AIG: Opportunity Knocking

We have recently started a long position in AIG. We are approaching a time that will represent an opportunity that does not come around very often. Of course there are many negative connotations that are involved with AIG in the present day, and will probably persist into the foreseeable future.  We currently own 40 dollar calls that expire in January 2015.

It is not a secret that AIG was deviating from their core business of insurance and became a multi-faceted company that was one of the most levered companies in history. Their bets that turned sour could have taken out our financial system. Fortunately the government came in and bailed them out. The government owned 92% of shares, and was helping the company stay in business to unwind these trades. Since 2007 AIG has worked to get back to its core as an insurance company. They have sold the majority of their non core businesses and have been focusing more on guaranteed profits. As an insurance company, they have consistently been able to generate solid earnings with little risk.  This is why we are buying AIG –  as an insurance company they present an opportunity we have never seen.

AIG, as controversial as it may be, is in a wonderful spot. They are currently trading at 32.40, an extreme discount to their book value. If you are not familiar with insurance companies, their book value is never this deeply discounted. AIG ex AOCI book value currently stand at 61.49. This is up a whopping 9.6% since last quarter’s reported earnings. With this huge jump in book value, the market is still highlighting the negatives. Although we think it is important to note the negatives: their ROE is trailing industry peers, their combined ratio has been higher than recent street expectations, a low interest rate environment will hurt earnings power, recent hurricane Sandy will be a large hit to cash, and the government still owns 15% of shares outstanding.

We think that the majority of these negatives actually reinforce our bullish case. ROE is trailing peers because the company has been trying to get back to the basics with insurance.  To aggressively price insurance your premiums received are going to be lower until you are able to compete better with your peers. This is a natural cycle of supply and demand.  To increase demand you need to lower the price paid up front by the consumer. Once they are able to increase NWP(net written premium), they will have a larger revenue stream in the future. This is why they have trailed peers with their ROE.  They were also subject to large losses that were not classified as a catastrophe within the last year.  These losses were very unusual as far as insurers are concerned, but not large enough to be categorized as a catastrophe.  This is why their P&C earnings were light.  The low interest rate environment will affect everyone equally, so each firm will struggle to make a decent profit on their annuity products.  Hurricane Sandy exposure is currently less than 1% of book.  Other industry peers have already announced related losses and they have not been worse than expectations.  One of the last hurdles for AIG is that the government still has a 15% stake.  This has diminished with increasing velocity, with the last lock up expiring on November 9.  Now the company is free to buy out the rest of the stake and start to return cash back to shareholders.

We are in a slow economic recovery, but the majority of AIG’s risk assets have been sold for a gain and their focus has been getting back to insurance.  There are risks that remain with AIG, but does not currently carry any more risk than its peers.  Their huge increase in book value recently gives them more earnings power than any one else in their industry.  As low interest rates persist, they will be able to buy back shares at a 50% discount.  Every share they buy back is immediately accretive.  This makes AIG a very unique case.  We think the company’s main focus will be to buy back shares and this makes owning long dated calls extremely attractive, as you get exposure to extraordinary upside without having to tie up much capital.  The longer AIG stays in the low $30 range, the more we will be accumulating.

The Bear Case for Apple

To say Apple has had an amazing run over the last few years is an understatement.  The company has completely changed people’s lives forever.  We’re not here to discuss whether they are still the most innovative company in the world.  We’re here to discuss how recently, the company has changed, and how that change is a cause for concern for investors going forward.

Our biggest concern is what seems to be Apple’s fundamental change of philosophy since Steve Jobs passed away.  Under Jobs, the company was revolutionary in the consumer electronics category.  The company literally created new categories of products under his watch.  Each and every update to each product was something so simple, yet so new, that one could not help but impressed with its design.  Under Jobs, Apple truly was a “rebel” in consumer electronics category.

That seems to have changed.  With the release of the iphone 5, Apple seems to be making products that are more evolutionary, than revolutionary.  Although it’s great that they are making their products faster and lighter, there’s no “WOW factor” there that we had with the first editions of the iphone.  Furthermore, the ipad mini seems to be more of a response to competition than anything else.  It is something Jobs did not want to make, and even worse, in an attempt to make it more competitive in the marketplace, the specs are even worse than the ipads currently on the market.  This is something Jobs would have, without a doubt, never let happen under his watch.

This brings us to the question on margins.  Following last quarters report, people are  concerned about the company’s margins going forward.  Apple is known for guiding conservatively, but the margins for Q1, seem to be overly conservative.  Now, we think they are setting themselves up for a beat, but still why so much caution going forward?  Could margins on the subpar mini be significantly worse than the regular sized ipad?  And then compounding the problem by cannibalizing sales?  Is competition finally catching up to their innovation and causing Apple to retaliate by cutting profits?

Apple stated in their release that generally when they release a new product, their margins are lower, and then begin to normalize over time.  Recent media reports say that the company is looking to shorten the product life cycle and begin an iphone 5s refresh in September.  Two questions come to mind: 1. Why shorten the product lifecycle if it will impact margins negatively?  2. Why alienate loyal supporters by shortening the lifecycle?  With the ipad mini announcement, Apple also released a new version of the regular sized ipad, a mere 6 months after the last refresh.  As buyers of all things Apple over the last few years, we can tell you that we are not rushing out to buy either the ipad mini or the new New ipad.

All this brings us to the stock price.  Institutional sponsorship of the stock is at nosebleed levels.  In the quarter ended September 2012, 231 hedge funds held the stock in their accounts, up from 230 in June 2012, but more importantly up from 173 in March of 2011, when the stock closed at $348.  Value funds, growth funds, dividend funds, and individual retail investors all love the company.  So then the question becomes, who is the incremental buyer?  Where do we find the greater fool?  We’ve been hard pressed to figure out who that is.

We closed our short position last week at around $545 after shorting above $660 and around $700 on the day of the iphone 5 announcement and first day of iphone 5 sales.  At these prices, we don’t like the risk/reward on the short side, although our thesis remains intact.  The short will get much more interesting to us when the stock tops out above the the 50 DMA, which currently stands at $621.  Until then we will stand on the sideline waiting for our opportunity to present itself.