015 (ytd) -12.0% -33.4%

If forward earnings estimates stop being cut, then the current PE multiple of 16 looks reasonable and in-line with the long-term average. But if the forward PE multiple is juxtaposed with historically low levels of interest rates, then there is a good chance that multiples can rise.

As seen in the following Investors Intelligence poll, the recent correction has erased the high levels of bullishness that existed during the past few years and has created excessive pessimism, which should also support equity prices.

Investors Intelligence Survey

Market breadth remains my only concern, though it was encouraging to see during Friday’s sell-off that breadth did not make a lower low.

Market Breadth

My own expectation for 2016 is that the US dollar will be stable (+/- under 5%), oil will range between $30 to $60 per barrel, interest rates will be somewhat higher, US economic growth will pick up to 3%+, and the rest of the world will continue to be weak. Under such a scenario, I estimate S&P 500 companies to earn $110-120/share next year leading analysts to pencil in $130/share for 2017. If forward multiples rise to 17 or 18 to reflect receding worries of a US recession and a rapid tightening of monetary policy, then I believe that the S&P 500 can reach between 2200 to to 2350 next year.

According to Sam Stovall, a U.S. equity strategist at S&P Capital IQ:

“For 2016 I don’t see another flat year, nor would history say that flat years typically follow flat years. In fact, there have been 10 times since World War II in which the S&P 500 rose or fell by 3 percent or less. In the subsequent year the S&P 500 rose in price 80 percent of the time and posted an average annual increase of nearly 13 percent and was flat only once. We think that the S&P 500 will close 2016 at 2,250, representing a mid-to-high-single digit price appreciation.”

Given the market’s flat performance in 2015, the upper end of of my range, which corresponds to a high single-digit to double-digit percentage gain looks more likely. As I tweeted, my bullish outlook allowed me to get 100% invested near the bottom of the market’s decline last quarter. Although, I trimmed my position during the ensuing rally back towards the highs in expectation of turbulence as we approached the Fed’s first rate hike in nine years, the sell-off last week allowed me to rebuild a 90% long position.

RisksandReturns
Reducing net long exposure to 90% from 100% with $SPX at 1990.
9/16/15, 1:31 PM
RisksandReturns
Reducing net long exposure to 75% from 90% with $SPX at 2075
10/23/15, 10:16 AM
RisksandReturns
I bought near lows, believing this is not a bear mkt. But with $SPX just 2% below ATH I also think more time is needed before breaking out
10/23/15, 10:20 AM
RisksandReturns
Back to 90% net long at 2010 on $SPX. I believe bull market is ready to resume.
12/21/15, 4:09 PM

The closure of extraordinarily easy monetary policy has brought on the long awaited stock market correction. But, as opined by Jeremy Grantham in the quote at the beginning of this post, make no mistake about the Fed’s intentions: it remains the market’s friend. And once the market realizes it, the bull market will resume – it is only a matter of time!

I’m 100% Long for the 1st Time in Years

The 5-15% multi-month correction that I was waiting for since May has finally arrived. Last Friday I tweeted that I increased my net long exposure to stocks from 25% to 75%. And I tweeted again on Monday morning that I was using my remaining cash balance to buy stocks during the early morning flash crash.

RisksandReturns
Increased my equity exposure from 25% to 60% on this 5% pullback in the S&P 500
8/21/15, 10:15 AM
RisksandReturns
Further increased equity exposure to 75% on S&P 500 dip below 2000
8/21/15, 1:43 PM
RisksandReturns
Just went 90% net long as S&P 500 futures broke below 1900. Sell offs based merely on EM problems has always been a good buying opportunity.
8/24/15, 8:13 AM
RisksandReturns
Just went 100% long on test of Oct ’14 low. Could not get filled on individual stocks so bought $SPY
8/24/15, 9:44 AM

I almost always keep at least a 10% cash balance, but the indiscriminate panic selling seemed to be devoid of any fundamental reason making me convinced that markets will experience at least a short term rebound. The most popular reason ascribed to the August selloff, the crash in the Shanghai Composite and the slowing Chinese economy, do not warrant a 12% correction in my view.

Rather, the best explanation for the correction is that the market was simply due for it after not having experienced a 10% pullback for one of the longest stretches in history.

Months Without a 10% Correction
Source: Ryan Detrick

Moreover, with the Fed having supported financial markets with extraordinary monetary stimulus during the past 7 years, it would seem likely that markets would stumble as the Fed backs away.

