Assured Guaranty reports earnings on Thursday of this week and the conference call will be Friday, after which I’ll post a full and comprehensive research report. There are few investments that I’ve been so excited and so confident in.
In a very expensive market where there are very limited opportunities, many, if not most market participants, are allocating money into investments that are unlikely to earn satisfactory returns over the next several years and could potentially generate very large losses. That doesn’t prevent analysts from recommending FB at 100 times adjusted earnings, or Netflix, or Amazon for that matter at similar valuations. Great companies that are now finding growth difficult to come by such as Procter & Gamble and Coca-Cola trade at 20 times forward earnings, and could easily decline 15-25% in a valuation adjustment, and likely have very little upside.
I’ve done more research on Assured Guaranty than any company in my career. I’ve talked with management of it and its competitors, and I’ve been invested in the company in some fashion for over 6 years now. I’ve witnessed the company go through the Financial Crisis and emerge as the leader in the industry. In March of 2009, the stock traded at $2.53 per share, so clearly it has done well. Believe it or not, I believe right now we have the best risk-adjusted opportunity we have ever had on the stock. The reasons are various but let’s start with Puerto Rico.
Puerto Rico is clearly in financial trouble and Assured Guaranty has exposure to various Puerto Rican bonds. It is important to understand two things. First is that different bonds have different legal and collateral protections, so not all Puerto Rican bonds are created equal. The second things is that Assured Guaranty is only obligated to pay interest and principal when due. Many of these payments are very far into the future so the present value is much less than the notional numbers. For taking on this risk, Assured Guaranty has already collected a premium, which it has been and continues to be investing with its massive investment portfolio, which exceeds $10 billion and generates about $400MM in investment income a year. There has been and will continue to be a great deal of noise about Puerto Rico, just like there was with Detroit where AGO and other bond insurers were also involved. A Governor can say “we can’t pay out debt” till they are blue in the face, but in reality there are protections in place and restructurings can take place inside or outside of court. For instance, Puerto Rico has one electric utility that is owned by the Commonwealth referred to as PREPA. This utility uses expensive oil to generate power and has been run in an immensely bureaucratic and inefficient way. PREPA made a very large payment on its debt on July 1st, the day after the Governor said the island couldn’t pay its debts. If PREPA defaulted on its bonds, the creditors would be able to appoint a Receiver. This is somebody that comes in and basically cuts all of the fat out of the company to protect the creditors’ interests. It is undesirable for PREPA to have this occur because it means a lot of bureaucrats with high-paying jobs will likely be let go, so for the sake of self-interest it makes a ton of sense to do whatever it takes to service the debt. While most commentators are basically assuming Puerto Rico will restructure most of its debts, I believe they will turn out to be very wrong. Weak bonds with little protection will likely see missed payments including an issue today, that AGO is not exposed to. Puerto Rico needs access to capital and defaulting on key debt and fighting with creditors is a great way to lose access to capital.
Puerto Rico has actually taken a lot of strong steps such as raising certain taxes and prices, which are very beneficial to its ability to pay its debts. If a default does occur on a certain bond, the next question is how does the restructuring work? There are various ways of dealing with this such as forbearance, interest rate reductions, or possibly a haircut. Regardless, AGO is only exposed to the highest quality Puerto Rico bonds and the severity or amount of a haircut that It would take on any issues, is not likely to be nearly as severe as much of the talk would indicate. Detroit was in even worse shape, albeit with less debt and Assured Guaranty barely lost any money whatsoever on the restructuring despite talk that many of the bonds would only get pennies on the dollar. Assured Guaranty also insured Detroit’s refinancing, which further reduced the loss and we would likely see similar circumstances with any Puerto Rican future debt issuances. None of the talk matters, it is just part of the negotiation.
This leaves us with a company that could not be liquidated for less than $40 per share, trading below $25. Another important metric is Adjusted Book Value for this industry. That number will likely be in the high $50’s by now and this number basically approximates the liquidation value including its unearned premium reserve, minus expected losses. Now this doesn’t mean the stock can’t trade down to $20, or any price for that matter. Most market participants chase short-term performance and don’t look at fundamentals. So if a Hedge Fund is trying to short Puerto Rican debt which is not easy to execute, it might instead sell short the stock of a company like AGO, which has exposure to it. This can create volatility but is completely irrelevant over the long-term.
Even better, Assured Guaranty is overly-capitalized, as its portfolio is amortizing at a more rapid rate than it is writing new business due to low interest rates. This means that with the additional capital, the company is buying back stock aggressively. It doesn’t take a genius to figure out that when you are buying dollar bills at 50 cents, the economic benefit is tremendous and that is exactly what is occurring right now.
Lastly, I wanted to touch on how the stock options work, specifically the puts we have sold. We’ve been selling puts on this stock for 6 years. It has never been a mistake, whether they have expired worthless giving us our whole premium or when we’ve gotten exercised and ended up owning the stock at cheaper prices. Over the short-term though, the option prices can increase and cause short-term mark to market losses. For instance, say we sold $25 January 2016 AGO puts for $2.50, or $250 on 100 shares. Our target return would be 11.11% on a maximum risk of $2,250 ($2,500-$250 premium). Our breakeven price per share would be $22.50. Well if the stock declines or if volatility increases, those options go up in price. Right now they might be going for $3.10 let’s say. This means that we are down on our position, but ultimately in January the options will expire. If the stock is above $25, we will have made that 11.11% return. If the stock is below $25, we’ll own it at a price of $22.50. Keep in mind that we believe this stock is worth over $40 per share. How many opportunities do you think there are to double your money over the next 3-5 years, with an investment that has very little risk of permanent losses of capital?
This is why we are big on the stock and big on sold puts. When all of our research, no matter how far we dig in, points us into this belief that over the long-term we cannot envision how we will be wrong, we bet convincingly! You only need a few great investments in your life to get rich and this is the furthest thing from a gamble, as we have a massive margin of safety. As a client, the biggest risk for you is that short-term swings will scare you out of the position. This is why all I talk about is focusing on long-term performance. We are looking 3-5 years out, not month to month or even just 1 year out. I could not be more excited about the opportunities that we have to significantly improve all of our financial conditions as we let these investments play out, but realize, our performance is likely to differ materially with the overall market. I view that as being a very good thing, as I’m not that optimistic on the overall market. I’ve been aggressively adding personally, and if you have additional capital that you are looking to invest I’d recommending giving me a call 805-886-8140, and I can help you put it to work in a smart and disciplined manner.