Thursday, 5 April 2012

Why invest in AIG common stock when you can invest in AIG warrants?

An OUTDATED article (written on 24 Feb 2012) that is still relevant in today’s context.

With a modest intrinsic value per share of $60 based on a price/normalized earnings of 15x, the yield on AIG common stock is 120%. But why invest in the common stock when you can invest in the warrants with a maturity date on 19 Jan 2021 that would yield much bigger gains as book value and earnings would continue to grow at a modest rate in 9 years time?

Assuming a very conservative 6% CAGR growth in AIG’s book value and earnings, the intrinsic value per share 9 years later would be in the range of $100. While the 9-year yield on common stock becomes 270%, the warrants have a yield of 610%! Forget about AIG common stock; Consider the warrants!

Readers should note that our investment thesis and hence, the format of our article on BofA warrants is similar to that of AIG warrants, in which we have previously written in the article titled ‘Why invest in Bank of America common stock when you can invest in BofA warrants?’. The similarities of both AIG and BofA include (1) a business that has minimum leverage/excess liquidity due to the actions taken during the 2008 financial crisis, (2) have bad loans/investments written off (or be taken care of) and (3) the underlying share prices of the warrants have a dramatic upside potential when the respective business cycle turns.

Introduction on AIG common stock. As of 24 Feb 2012, AIG common stock has a share price of $29, with a book value per share of approximately $45 on 1,797 million of shares outstanding. As the annual earnings power in the past three years has been masked by (1) huge interest expenses (due to the government loan), (2) unfavorable market valuations in the investment portfolio mainly due to mortgage backed securities and the like, (3) catastrophic insurance losses, (4) insurance reserve strengthening and (5) goodwill impairments, we have adjusted the profit excluding these items and consequently, the normalized profit after tax is $4 per share. All these translate to P/B of 0.64x and P/normalized earnings of 7.25x.

(More on how we have calculated the normalized profit after tax, we have factored in a combined ratio of 108% (2006-2007 figures) on a low annual premium volume of $48bn (2010 figure) and a net investment income/premiums ratio of 37% (2006,2007 and 2009 figures) and a 30% tax figure.)

A modest intrinsic value per share of $60. The above table shows the past P/B and P/E that AIG common stock has been trading for the past 10 years. The average P/B and P/E of 1.89x and 16.86x is calculated based on the Dec 2003-2006 figures (Dec 2001-2002 figures are unrealistic). If a range of intrinsic value estimates is calculated based on past average P/B and P/E, there exists a profit potential of 100-200%. My estimated intrinsic value per share of $60, therefore, is modest. (The author suggests you do the calculations yourself – and be amazed!)

More on AIG. The recapitalization has more-or-less been completed as AIG has repaid government debt through asset sales and the bulk of the toxic assets have been written off through special vehicles in Maiden Lane 2 & 3 that have been put in place to absorb these assets. Forget about the Old AIG. The current AIG is a New AIG with (1) plenty of liquidity, (2) little or no debt, (3) assumed-to-be-undervalued mortgage-backed assets in its investment portfolio, (4) under-utilized insurance assets as certain wholesale channels are still off-bounds due to the AIG meltdown saga in 2008 and (5) $25bn or $14 per share of deferred tax asset to be utilized which is not found on the balance sheet (hence, not in GAAP book value calculation). All these points to both an undervalued GAAP book value per share of $45 and normalized earnings per share of $4.

If, through verification, you are stupefied by how undervalued AIG common stock is, you can forget about AIG common stock; Consider AIG warrants:

Introduction on AIG warrants. Unlike the typical short-dated warrant which is no different from a bet on a horse-race or a soccer-match, AIG warrants are long-dated with a maturity date on 19 Jan 2021 or approximately 9 more years before maturity. The current warrants price is $7.77, with a strike price of $45 (approximately equal to BV per share). The break-even share price, therefore, would be $52.77.

Downside risk is zero? Based on the current price and long-term nature of the warrants, we believe the downside risk is close to zero, if not zero. Of course, the authors disregard opportunity cost in their argument that follows. The payoff structure of a warrant is such that the investor of AIG warrants will lose its capital if the share price of AIG falls below $52.77. Assuming a very conservative 6% CAGR growth in AIG’s book value and earnings, the intrinsic value per share 9 years later would be in the range of $100. The break-even share price of $52.77 is approximately 48% below the estimated intrinsic value of $100, 9 years later. (Book value per share and EPS would increase to $76 and $6.75 respectively. At the break-even share price of $52.77, the P/B becomes 0.69x and P/E becomes 7.8x.) What is the probability that on 19 Jan 2021, AIG share price would fall below $52.77 or trading below P/B of 0.69x and P/E of 7.8x?

