We’ve all seen it happen. You buy a stock and then it steadily drops in value. Either you were ill-informed about the investment idea, or simply off on your timing.

I’ve never wavered from my belief that municipal bond insurer Assured Guaranty (NYSE: AGO) had the makings of a great investment, but I also knew it could slump further before finally rebounding. And this is precisely what appears to be happening. The path to solid upside remains very much in focus.

This stock is up roughly 5% since I last looked at it in August 2011, but investors have had to hang on while the road got bumpy.

While this may just seem like a sideways stock chart, it’s the move during the past six weeks that should really get your attention. The stock has surged more than 40% from its lows, and if the chips fall into place, then it could double in value from here.

#-ad_banner-#This has been a poorly understood business for more than a year. Many investors have been under the impression that Assured Guaranty was exposed to significant risk ever since high-profile analyst Meredith Whitney warned that we’d see a massive wave of defaults in 2011. She was wrong, and as that prediction fades from view, investors are finally beginning to understand this is a healthy business with a sharply undervalued stock.

As I noted last summer, this stock traded for less than half of book value simply because investors feared that book value would sharply erode. After all, Assured Guaranty is on the hook for hundreds of million in loans if states and local governments default on their obligations. Providing bond insurance can be quite lucrative — especially since key rivals have had to retrench, and Assured Guaranty can exact even more profitable terms for its insurance — but the risks are abundantly clear.

In the past few years, I’ve penned several articles about the perilous condition of state and local budgets. More than a year ago, I wrote that a number of states had massive budget gaps that may be impossible to close without a miracle.

Well, no such miracle was needed. States laid off many employees, reworked union contracts and, most importantly, started to see revenue rise as sales tax receipts rebounded with the economy.

Where do things stand today? We can get a glimpse of the default risk by checking in on Illinois, which was faced with a 41% shortfall for fiscal 2011 when I last looked at the state’s financial picture. Fast forward to early 201,2 and bond rating agency Fitch Ratings just gave Illinois an “A” grade to $525 million in newly-issued general obligation (GO) bonds.

Here’s what they wrote:

“Following several years during which the state was unwilling to take action to restructure its budget to achieve balance and increasing reliance on borrowing to close budget gaps, the temporary increases in the personal and corporate income taxes that became effective Jan. 1, 2011 and enacted spending limits closed a significant portion of the structural gap in the state’s budget through fiscal 2014.”

Investors have stopped worrying that a major municipal bond default is looming. Here’s a fresh look at the Municipal Bond Index since I looked at Assured Guaranty back in August.

 

The actual impact for Assured Guaranty is negligible. Analysts are unlikely to boost their earnings forecasts for the bond insurer simply because state and local government finances are improving. Instead, the risk in the stock is sharply declining, which explains why it has begun to rally in recent weeks.

Yet even with a strong recent move, investors need to assess this company’s value in the context of its balance sheet. This is a company that is being valued at $2.6 billion, but has tangible book value of $4.8 billion. Said another way, the $14 stock has roughly $26 in tangible book value — almost twice as much. Here’s the best part: Assured Guaranty is earning roughly $3 a share every year, so tangible book value is likely to top $30 sometime early in 2013, assuming current business trends remain intact.

Also note that a clear catalyst exists for the very near future. Back in November, Moody’s downgraded its rating on Assured Guaranty’s bonds from “Aa2” to “Aa3,” the fourth highest investment grade. This effectively prevented the company from writing new business. The company noted — correctly in my view — that Moody’s perception of heightened risk for Assured Guaranty’s bonds was mistaken, as no signs of distress had emerged. The company made plans to sit down with the ratings agency this quarter, and it has expressed confidence that Moody’s will reverse course.

Moody’s cut Assured Guaranty’s financial strength to the fourth-highest investment grade. This forced the company to cease any new underwriting until the rating changed. Equally important, Assured Guaranty has signaled plans to conduct a stock buyback when the matter is resolved. Trading so far below tangible book value, this is the wisest move the company can make.
  
Risks to Consider: Although the chances of any major municipal bond default now appear increasingly remote, any headlines about struggling state and local finances could scare investors once again.

Action to Take –> Will the stock trade up to book value? Not any time soon. Perhaps never. But the stock will most likely move TOWARD book value as the risk recedes.

Using a rough approach to the “de-risking” taking place with this stock, I see no reason it can’t hit $20 later this year, and $25 by 2013. If the economy is on a truly healthy path 18-24 months from now, then this stock could very well trade up to book value, implying a potential double for patient investors.