AIG: Diamond In The Subprime Rough? (AIG)

By Wayne Pinsent | August 15, 2007 AAA

The subprime meltdown is having big implications on the market. Not too long ago, Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson both went on record saying the subprime problems would be contained.

But now, it appears they may been mistaken, as the problems are now seen bleeding across the credit markets.

While there are some justifiable concerns in the market, some of the recent movements in equity markets have been largely due to sentiment and not on fundamentals. However, there is still some great value in the market when focusing in on the latter. American Insurance Group (NYSE:
AIG) recently reported earnings, and even with subprime ties the business looks to be on very solid ground. (For more on Subprime lending, see Subprime Is Often Subpar.)

Diversification
Subprime loans and housing sector problems are tearing through the markets, and some of AIG's business is closely tied to this. The reason AIG is different from the other companies getting crushed is two-fold. First, AIG has a strongly diversified business. AIG said in its release that its mortgage insurance business weakened during the second quarter due to the weak U.S. housing market, with the unit losing $78 million.

Its American General Finance business unit also saw moderate adverse effects from subprime exposure, which constitutes about 31% of its real estate portfolio. Yet, even with these problems, the company still grew net profits by 34%, beating consensus estimates. This was led by strong results from its Property and Casualty and Life insurance groups, which have consistently performed well.

The Right Exposure
The second reason AIG is different is due to the nature of its subprime exposure. Along with its earnings release, the company outlined the strength of its asset pool. Of the company's subprime mortgage-backed securities, 98% are rated AAA or AA (86% and 12% respectively). Management said that it would take Depression-era declines in housing and record-setting default levels for the business to be harmed.

Despite defaults rising, AIG has enough cash to mute those effects. Unlike hedge funds and investment banks reeling and taking losses to get rid of anything tied to mortgages, AIG is comfortable with the quality of its investments and can hold them to maturity. This eliminates the interest rate sensitivity that is ripping into the rest of the market.

A Value Buy
One effect of the recent market plunge is that it is offering long term investors opportunities to buy financial companies cheap. You have to be selective and prudent in your choices, but there are some very attractive stocks getting taken down by systematic risk. I mentioned in a previous article that Citigroup (NYSE:C) looks like a very smart long-term play, and AIG looks good on all the same metrics.

The stock is currently trading at less than 10-times forward earnings estimates. Historically they have traded at around a 16 price-earnings multiple. The cause of the plunge is not based on the underlying numbers for the company, since they have continued to look good. The plunge is due to anything financial being dragged down, and once focus gets back to the company itself there is plenty room for the stock to go up.

Tread Lightly
While I do believe this is a great value going forward, there are short-term concerns. Liquidity has been drying up in the markets, due to subprime problems. I believe that AIG's core business will remain stable and strong throughout this volatile period in the markets. However, it would be imprudent to jump right in during such a rocky market environment. Even if subprime doesn't damage AIG's business, it can most certainly affect the stock price.

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