An awesome 9-year yield of 610% on the warrants! Now on the upside: With an estimated 9-years-later intrinsic value per share of $100, P/B and P/E would become 1.33x and 15x respectively. The main flaw in our argument is, of course, earnings and book value do not compound at a rate of 6% per annum moving forward. However, with a conservative ROE of 10% moving forward and a well-known fact that AIG retains the bulk of the earnings, my projected growth is absolutely conservative. Assuming our argument is not flawed, the warrants will yield an awesome 610%! (AIG common stock, meanwhile, only yield 245% though)

What if, on 19 Jan 2021, the price of AIG common stock is not 1.33x, but 3.00x of book value? With an estimated book value of $76 on 19 Jan 2021, the warrants would have a yield of 2255%!

Confessions of the authors: We have no idea why we have such a huge stake in BofA warrants. See to understand why.


  1. What is AIG's exposure to Japan's economy and currency?

    Same question for the Euro?

    Within 10 years one of the two will face a major crisis (my money's on Japan). Being an underwriter of risk, and with questionable results deriving from large tail risk events, how comfortable are you that their exposure is minimal and would not impact your thesis?

    Similar question regarding US Muni bond insurance and other Government debts?

  2. While we do not have the figures with us, AIG derives about 50% of their revenues internationally.

    Relating to your question on Japan and Europe and muni bond insurance exposure, AIG's property and casualty (P&C) insurance business is probably the best in the industry. Excluding reinsurers, AIG has the widest geographic exposure of all the insurance companies. This implies that (1)returns are derived from undertaking the least risk when compared with their peers, and (2) volatility of the returns is also minimal; AIG P&C business is an economic franchise.

    Just take 2011 for example, we have earthquakes in Japan and New Zealand, floods in Thailand and Australia, and tornadoes and hurricanes in United States. But AIG managed to break-even (paid $25bn in claims). In contrast, Thai Re which has consistently earned ROE of 20% would have went bankrupt last year because of the Thailand floods if Prem Watsa of Fairfax Financial did not recapitalize the company.

    And we all know that it is extremely difficult to build a 'direct' insurer with that kind of geographic exposure that AIG possess. Therefore, we still view AIG as being the elite of the P&C insurance industry both now and in 10 years time.

    Second, we are extremely impressed with how AIG managed to pay off the government debt of more than $100bn. Of course, this would not be possible without government assistance. But $100bn is a huge, huge sum and we think AIG deserves applause and recognition for it. It also gives us the comfort when we invest in AIG because if the future remains bleak for P&C insurance industry, AIG will be able to overcome any obstacle better than all of their peers.

    With regards to their investments (on other Government debts), they are pretty diversified with investments skewed towards corporate debt. In addition, within each category of investments including government debts, they are also pretty diversified.

    Of course, the insurance business is a leveraged business, so the figures for each category of investments are still in the tens of billions of dollars (while their equity is about $100bn). If anything is to blow up in there, AIG will suffer a fair share of losses. But what keeps us very excited and confident about AIG is their economic franchise in P&C insurance which we believe will provide annual recurring income (before tax) of $14bn. You may decide for yourself whether (1) our estimate of $14bn is reasonable and (2) if our estimate is correct, whether the $14bn will be able to cushion the investment losses relating to other goverment debts or even on U.S municipal debt.
    On top of that $14bn estimate, AIG common stock is selling at P/B of 0.6x, which implies the investor of AIG is expecting further losses. Therefore, you may also want to estimate with that kind of valuation, how much further losses can AIG business incur before an investor really 'lose money on AIG investment'. While we did not do the calculations, we figure out that AIG has to lose 'alot' of money before we start losing money on an AIG investment in common stock, which also explained why we invest in the warrants instead of the common stock.

  3. 12 guys in a room in London cost the company $100B. Yes, their earnings power is strong and they should be applauded for repaying their debt, but black swans are a common occurrence. Irrespective of their ability to generate cash, it must considerably trump risk. Between the Middle East, EU, Japan, and China, I cannot wrap my head around their exposures to have the same level of confidence as you. I wish you both the best of luck.

  4. We totally understand your concerns. Before we initiate a position in AIG, our discussions have always revolved around whether AIG would fail again.

    While many claimed the 2008 AIG meltdown saga as a black-swan event, the kind of businesses - credit default swaps and the insurance on mortgage-backed securities - that were being exposed in 2008 are just plain bad insurance businesses.

    Any student who takes Insurance 101 would understand that insurance businesses who undertake risk of widespread failure are bound to fail. The risk associated with 'failure-upon-an-occurance-of-financial-crisis' underlying the credit default swap business and the inadequate-pricing of the insurance on mortgage backed securities due to the undertaking of excessive risk associated with the real quality of the mortgage-backed securities as a result of 100% securitization of the mortgage-backed securities by the banks would guarantee these businesses to be unsustainable. But the magnitude of the devastating effects is unimaginable until the 2008 crisis.

