Yesterday, I posted the bear case for AGO. Today, I wanted to dive into the bull cases.
Just a quick summary of the bear case before we dive in: AGO is a financial guarantor. Your big worry with AGO is that most of their guarantees are against municipalities, and municipality budgets appear stretched, yet AGO hasn't really increased their loss reserves since the beginning of the year. Given how much debt AGO insures, if AGO's reserves prove to be off by even a small percentage of their overall guarantees, AGO's shareholder equity could be quickly wiped out.
That's the bear case. I think there's some real teeth to it; AGO's management doesn't seem to agree. With that in mind, let's turn to the bull case.
Your bull case for AGO can be pretty simple: AGO trades way, way below book value and is a voracious repurchaser of their shares. Today the stock is trading for ~20% of book value; that's a mammoth discount and it means every share repurchased today is hugely accrettive (provided, of course, that you trust the book value number!).
However, that might undersell AGO a bit. Below is a slide from their Q2'20 earnings that shows their book value per share over time. It shows adjusted book value has grown at a 9% CAGR over the past 15+ years.
Say AGO was just some run of the mill P&C insurer and I showed you their track record of book value compounding. What would you pay for them? Personally, I think an insurer with that track record would be worth a slight premium to book. We could argue about whether a slight premium means 1.1x book or 1.3x book, but I'd be pretty sure it was worth a little more than book. Today AGO is trading for <$20/share with a book value of >$100/share.... and we just made an argument that their track record suggests they should trade for a small premium!
So, AGO is statistically cheap and buys back shares. I think that's the best part of the bull thesis. That said, I do think you can make an argument that their is some operational value here.
Remember that AGO's business is basically using their stronger balance sheet to guarantee company/municipalities debts so that they can borrow at a lower rate. AGO charges a fee for this. I argued in yesterday's post that this was financial engineering at its worst. However, if you wanted to put rose colored glasses on, you could probably squint and see how AGO's model creates value.
The argument would probably look something like this: AGO mainly guarantees municipal debt. Municipal debt is tax free, so it's generally bought up by taxable investors (in general, individual investors). And municipalities are pretty small; in general, the market is dominated by thousands of small municipalities issuing tens of millions of dollars in debt.
The depth of the municipal market can create issues when it comes to bankruptcies and restructurings because the individual expense outweighs the benefits of participating in any one case. Say a small town in Ohio defaults on $10m in bonds. If those bonds are owned by 1000 different investors who each own $10k of the bond, none of those investors are going to have the ability or incentive to really get involved in the restructuring and ensure that the process goes smoothly. I could easily imagine a scenario where if someone really went in and fought, that bond would pay off at 80 cents, but because the time and effort is too large for any one individual to make a go of it, that bond pays off at 70 cents instead.
That's where you could argue AGO comes in: by insuring municipalities across the country, AGO becomes something of a standard bearer. If they had insured that defaulted debt we just mentioned, AGO would go in and fight hard for the best outcome. Not just because they've insured $10m of debt and having it pay off at 80 instead of 70 means they save $1m, but also because they've insured another 100 municipalities across the country just like this one and ensuring that this one plays out properly means that AGO is setting the right precedent for the other 100 in the case of financial distress.
This reminds me a little bit of microcap activism. Every investor at some point is going to consider an activist campaign at a microcap. The issue is that if you're running an activist campaign, the costs are reasonably fixed. It's going to cost you ~$100-250k regardless of whether the company is a $10m company or a $10B company. Say you own 10% of a $10m microcap, so you've got a $1m position. It can seem tempting to wage an activist battle, but if you do you're going to spend $100k on a $1m position. What's more, the company is probably going to spend a similar amount. That would be a rounding error at a larger company but for a company this small that's a devastating expense. So while microcap activism seems appealing, it quickly becomes apparent that it's simply not worth the hassle.
In some ways, municipalities are the nanocap companies here. As an insurer across the ocuntry, AGO is like Vanguard if Vanguard really cared about corporate governance and getting their hands dirty: they own so much of every company / municipality that they can spend a little more on one individual fight/position than their pure position size would dictate because it has positive carryover effects to the rest of their portfolio.
