case study - csinvestingcsinvesting.org/.../aig-case-study-fairhome-2012.pdf · this presentation...

CASE STUDY IICASE STUDY II

FAIRHOLMEIgnore the crowd.

This presentation uses American International Group as a case study to illustrate Fairholme Capital Management’s investment strategy for theFairholme Fund. In the pages that follow, we show Fairholme Fund shareholders why we “Ignore the crowd” with regard to our portfoliopositions that are currently out of favor in the market.

However, nothing in this presentation should be taken as a recommendation to anyone to buy, hold, or sell certain securities or any otherinvestment mentioned herein. Our opinion of a company’s prospects should not be considered a guarantee of future events. Investors arereminded that there can be no assurance that past performance will continue, and that a mutual fund’s current and future portfolioholdings always are subject to risk. As with all mutual funds, investing in the Fairholme Fund involves risk including potential loss ofprincipal. Opinions expressed are those of the author and/or Fairholme Capital Management, L.L.C. and should not be considered a forecastof future events, a guarantee of future results, nor investment advice.

The Fairholme Fund’s holdings and sector weightings are subject to change. As of February 29, 2012, American International Group securitiescomprised 32.2% of the Fairholme Fund’s total net assets. The Fairholme Fund’s portfolio holdings are generally disclosed as required by lawor regulation on a quarterly basis through reports to shareholders or filings with the SEC within 60 days after quarter end. A complete list ofthe Fairholme Fund’s top ten holdings is available on our website at www.fairholmefunds.com.

The Fairholme Fund is non‐diversified, which means that it invests in a smaller number of securities when compared to more diversifiedfunds. Therefore, the Fairholme Fund is exposed to greater individual security volatility than diversified funds. The Fairholme Fund can investin foreign securities which may involve greater volatility and political, economic, and currency risks and differences in accounting methods.The Fairholme Fund may also invest in “special situations” to achieve its objectives. These strategies may involve greater risks than otherfund strategies. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer‐termdebt securities. Lower‐rated and non‐rated securities present greater loss to principal than higher‐rated securities.

The Fairholme Fund’s investment objectives, risks, charges, and expenses should be considered carefully before investing. The prospectuscontains this and other important information about the Fairholme Fund, and may be obtained by calling shareholder services at (866)202‐2263 or by visiting our website at www.fairholmefunds.com. Read it carefully before investing.

FAIRHOLME Ignore the crowd.

Trades at less than one‐half tangible book value* “De‐risked” balance sheet1

Shareholder equity‐to‐assets ratio of 15%* Repurchasing common stock Leader in global property and casualty insurance Dominant U.S. life insurance and retirement services provider 86 million customer and client relationships worldwide

CURRENT INVESTMENT OPPORTUNITYWe have identified a public company:

…Sound interesting?

FAIRHOLME Ignore the crowd.1 Peter D. Hancock, May 31, 2012.* See last page for definitions of terms.

…We certainly think so.

“Insurance is critical to the smooth functioning of the world economy.Businesses cannot operate without coverage against the unexpected andmost capital transactions cannot be financed without insurance.”

Bruce R. BerkowitzOutstanding Investor DigestYear End 2001 Edition


Investment Thesis for AIGReasonable Expectations

10% Return on Owner’s Equity*

20% Implied AnnualReturn on Investment*

This is a reasonable return even at heightened capital ratios expected this cycle.1

This is a reasonable return when you buy stock at less

than half book value.


1 AIG’s 1Q 2011 10‐Q filing announced a long‐term aspirational goal of 10% or more Return on Equity by the year ended December 31, 2015. Between 1988 and 2007, before the financial crisis, AIG’s Return on Equity has averaged 14%.* See last page for definitions of terms.

$‐

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

Price

Price Book Value per share

Experienced with insurance companies Favorable earnings power

Investing in our Circle of Competence * Improved Fundamentals Available at attractive prices

Date of reverse split: 07/01/2009

Initiated purchase afterthe financial crisis.


