AIG is Undervalued, but Buffett says...
Mike is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Remember the good old days of AIG (NYSE: AIG) when the financial world was coming to an end and people of all ages were wielding pitchforks outside the mansions of AIG execs? What fond memories.
Well since then, the company has gone through quite the crazy ride. The stock dropped over 97% and the Treasury/Federal Reserve combo loaded their boat with AIG commitments. At one point the Treasury owned 92% of AIG stock plus a ton of other commitments. Since all that fun, AIG has sold off huge assets, the Treasury/Fed has received a positive return on its investment, and the AIG stock is up 42% in the last 52 weeks.
Yes, the stock is up a lot lately but it is still far better deal than its peers. Time for a quick, back-of-the-napkin analysis. Let's compare PE and PB ratios, then look into quality.
AIG's price to book value is considerably less than most of its peers except for MetLife (NYSE: MET), which has a ratio almost as low as AIG. MetLife does have other problems though, like declining revenue and massive financial leverage. From the PE ratio perspective, AIG is far lower than all competitors. Prudential's (NYSE: PRU) PE is at 8.2 while AIG is only 3.1.
So AIG is cheap, but is it a decent business? Currently, their profit margin is at 30%...not bad given the other insurance companies are at 10%ish. AIG's profit margin will likely decrease when it starts paying taxes but that should only knock the profit margin down to about 20%. Plus return on equity is sitting at 26%, which is far higher than the others.
Looking at these numbers, AIG is a great investment compared to its peers. If it continues to increase its net income and its PE ratio moves up to the industry average, an investor could make a good return on their investment. At this rate of return on equity, AIG's income in 2 years would be about $9/share ((((Trailing 12 mo EPS - Taxes) + Book Value Today) x ROE)-Taxes), which is still less than the trailing 12 month EPS today due to AIG paying taxes in the future. Then if we assume AIG moves up to a conservative PE of 6 (it was more than triple this in its glory days), the stock price would be $54. That is a 50% gain in 2 years from the $36 price today. The stock is undervalued and AIG knows it. They are buying back their stock at prices far below book value.
Why is it Undervalued?
There are a few factors causing the low stock price.
1. The Treasury is madly selling AIG stock. The government seems to just want out as long as they have a positive return on the overall commitments they made in 2008-2009. Since May 2011, the Treasury started selling off its 92% stake. That is a lot of shares to get rid of in a couple years. After this September their stake will be down to 16-22% (depending on certain options being exercised) of the overall shares outstanding. This mass amount of supply is putting downward pressure on the stock.
2. AIG is still out of favor. People have the horrific memories of the financial crisis collapse.
These reasons make sense but investors that understand them have a huge advantage.
But Buffett Says...
In the Berkshire Hathaway letter to shareholders from 1996, Buffett writes, "What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected” -- You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
Does the overall business of insurance make sense to me? Yes, take risks at good prices and successfully invest the float. But is AIG within the circle of competence for me and 95%+ of investors? No. Most investors do not know insurance, especially when it comes to the nitty gritty attributes of certain risks, securitization techniques, and all the types of leverage/derivatives involved.
Given Buffett’s experience investing in insurance at Berkshire, it is within his circle but the average investor should either stay away or keep this investment an insignificant piece of his/her portfolio. Most investors need to stick to simpler investments that they understand like Coca Cola. Most people can grasp drink sales but not hidden derivative contracts.
Could the AIG stock jump 50% in the next few years? Yes, there is a good chance it will. However, investing out of your circle of competence is not a risk worth taking. If you are wondering why, just ask the investors involved with AIG only a few years ago.
mthiessen has no positions in the stocks mentioned above. mthiessen runs a partnership that invests in public and private companies. The Motley Fool owns shares of American International Group, Berkshire Hathaway, and The Coca-Cola Company and has the following options: long JAN 2014 $25.00 calls on American International Group. Motley Fool newsletter services recommend American International Group, Berkshire Hathaway, and The Coca-Cola Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.