Investing in AIG at a Discount: Upside Value in a Beaten Down Stock

American International Group (AIG) was one of the most maligned companies following the subprime crisis. The company was berated by the public and the stock was ignored by investors. More recently, AIG regained some investor attention when famed value investor Bruce Berkowitz amassed a sizeable position in the company.

While his bullishness and success have turned heads and changed some minds, AIG is still far from a popular stock. AIG closed at $38.54 on February 25, a discount to the company's $46.80 per share book value on December 31, 2010. Not only is the company still burdened by a damaged brand, the stock price is weighed by an impending sale of the government’s 92% stake in the company.

Despite this ominous backdrop, there is an attractive investment opportunity in the AIG rumble. As part of the government’s reorganization of AIG, they allowed the company to issue 75 million warrants to existing shareholders. The warrants are American style securities that expire in January 19, 2021. The warrants have a strike price of $45 and dilution protections that adjust the warrant exercise price to the extent that cash dividends exceed $0.67/year.

Based on closing prices from February 25, the AIG warrants trade at an implied volatility of 27% (as calculated by the option calculator at iVolatility.com). This level is much lower than the 32% implied volatility of the JPMorgan (JPM) TARP warrants that expire on October 2018. If the AIG warrants were to trade up to an implied volatility of 32%, the warrants would be worth $14.41, a 14% premium to the current price. JPM’s implied volatility is a conservative comparison for AIG, whose warrants could demand a higher implied volatility because of its smaller size and greater uncertainty of future prospects. A 35% implied volatility would value AIG warrants at $15.50, a 23% premium to current prices.

CALCULATION INPUTS

Prices are as of the February 25th close.

I set the interest rate to 4.5% because of the current yield on the 30 year Treasury. If you use a lower interest rate, it will decrease the value of the warrant. If you use a higher interest rate, it will increase the value of the warrant.

AIG warrants:

• Expiration: January 19, 2021
• Strike: $45
• Option Price: $13.05
• Stock Price: $40.43
• Dividend: $0.67 (Dividends in excess of this amount will adjust exercise price of warrants)

JPM warrants:

• Expiration: October 28, 2018
• Strike: $42.42
• Option Price: $16.83
• Stock Price: $46.88
• Dividend: $1.52 (Dividends in excess of this amount will adjust exercise price of warrants)
• Implied Volatility: 32%

INVESTMENT OPTIONS

Treat the AIG warrants as an arbitrage by buying the warrants and shorting AIG equity to remain delta neutral, possibly netting a 14% return.

If you want the long exposure to AIG, you can think of the undervalued warrants as offering an additional margin of safety to your investment. For example, if the AIG warrants are supposed to trade near an implied volatility of 32%, you are effectively buying a warrant priced as if the underlying stock were priced at $36.05.

Use listed AIG options to hedge long exposure in the AIG warrants. This could be a good strategy because the listed options trade above a 32% implied volatility. In addition, with the looming sale of the government’s 92% stake in the company, near term stock appreciation may be limited. Under this scenario, you should be very comfortable with options and understand the risks associated with shorting calls and mismatched hedges.

Disclosure: I am long AIG warrants.