* Bruce R. Berkowitz has been investing in financial stocks for over 20 years. An interview with Mr. Berkowitz in Outstanding Investor Digest dated November 25, 1992, is available on www.fairholmefunds.com.

“The seeds of great performance are usually sown in times of intense fear after a disaster.”

– Bruce R. Berkowitz, Letter to Clients, October 2011


$0

$10

$20

$30

$40

$50

$60

Price

Price Book Value per share

“When a recovering icon trades at half of our understanding of intrinsic value for a reason that has nothing to do with its prospects, we swing big.”

– Bruce R. Berkowitz, Letter to Clients, June 30, 2011

As the gap between AIG’s stock price and book value widened in 2011, we increased our stake.

With AIG’s price significantly below book value, we initiated

our investment.


“AIG’s crisis is over…all the fundamentals of running this company are moving in the right direction. We can look forward and focus on operating results. It’s all about how

to create the best shareholder value going forward.”

—Robert H. Benmosche, President and Chief Executive Officer, AIG, August 5, 2011

is Back *#1 Global Property and Casualty Insurer, Serving Customers in more than 130 Countries

REGION #1 Western Europe #1 Latin America #2 North America #2 Asia #2 Central & Eastern Europe

CATEGORY #1 General P & C #1 D & O Liability #1 Marine and Fire #1 Medical and Life #2 Catastrophe

EUROMONEY INSURANCE SURVEYBEST INSURER OVERALL ‐ GLOBAL


* AIG Press Release, February 23, 2012.

Key Franchises Unscathed by Crisis, Revenues Have Grown

World leader in global property and casualty insurance.

U.S. life insurance and retirement services leader.

• 45,000 employees• 70 million worldwide clients• #1 Global Insurer (Euromoney)

$27,482 $30,273

$10,147 $11,317

YTD 2010* YTD 2011**

Chartis SunAmerica

• 13,000 employees• 16 million customers• Recognized leader in U.S. market

$37,629

$41,590

+10%+10%

Revenues by Reportable Segments (in millions)

* Revenues by reportable segments through 09/30/2010** Revenues by reportable segments through 09/30/2011

Past performance does not guarantee future results.FAIRHOLME Ignore the crowd.

2011 ACCOLADES

BUYER’S CHOICE AWARD FOR EXPERTISE, BUSINESS INSURANCE

INNOVATION AWARD, BUSINESS INSURANCE

MOST TRUSTED BRAND IN KOREA, CHOSUN ILBO

BEST QUALITY SERVICE TRAVEL INSURANCE COMPANY (CHINA), WORLD TRAVEL FAIR

STANDOUT COMPANY AWARD (BRAZIL), REVISTA SEGURADOR BRASIL

BEST PRODUCT INNOVATION AWARD (GENERAL INSURANCE), CELENT

COMPANY OF THE YEAR (HEALTH INSURANCE), CELENT

BEST PRACTICES IN TECHNOLOGY(GLOBAL MARINE AND ENERGY), CELENT

Industry Leader With Loyal Customer Base *

~ 93%** Retention on these Segments

98%

96%

89%

~33%

* Pie charts represent the proportion of each indicated segment that does business with Chartis.** At September 30, 2011, based on a 12‐month rolling average.


Tracing its history back to 1850, SunAmerica has over a 160‐year track record of leadership in the U.S. life and retirement services market.

LEADING PROVIDER OF TERM AND UNIVERSAL LIFEPRODUCTS

LONG‐STANDING LEADER IN THE STRUCTUREDSETTLEMENT ANNUITY MARKET

LONG‐STANDING LEADER IN 403(B) DEFINEDCONTRIBUTION MARKET

TOP BANK CHANNEL FIXED ANNUITY PROVIDER FOR15 CONSECUTIVE YEARS

LEADER IN INDIVIDUAL VARIABLE ANNUITIES


Trust But VerifyOur Research has been Enhanced by Unprecedented Disclosure

“We are committed to adding even further disclosure…to make it easier for people to reach their own conclusions [about AIG]. We [have also] accelerated the pace of

third‐party scrutiny by outside actuaries so that it’s not a slower cycle.”