And because AGO can act as something of a protector of creditor rights, they can actually create value by writing insurance on one municipality. An AGO insured credit becomes a better credit because the recovery value is significantly higher. If town A and town B are the exact same except town B has AGO involved in some way, town B is a better credit because AGO will go in and get a much better recovery in a default. In this way, towns that would be "BBB" credits on their own become "A" credits once AGO underwrites them. AGO is not underwriting BBB credits at A prices; AGO's insurance turns BBB credits into AA credits and, after AGO's fee, AGO lets them borrow at A prices. It's a win for everyone: AGO enhances the credit and makes a profit for their skills in structuring, the town borrows cheaper, and investors get a better credit and better protection if something ever goes wrong.
Do I believe that narrative? Yeah, part of me does! But I'm not 100% convinced, and clearly the market is roughly 0% convinced given AGO trades at a fraction of a fraction of book value.
Note you could also extend that narrative a little bit to trading liquidity. If one town is issuing $10m of bonds, those bonds are going to be insanely illiquid. If you need to sell for any reason before maturity, the transaction costs will be high and you'll likely be taking a pretty low ball bid. However, adding AGO insurance to a bond should increase liquidity. A potential buyer no longer needs to do specific analysis of this one little town; instead, they can simply look at where similarly dated AGO insured bonds are trading and pay around that price. Increased liquidity means that the interest cost should go down, so again here AGO's insurance is actually creating value.
Both the liquidity argument and the "creditor rights" argument are important for another reason: scale. I argued in the bear case that a competitor could come in and win a ton of business by way undercharging for the insurance they offer. That is certainly true, but I do think that AGO's scale gives them some benefits here. If AGO insured bonds are more liquid than peer bonds, that means investors will pay more for (or demand lower interest rates for) AGO insured bonds, which gives AGO an advtange when offering insurance (to simplify: even if AGO and a peer had similar ratings, an investor might bid 5.5% for an AGO bond versus 6% for a peer insured bond because the AGO bond is more liquid. That gives AGO a huge edge when insuring business: they could charge the same issuer 40 bps per year less than the peer and still make 10 bps more of profit simply because investors give AGO a lower cost of capital thanks to their liquidity!). And if AGO insurers more bonds, they'll be able to spread out the costs of fighting for creditors' rights over more business (and issuers will be less likely to mess with AGO knowing that AGO will fight tooth and nail because it's not just about one specific fight for them; it's about protecting their overall franchise).
To sum up: The main piece of the bull case is AGO is really statistically cheap and a voracious share repurchaser. While I'm a little skeptical of the business, I think you could easily talk yourself into arguing that this business actually does create value and has some scale advantages. Combine the two and you've got the makings of a stock that could be significantly undervalued.
There are some other things to like here. I generally think management is good. Their track record is solid from an operational standpoint (again, this is the only guarantor that didn't explode during the crisis), they own a bunch of shares (see image below), and I think their incentives are reasonably well tied to what should drive shareholder value (long term equity awards are tied to growth in adjusted book value and shareholder returns beating the market; given what a discount AGO trades at, both numbers should heavily push AGO to buying back shares).
I also think there are some inorganic growth opportunities here. Every other guarnator is effectively in run off, and over the years AGO has made a bunch of deals where they basically reinsurer their former competitors books in exchange for upfront payments. These deals have proven very accrettive for AGO; the last one they did with Syncora increased book value by ~$250m (see Q2'18 earnings for final accretion number). Two major former guarantors, MBI and AMBC, are both effectively in liquidation; I wouldn't be surprised if AGO ended up reinsuring their portfolios at some point in the future and realizing a substantial book value gain from doing so. Doing so could result in significant accretion; Syncora's deal was for <$15B, but both AMBC and MBI still have ~$50B in policies in force. AGO only has ~84m shares outstanding; doing a deal with AMBC and/or MBI could easily add several dollars of book value if the Syncora deal is a guide.
Anyway, that's an overview of the bull and bear case of AGO. There's some other angles to this and I'll dive into them a little bit in the odds and ends. I think I lean pretty bullish here, but there's a lot of stuff I worry about. In particular, I worry about the black box nature of the balance sheet and the lack of reserves from the pandemic, but I do think the current price more than prices in those risks.
Odds and Ends