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AIG Turnaround: How Did Bruce Berkowitz Know?

By Jim Fink on February 7, 2011

All investors and analysts are wrong from time to time; the key is how you recover from your past missteps.

Elliott Gue, Personal Finance

With the loss of the Pittsburgh Steelers, the turnover-prone football team I rooted for in the Super Bowl, I’m in a contemplative mood about other setbacks I have faced. Last April in an advisor roundtable, I discussed my worst investment mistake, and more recently I publicly ate crow for recommending a short of Netflix (NasdaqGS: NFLX) at a price much lower than its current one.

Mea Culpa on AIG

But there’s one more investment mistake I’ve made that I haven’t come clean on yet and is really gnawing on me: AIG. Last March, I wrote an article arguing that the stock of insurance firm American International Group (NYSE: AIG) – which at the time was trading for $25 — was actually worthless. Today, the stock is trading 60% higher at $40 per share and the U.S. Treasury announced on January 14th that it expects “taxpayers will get back every dollar of their investment in AIG.”

Actually, AIG’s 60% gain understates my mistake because, as part of a September restructuring, AIG issued a little more than half (0.533933 to be precise) of a 10-year warrant per share to buy AIG stock at a strike price of $45. That warrant is currently trading for $14.10, so feel free to tack on an additional $7.53 (0.533933*$14.10) to my blunder. As an aside, if you were wondering why AIG appeared to plummet so precipitously on January 20th, it was because the warrants were spun off from the stock that day, not because AIG announced any bad business news.

AIG Was Tough to Analyze

To be fair to myself, all investors – including Warren Buffett – make mistakes. And I found out only later – in May and August — that legendary Fairholme Fund (FAIRX) manager Bruce Berkowitz was buying AIG. I also can’t feel too bad because many smart people – including executives at AIG itself – believed back in the autumn of 2009 that AIG common stock was worthless. The company’s own balance sheet (p. 194) from its 2009 10-K filing revealed that it owed the U.S. government more than $100 billion and common shareholder equity (total shareholder equity minus preferred shareholder equity) amounted to only $40 million. Based on a share count of 135 million shares at the time, that $40 million in shareholder equity equalled a book value per AIG share of only $0.30 ($40 million/135 million shares).

Furthermore, the U.S. government had expressly stated in October 2009 that AIG’s “long-term stability” depended on it keeping all of its four profitable subsidiaries (AIA Group, American Life Insurance Co. (ALICO), Chartis, and SunAmerica Life). Yet, the company subsequently sold ALICO to MetLife (NYSE: MET) for $16.2 billion ($7.2 billion in cash) and sold 59% of AIA Group in an initial public offering for $20.5 billion, leaving it in control of only two core businesses: property & casualty insurer Chartis and life insurer SunAmerica.

But I wrongly dismissed as unimportant a decision by AIG executives in December 2009 to accept their bonuses in common stock. In retrospect, these executives must have had conversations with the U.S. government assuring them that AIG stock would retain significant value. Perhaps the government even told the AIG executives that it planned on converting its debt into common shares, which is exactly what it ended up doing (see below).

U.S. Government’s Debt Conversion Sealed AIG’s Turnaround

The real clincher for AIG’s successful turnaround was the U.S. government’s September 30th decision to exchange its $49.1 billion in AIG preferred shares into 1.655 billion shares of AIG common stock, thus increasing the government’s stake in AIG from 80% to 92.1%. To find the share price AIG common stock must trade for in order for the U.S. taxpayer to break even on the bailout, simply divide the government debt of $49.1 billion by its stake of 1.655 billion shares and you get a price of $29.70 per share. With AIG at $40 today, the U.S. government not only breaks even but makes about a $17 billion profit.

Of course, AIG stock may not stay at $40, especially when the government begins flooding the market with sell orders, but the company’s latest balance sheet from September (p. 5) states that book value per common share has risen to $48 per share, so it’s looking pretty good for U.S. taxpayers. Going from a book value of $0.30 per share to $48 per share in less than a year’s time is quite a turnaround!

It just goes to show that mark-to-market accounting can produce tremendous value fluctuations in a short period of time. I also think that the Federal Reserve’s quantitative-easing program has inflated both stock and bond market values, which has helped troubled companies like AIG get back on their feet in record time. As I noted in Best and Worst MLPs of 2010, “quantitative easing and an economic recovery have helped junk rise to the surface.” In a more normal monetary environment, I don’t think AIG’s quick turnaround would have been possible.

Bruce Berkowitz is Either an Oracle or a Lucky Gambler

Just as amazing to me as AIG’s turnaround – which I could not foresee — is the fact that Bruce Berkowitz did foresee it and bet heavily on it. Berkowitz currently owns 44 million shares of AIG, making it his fund’s largest position and about one-third of AIG’s entire share count not owned by the government.  Berkowitz recently explained his thinking in a Fortune Magazine article:

All of my most intelligent friends in the insurance world think I’m an idiot. These are CEOs of insurance companies. But it’s just right there.

At its core, AIG’s intact franchises make money. The good thing about AIG is that it’s just so complex. For a mere mortal with an average intelligence, it takes a long time to try to put all the pieces together. It’s all there to be put together, it’s just that you need to have no social life and not too many investments.

This Berkowitz quotation reminds me of Albert Einstein’s famous statement: “It’s not that I’m so smart, it’s just that I stay with problems longer.”

Personally, I think that Berkowitz took a gamble that the U.S. government would convert its debt into common shares. If it hadn’t, I’m pretty sure AIG’s common stock would be trading today at a much lower price than it currently is. But Berkowitz’ gamble paid off; he was right, I was wrong, and I give him all the credit in the world.

The Best Financial Stocks Can Be Found in Personal Finance

Personal Finance is composed of an all-star team of analysts that beats the market by providing penetrating bottom-up analysis of public financial information as well as top-down analysis of industry trends.

In Personal Finance, both Elliott’s “Growth Portfolio” and Roger Conrad’s “Income Portfolio” currently include a select number of carefully-vetted financial stocks. In fact, Elliott just recommended a money-center bank in the latest issue (Feb. 4th) of Personal Finance, stating:

Banks enjoy a healthy spread between their borrowing costs and what they charge on loans. The economic recovery should bolster loan volumes. Several of the nation’s largest financial institutions noted an uptick in demand for commercial and industrial loans, even among smaller companies that are more sensitive to economic conditions. This nascent trend should gain strength throughout 2011, which is good news for the sector.

To find out the specific names of the financial stocks Elliott and Roger like best now, give Personal Finance a try today!

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