—Peter D. Hancock, Chief Executive Officer, Chartis, December 7, 2011FAIRHOLME Ignore the crowd.

[Note: The seals below depict several of the government agencies that have examined AIG, but in no way signify an endorsement of any kind.]

35,000

16,100

3,900 2,100

‐

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

2008 2009 2010 3Q2011

Outstan

ding

Trade

Position

s

‐94%

$302,201

$183,526

$59,850

$26,042

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

2008 2009 2010 3Q2011

Supe

r Sen

ior C

DS Expo

sure

(in m

illions)

‐95%

$1,450

$65

$240

$40$144

$18 $8 $20$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

Market Derivatives Arbitrage/MultiSector CDS

Regulatory CapitalCDS (includingMezzanine)

Stable Value WrapBook

Expo

sure (in billion

s)

2008 3Q2011

‐89%

AIG Moving ForwardAggressively Winding Down and De‐Risking the AIGFP Derivatives Portfolio 1

89% Reduction in Derivatives Exposures

94% Reduction of Trade Positions

95% Reduction of CDS* portfolio

1 AIG Financial Products Corporation* See last page for definitions of terms.FAIRHOLME Ignore the crowd.

**

**

*

AIG has considerably reduced its legacy AIGFP portfolio since2008. The Company’s current derivatives portfolio facilitates thehedging of the its assets and liabilities.

Powerful Franchises and Valuable AssetsAs AIG sheds additional non‐core assets and further reduces risk exposures,

the value of its powerful franchises and assets will emerge.

AIA

ILFCMORTGAGEGUARANTEE

SUNAMERICACHARTIS

MAIDEN LANE II / MAIDEN LANE III


‐

0.20

0.40

0.60

0.80

1.00

1.20

1.40

Chubb Ace Travelers Allstate American International Group

Price to Boo

k

5‐Year Average Price / Book * Current Price / Book *

Compared to its Peers,AIG is Exceptionally Cheap

(Market Cap: $47+ Billion) (Market Cap: $14+ Billion) (Market Cap: $23+ Billion) (Market Cap: $23+ Billion) (Market Cap: $18+ Billion)

AIG Price/Book * = 0.56

Historical 15‐year Price/Book Average for Property & Casualty Insurance Sector = 1.30


* Price/Book: A ratio used to compare the market value of a stock to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter's book value per share.

Market Capitalizations as of January 30, 2012.

Market Cap: $47bn

$25 Buys You $45+…“Investing is all about what you give versus what you get.” *

* Bruce R. Berkowitz, Morningstar Conference, June 9, 2011Market Prices as of January 30, 2012.

** Future cash flows are not guaranteed.

In return for purchasing stock (above) at historiclows, an investor in AIG receives book value(right) that far outweighs the cost. This providespotential downside protection as well as upsideopportunity. There can be no assurance that themarket will recognize AIG’s true intrinsic value,but when the market returns to a “weighingmachine,” AIG’s market cap should increase.

Tangible Book Value: $80bnReserves: $73bn

DTAs: $17bn ‐ $25bn

Future Cash Flows **

GIVE = $25

GET = $45+


AIG’s Long‐Term GoalsPreparing to “Prosper Once Again” *

INCREASE RETURN ON EQUITY (ROE) TO 10% GROW EARNINGS PER SHARE INCREASE PRE‐TAX OPERATING INCOME UTILIZE DEFERRED TAX ASSETS (DTA) REDUCE GENERAL & ADMINISTRATIVE EXPENSES DEPLOY EXCESS CAPITAL FOR:

• POTENTIAL SHARE REPURCHASES• DIVIDEND PAYMENTS• ACQUISITIONS• ORGANIC BUSINESS OPPORTUNITIES

“Simply put, this company is too valuable to ignore. And we have a clear vision for [AIG] to be the most valuable insurance company, not the biggest. This is a

franchise that has a real extraordinary uniqueness to it.”