Fed QE Impact on Market-2

Although, the Fed wisely decided to taper its QE3 program to avoid the market dislocations that ensued after QE1 and QE2 were halted, the fear of a rising Fed funds rate has spooked markets once again. If the current panic does not subside before the Fed’s September meeting, a rate hike is likely to be postponed.

During market turbulence it is important to not get caught up in the media noise and lose sight of the economic fundamentals which ultimately determine equity prices. As shown below, after the winter induced Q1 slowdown. the US economy is back on track for 2-3% growth. And looking ahead, the economy is on the verge of accelerating to 3%+ growth as I wrote about here.

2015 Q1 GNP-2

By almost every sentiment and technical measure, the market is due for a rebound at which time I will get back to a 10% cash cushion. I do not know if we have seen a bottom, but after a 12% correction I believe we are closer to the bottom than to the top and new highs are only a matter of time. Therefore, I want to be heavily long US stocks.

 

A Market Correction is up to the Fed

Since I turned cautious on stocks in early May, the market has been treading water with minimal volatility. If the year ended today, the S&P 500’s intra-year decline of 4% would be the 2nd smallest in 35 years.

S7P 500 Intra-Year Declines

This would be highly unusual for a year in which corporate earnings estimates have been slashed and economic growth has disappointed. Moreover, we have seen significant deterioration in the market’s breadth with the utilities and transports both having already corrected 15%.

I believe one reason that the major averages are holding up is that expectations of Fed rate hikes have been pushed back.

Economists Fed Rate Hike Forecasts

Coming into 2015, economists were projecting the first Fed funds rate increase to take place in June — now they believe it will occur in September. Market participants, on the other hand, are betting on December as seen in Fed funds futures pricing. By pushing out expectations of rate increases, the Fed has in effect eased.

However, I believe there is a reasonable chance the Fed could move in September. Fed chair Janet Yellen has repeatedly said that the Fed will not wait for inflation to hit its target. All that is needed is confidence that inflation is moving towards its target. If job growth continues at its recent pace, then it will be hard for the Fed to justify emergency level rates with unemployment approaching 5%.

Therefore, the July and August inflation and jobs data will be worth paying attention to. 200,000+ monthly job growth with rising inflation will cause the Fed to move in September. Since this is not currently priced into the markets, a major stock market correction could ensue. However, weak economic numbers could lead to a Fed on hold and a continuation of the recent choppiness or a slight move higher.

Nevertheless, the 4% year to date correction in the S&P 500 seems too mild to me, and I will wait patiently for more of a pullback.

 

Time to be Cautious of US Stocks

I have been quite bullish on the US economy and US stocks over the past couple of years. I viewed every correction as an opportunity to increase my long position. In fact, the near 10% correction in October got me 90% invested – one of my highest exposures to US stocks ever.

That sell off got me particularly excited because it was just before the most seasonally bullish period: the first 6 months of the pre-election year of the presidential cycle. As the following chart by Ryan Detrick shows, since 1950 the market has gained every time during the November to April period of the 3rd year.

Presidential Cycle Returns-2

With April ending last week, true to form, the market gained once again during the past 6 months, although by only 3.3%. Last week I decided to do some significantly selling so that I am now only 25% net long. However, I plan to remain long all the stocks listed in the trades section.

My cautiousness stems from not only from the seasonally unfavorable May to October period, but also due to sentiment and valuation. One important sentiment indicator, insider transactions ratio, shows that executives are selling much more of their own shares than buying.

Insider Transactions Ratio

In addition, Investors Intelligence survey of financial advisors and newsletter writers shows bears are near historic lows.

Investor Intelligence Bears

And the Hulbert Stock Newsletter Sentiment Index also confirms that bullishness is prevalent in the investment community today.

HSNSI 4:24:15

Valuation also presents a near term obstacle for stocks as the collapse in oil prices and the surge in the US dollar has caused S&P 500 earnings to decline while the market remains near record highs. As a result, the market is trading at 18x forward earnings estimates compared to the long term average of 16x. And there is a good chance that estimates of record earnings in Q3 and Q4 could be slashed.

An important support for stocks during this bull market has been the ‘Fed put’. That is, whenever stocks sold off or the economy weakened the Fed was ready to stimulate the economy with QE or pushing out market expectations of rate hikes. While that put still exists, I would argue that there is also now a ‘Fed call’ in play. If the economy or stock market were to heat up, the Fed stands ready to increase rates thereby capping the upside returns to stocks.