    So we analyze the various insurance businesses that AIG has that fall under the category of 'risk of widespread failure'. And we are particularly concerned with the municipal bond insurance business. In fact, AIG has double exposure to municipal bonds, accompanied by their investments in these bonds. We believe this is the biggest risk that we are undertaking when we invest in AIG.

    However, the kind of confidence that we have over an investment in AIG is threefold. We believe it is worth taking the risk (1) associated with municipal bond insurance business and investments, (2) especially after what happened in the aftermath of 2008 crisis and (3) the price that we paid to undertake the risk.

    On (1): There is a fundamental difference between municipal bond insurance and insurance on mortgage backed securities: The originations of mortgage-backed securities are by the 'finance guys' who are profit-driven , while municipal bonds are issued by the governments.

  5. On (2): The 2008 meltdown saga would have result in tight supervisions imposed on AIG and regulatory measures undertaken and to-be-undertaken by AIG to prevent the failure of AIG again. To put it this way, if the 2008 meltdown saga did not happen, we would not have invested in AIG (and BofA) even if we believe both securities are priced attractively. These financial institutions are just way too complicated. Unlike many commentaries regarding criticism on the various regulatory guidelines imposed on these financial institutions, we believe the government is doing a wonderful job to 'stifle risk' (instead of 'stifile profitability' according to many commentaries) in these financial institutions. We believe these financial institutions will be earning an optimal return relative to risk for many years to come. (While capitalism has its benefits, the combination of capitalism and proper regulation and supervision in place would result in a more balanced approach in our view.)

    On (3): Finally, while we may find the business economics of AIG to be attractive, we take a gigantic position in AIG mainly because of the price that we paid as compared to the price others are willing to pay during 2000-2007. In our view, buying at the current price is equivalent to between 1/3 to 1/7 of what investors are willing to pay for the 'same thing' during 2000-2007 as the business fundamentals remain intact, and 1/2 of what investors currently are willing to pay for the other similar insurance companies. (We are led to believe that investors are still haunted by what happened in 2008 or investors are just not buying because government is holding a gigantic stake in AIG)

    While we don't hope to convince you or anyone with regards to an AIG investment, we feel obliged to reply as you have pointed out major concerns regarding an investment in AIG. We ought to thank you for the brilliant comments you have made in Valueground. We hope you will continue to 'patronize' Valueground and leave more comments in the future.

  6. Today CNBC announced Warren Buffet might be interested in buying AIG treasuries. This is only a RUMOUR
    at this time but it wouldn't surprise me in the least.

    AIG (NYSE: AIG) is ripping higher Thursday on rumors that none other than the Oracle of Omaha, Warren Buffett, could buy a large chunk of the government's remaining stake in the company.

    The U.S. Treasury still holds 1.248 billion shares of AIG common stock, or 70 percent of outstanding common stock. This is in addition to FRBNY's $9 billion loan to Maiden Lane III, which is preparing to get bids.

    Buffett, as you may know, is no stranger to the insurance business. His Berkshire Hathaway (NYSE: BRK-a) is huge in the space.

    Still the rumors are just that - rumors - and many of these have no merit.

    Street Insider

  7. Seems like his 'trigger finger' for the elephant gun is itchy again.

  8. I don't know if I've mentioned this before but Bruce Berkowitz owns over 24 million of the AIG warrants which is close to one third of the 75 million warrants. Cheers

  9. We have not mentioned it before but we are well aware of it. He got most of his options at a very low cost though. Imagine the profits he will be making in the future, tremendous.

    We felt a bit sympathetic towards berkowitz though for being one of the earliest investor in AIG. Now, we have others like Whitney Tilson taking a huge position in AIG. Cheers.

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  11. I have a question that I'd love your advice on... what are your thoughts on the JAN 2014 options with a strike of 50 trading at $1.00? If book value is, say, $75 by the end of 2013 and we're trading at 80% of book by then, that would indicate a share price of $60. $60-$50 strike = $10 on $1 investment (10-bagger). Am I crazy on thinking this is a decent risk/reward? What are your thoughts?

  12. Hi Mark, option is essentially a form of leverage to boost your returns, which explains the 10-bagger returns you are looking at now. However, there is always a risk of total capital loss due to the options expiring out of money. For the warrants you mentioned, our thoughts are that the time period is simply too short for it to be a sound investment.

    Contrast this to the long-dated warrant we mentioned in the article. From now till the expiry, we have got a good 8 years for our investment thesis to play out. There is minimal, if any, risk we believe in investing in these long-dated warrants instead. AIG just need to trade back to pb of 1, for us to make decent returns in the coming years.

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