—Peter D. Hancock, Chief Executive Officer, Chartis, December 7, 2011


* AIG Press Release, February 23, 2012.

“Many shall be restored that now are fallen…”

* Date of reverse split: 07/01/2009

– Horace, Ars Poetica


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$1,000

$1,200

$1,400

$1,600

$1,800

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5,000,000

10,000,000

15,000,000

20,000,000

25,000,000

30,000,000

35,000,000

40,000,000

Price *

Short Interest

Short Interest Price

As AIG’s share price decreased during the financial crisis, short interest grew. Recently, short interest has decreased, although it remains at elevated levels.

Staying the CourseCourage of Conviction

“This is not an easy time for value investors. As we practicethe strategy, value investing has been underperforming andprices for our companies are depressed and do not reflectintrinsic value or business fundamentals…Each of our holdingsgenerates excess free cash. All are at bargain prices. Yet, ourinvestment experience has taught us that we cannot controlprices. Cheap can get cheaper, even if there is nothingfundamentally wrong. However, market history says that highquality, well‐managed companies don’t stay cheap for long.”

Bruce R. BerkowitzLetter to ClientsFebruary 2000

FAIRHOLME Ignore the crowd.Past performance does not guarantee future results

Book Value: The net asset value of a company, calculated by total assets minus and liabilities.

Equity‐to‐Asset Ratio: A ratio used to help determine how much shareholders would receive in the event of a company‐wide liquidation. The ratio,expressed as a percentage, is calculated by dividing total shareholders’ equity by total assets of the firm, and it represents the amount of assets on whichshareholders have a residual claim. The figures used to calculate the ratio are taken from the company’s balance sheet.

Implied Annual Return on Investment: Calculated by dividing a company’s implied annual earnings by its total market capitalization at the time ofinvestment.

Return on Equity (ROE): The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation’sprofitability by revealing how much profit a company generates with the money shareholders have invested.

Credit Default Swap: Transfers the credit exposure of fixed‐income products between parties. The buyer of a credit swap receives credit protection,whereas the seller of the swap guarantees the credit worthiness of the product. Risk of default is transferred from the holder of the fixed income security tothe seller of the swap.

Market Derivatives: Derivatives are financial arrangements among two or more parties with returns linked to or “derived” from some underlying equity,debt, commodity, or other asset, liability, or foreign exchange rate or other index or the occurrence of a specified payment event.

Arbitrage/Multi‐Sectors CDS: Represents the CDS portfolio that, according to Federal Reserve officials, is a synthetic long credit position and written onCDO transactions that generally had underlying collateral of residential mortgage‐backed securities, commercial mortgage‐backed securities, and CDOtranche securities.

Regulatory Capital CDS (Including Mezzanine): Represents derivatives written for European banks that allowed them to reduce the amount of capital theyneeded to set aside to cover potential losses on certain asset portfolios of residential mortgages and corporate loans by buying protection against losses onunderlying assets. Mezzanine refers to transactions in which the underlying collateral credit ratings on a stand‐alone basis were predominantly A or lowerat origination.

Stable Value Wrap Book: Maintenance agreement that a stable value fund enters into with one or more financial institutions to maintain a stable orpositive net asset value. The wrap contract is known to smooth performance and reduces the impact of market volatility. Stable value is a low‐risk assetclass that seeks capital preservation and consistent returns.

Super Senior CDS Exposure: Credit default swap transactions were entered into with the intention of earning revenue on credit exposure. In the majority ofthese transactions, credit protection was sold on a designated portfolio of loans or debt securities. Generally, such credit protection was provided on a“second loss” basis, meaning that credit losses would be incurred only after a shortfall of principal and/or interest, or other credit events, in respect of theprotected loans and debt securities, exceeds a specified threshold amount or level of “first losses.”

Fairholme Distributors, LLC (06/12)


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