#-ad_banner-#By now, even the most casual investor (and American taxpayer) is familiar with the American International Group, Inc. (NYSE: AIG) story.

 

The company’s financial products division drove the company to the brink of bankruptcy, and the largest private sector bailout in American history saved it.

 

But those who dismiss AIG as an investment opportunity today because of past mismanagement are missing an incredible turnaround opportunity.

 

The company has divested numerous assets in an effort to slim down and simplify. Most importantly, it no longer has the financial products division that destroyed shareholder wealth in 2008 and 2009. Despite these positive steps, the company’s turnaround is still in the early stages and offers a lot of upside for patient investors.

 

If you’ve been hesitant to believe in and invest in the post-crisis AIG, then most of Wall Street agrees with you. AIG’s share price has barely budged these last 18 months, while the rest of the market has shot to new highs.

 

AIG’s lackluster stock performance, while share prices of rivals have surged, has created striking valuation differences among property and casualty insurance industry stocks. Competitors, like the The Travelers Companies, Inc. (NYSE: TRV) and The Chubb Corp. (NYSE: CB), trade at price-to-book values of more than 1.4; AIG trades at just 0.7 times book, significantly less than even its breakup value.

 

While Travelers and Chubb are extremely well run companies, the growth needed to justify the valuations just isn’t there. With AIG, investors have the opportunity to pick up a Ben-Graham-style bargain.

 

But make no mistake, this is a turnaround story. AIG must continue to improve its core insurance operations to reach its full potential. Chubb and Travelers trade at premium valuations, because each company has a firm grasp on insurance industry best practices. The combined ratios of the three companies, which measures what percent of income gets paid out to claimants, tells the story.

 

 

For every $100 AIG in premiums received from customers between 2012 and 2014, it has paid out more than that in claims, as the chart above highlights. Travelers and Chubb consistently create operating profits by keeping this ratio below 100.

 

AIG is a clear risk-management laggard, but the trend is encouraging. While the company can tread water with a combined ratio at these levels, it needs to consistently remain below 100 for AIG to truly thrive. As long as this number stays above 100 and AIG’s insurance operations operate at a loss, management’s ability to run the company will be called into question. And investors won’t have unlimited patience with this subpar performance.

 

The company’s second path to greater profitability is out of its control, but is still significant. AIG (and every other insurance company) invests the vast majority of collected insurance premiums, called float, in highly-liquid corporate and government bonds. That money is held in reserve until it used to pay out claims.

 

The Federal Reserve’s policy to keep interest rates near zero hampers AIG’s ability to garner meaningful returns from its investment portfolio. If and when interest rates do rise, the higher yields AIG receives on the investable float will flow directly to the bottom line.

 

Despite low interest rates and some business difficulties, AIG has boosted  book value per share to $77.69 at the end of 2014, from $52.81 in 2011.  Book value per share is rising quickly, because shareholder’s equity is steadily growing while the share count is falling, thanks to ongoing share buybacks. Eventually, shares, which are currently worth around $55, will trade up to that tangible book value per share figure.

Yet book value isn’t remaining static. I anticipate it will rise to around $115 per share in 2021, and the upside is even greater if AIG’s operations continue to improve. You could buy the stock and earn annualized gains of 13% plus dividends.

 

But I have a better approach for this stock.

 

As part of the government bailout, AIG issued warrants (NYSE: AIGWS), which are essentially long-term call options on the stock, with a strike price of $45 and an expiration date of January 2021.

 

Purchasing the warrants certainly carries higher risk. If AIG’s stock doesn’t trade above $45 in 2021, the warrants expire worthless and your entire investment is wiped out. However, if the stock’s price reaches $115 in 2021 (which means the stock is trading at a price-to-book ratio of about 1), the 20% annual returns for the warrants will trounce the returns of the common stock.

 

Risks To Consider: AIG’s business performance is still on unsteady footing> Management needs to improve profitability and expand the business while maintaining prudent risk-management. AIG’s CEO Peter Hancock is still in his first year. While Hancock is a highly regarded industry veteran, his actions warrant extra scrutiny until he proves himself to be a suitable leader.

Action To Take –> For aggressive investors comfortable with a longer time horizon, the warrants, which currently trade around $24, offer a very reasonable opportunity for 20%+ annual returns. Please read the company’s explanation of the warrants here. For more risk averse investors, the common stock still looks very cheap and pays a small dividend.

Special Note: Our friend Frank Bermea, publisher of StreetAuthority’s sister company, Profitable Trading, recently sat down to interview Jared Levy, a man who knows more about options trading than anyone we’ve ever met. 

Jared is something of a wunderkind. He began trading options at 16 and quickly found himself making upwards of $600,000 a year. Since then, he’s written two books about options trading and is now regularly featured as a guest on financial news programs on CNBC and Fox Business. 

In the interview, you’ll learn more about Jared’s fascinating background and details on the options strategy that allowed him to retire a millionaire from Wall Street at the age of 23.

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