I want to be clear that I remain bullish on the US economy and stocks (in the long term). And without an imminent recession or sky high equity valuations, a bear market looks unlikely. However, sentiment measures and high valuations underscore the need for a 5-15% multi-month correction to refresh the bull market.

Shorting Palladium

A lot of my financial wealth was created riding the great commodity super cycle during the previous decade. In 2004, when I first had enough money to invest, it was apparent to me that the industrialization of China, the underinvestment in mining, and easy US monetary policy would create an ideal setting for commodities to rally. To speculate on this, I bought a basket of Junior gold exploration companies and watched their value multiply several-fold.

But in 2010, short seller Jim Chanos opened my eyes to the growing fixed asset investment bubble occurring in China. Fearing that a popping of the bubble could lead to a drop in demand for commodities and a stronger US dollar led me to believe that the great commodity super cycle was about to end.

Sure enough, commodities have been a house of pain for investors since then.

Commodities Price Performance

Most commodities have declined by 30-50% during the past 4 years with one exception: palladium. Palladium has been resilient while even platinum (a fellow PGM metal) lost 35%. Why did the palladium price decouple from the rest of the commodity complex in 2014?

Early 2014 saw the rise of tensions between Russia and Ukraine leading western countries to slap sanctions on Russia. That spooked the palladium market because Russia is the world’s largest palladium producer supplying 40% of mine supply annually.

Palladium 20 Year Price

In the late ’90s, western countries implemented stringent auto emissions restrictions requiring car companies to fit their cars with catalytic converters which require palladium. This caused a surge in palladium demand that Russian mines could not fully supply. The Russian government, desperate to build up foreign exchange reserves after their debt default, sold off its palladium stockpiles to meet the increased demand until it ran out of inventory. To rebuild its inventory, the government delayed issuing palladium export licenses causing a spike in palladium prices.

That experience has made market participants worried about any sanctions that may affect Russian palladium exports. In addition, mine workers in South Africa, the second largest palladium producer, were on strike during the first half of 2014. However, a resolution was reached last June and palladium prices topped out shortly thereafter.

Fears of western sanctions that block Russian palladium exports appear overblown to me because they would hurt western auto manufacturers, while Russia could still sell their supply to China and India. The global automobile industry consumes almost two-thirds of annual palladium supply.

As a side note, I believe the rise of electrical vehicles (which do not have catalytic converters), could cause a significant drop off in palladium demand down the road. But it will take a few more years for battery technology to be price competitive with and as efficient as internal combustion engines.

Nonetheless, I still believe that the palladium price will soon join other commodities and experience a significant decline. My confidence is based on chart analysis.

palladium price

From 2010 to 2013 palladium prices were tracing an alternating series of lower highs and higher lows – a pattern that chartists call a triangle. When the price eventually breaks out of the triangle, it could lead to a sharp move in the direction of the break. However, a false break could arise where the price fails to move quickly and reverses to fall back inside the triangle. This would signal that a sharp move could be forthcoming in the opposite direction of the false break.

In my experience, a well traced out triangle pattern in a widely followed market such as palladium often leads to false breaks. Sure enough, the Russian invasion of Crimea in 2014 led to a breakout, but the price failed to rise much and made only a marginal high before falling back below the lower trend line of the triangle.

I believe that palladium has experienced a false breakout and shorted it on Friday at an average price of $742. The beauty of this trade is that I can stop myself out if the price rises back above the trend line to approximately $775 on a weekly closing basis and take a small loss. Alternatively, I may add to my short position if the price breaks the downward sloping support line at $700.

I will be tracking the trade here.

 

Closing Fiat (Italy: FCA)

Today I sold out of my position in Fiat Chrysler at a price of €14.10. I established the position on July 28th of last year and enjoyed an 80% gain in 7 months. The company is benefiting from an improving European economy, a weaker euro, and the upcoming spinoff of Ferrari.

Although I see nothing wrong with the stock other than it is 80% more expensive than it was half a year ago, I am seeing better opportunities to play a European market melt up. Also, the stock is close to the €16.50/share fair value estimate presented by 2014 Ira Sohn Contest winner Michael Guichon.

I will remove the stock from my open positions.

Buying AIG (NYSE:AIG)

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.

AIG Financial Ratios

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.