Yesterday I was reading an interesting in interview with Bill Ngyren who is a famous value investor that runs Oakmark. Ngyren’s funds are also invested in AIG as well as a few other financials similarly to how we’ve been invested for years now. His rationale is not much different than mine, but I thought I’d share it just to add additional perspective on the investment. Here is his basic description of the investment thesis in AIG:
Please comment on your view of American International Group Inc. (AIG) going forward and on your estimates in growth in BV/Share for the next 5-10 years.
At the end of March, AIG’s stated book value was $80 per share. Most analysts tend to discount stated book and instead focus on book value ex- AOCI and DTA, which is just $61. Oversimplifying, that means excluding unrealized gains in its bond portfolio and excluding the value of its deferred tax asset (because of historical losses, AIG won’t be a cash taxpayer for years). Even using the $61 number, AIG stock at $58, to us looks inexpensive because we believe that an insurance company with a valuable brand name ought to be worth somewhat more than book value.
Looking out seven years, let’s assume that AIG averages after-tax earnings of $6 per year, or a total of $42 of income. That level of income would be enough to exhaust its tax loss carryforwards, so the $11 DTA would turn to cash. Additionally, over seven years most of the unrealized bond gain would also be realized. There will no longer be a reason to report three separate book value numbers. The $80 GAAP book would grow to $122, and the other book value numbers would also grow to roughly that same number (for this example I’m ignoring the small dividend AIG currently pays). On that basis alone, AIG stock would be positioned to more than double over seven years just by returning to book value.
What that analysis ignores, however, is what management will do with the excess capital the company earns. One of the reasons we own AIG is that management has demonstrated a willingness to grow by shrinking – that is to grow per-share value by reducing the shares outstanding rather that attempting to grow the size and value of the total company. Because AIG sells for less than book value, each share it repurchases increases the book value of the remaining shares. Because of that, our expectation is that seven years from now AIG will have fewer shares outstanding than it has today, and book value per-share will be higher than the numbers in the prior paragraph.
Ngyren is absolutely right in his analysis and this same basic arithmetic goes for all of our key financial positions. Because we are buying the stocks at such cheap prices, the companies don’t have to earn heroic returns on equity to make the investments highly profitable for us as they already have been. When you compare these types of opportunities to the overall market, you really have a tale of two cities. The overall market is not attractive whatsoever! Just about every bull thesis is based on earnings multiples going even higher than historical averages because of low interest rates. This is not an “investment” thesis but instead is much more akin to “speculation.” The reality is that we are at the point in the investment cycle when a lot of market participants will be making the big mistakes that cost them a significant amount of money, not unlike what we saw in 2000 or 2008. One of the biggest mistakes people make is chasing short-term returns instead of focusing on the long-term strategy. I’ll be putting out more content related to current valuations, but rest assured that we aren’t deviating whatsoever from our deep value investment strategy and I’m confident that with investments like AIG, etc., we should be able to post very attractive returns even in what I expect to be a very low returning equity market on average over the next 3-5 years. Below is my recent investment report on Deutsche Bank (DB), which I believe to be one of the most undervalued banks in the world: