Sometimes an investment looks like a no-brainer -- until you dig
a little deeper.
On the face of it,
Assured Guaranty (
looks like one heckuva stock. The company offers insurance policies
buyers, focusing on the state and local
business. It's a good business in normal times and a great business
right now, thanks to especially high premiums to insure these
increasingly risky bonds.
Assured's two main rivals,
Ambac Financial (
are on the ropes, enabling the company to steal
. Assured reported second-quarter profits last week of $0.91 a
share, roughly +30% ahead of consensus forecasts and a company
record since being spun-off from insurance giant
in 2004. And even after a nice double-digit gain on Friday, shares
trade for just 80% of
or about six times likely 2010 profits and 4.5 times expected 2011
The "potential" in this case depends on the
But what happens if the economy weakens further and state and local
governments start to default on their bonds? Or what will happen to
state finances once the Obama administration is no longer offering
support to keep teachers and policemen employed? (The Senate
recently voted to give the states another $26 billion, but it is
unclear if states can count on such largesse in 2011). In a
worst-case scenario, a wave of bond defaults would force Assured to
pay up on all of those bond insurance policies, wiping out any
profits the firm hopes to earn.
Yet we may not be headed for such a dire scenario, and those fears
are starting to look overblown. Assured Guaranty has been
diversifying its revenue streams and is seeing more stable -- and
profitable -- results from an acquired division that focuses on
France and Belgium, which don't face the specter of bond defaults.
And the company's reinsurance business, which helps backstop other
insurers as they take on risk, is a boring but steady profit
Indeed much of the upside in the most recent quarter stemmed from
the fact that the most challenging parts of the business, muni bond
insurance and mortgage insurance, are not doing as badly as some
To be sure,
are extremely volatile, as they involve a constant marking up and
marking down of the perceived health of various insurance
liabilities. Some investors prefer to focus on book value. UBS sees
Assured's book value rising to the $26 or $27 range during the next
12 months and sees shares rising up to almost that figure.
Yet as noted earlier, the competitive environment has clearly
shifted in Assured Guaranty's favor, and profit spreads could surge
to peak levels. Some investors think a target
ratio is a wise way to go. In this context, if the company can
avoid a wave of large bond defaults in the coming 12 months, then
shares might move up to around 10 times potential 2011 profits,
meaning the stock can double from current levels.
Action to Take -->
The strong business trends in evidence in the second quarter remain
in place, setting the stage for more estimate-topping results in
the coming quarter. Shares are likely to have a solid floor under
them, even after a recent run in price.
From there, perception is everything. If investors come to think
that state and local governments can muddle through this crisis
without defaulting on bonds, then shares should steadily climb
through the $20s in the near term. And if states and cities
actually do avoid a total financial meltdown, then this stock could
double. Conversely, if state and local finances weaken even further
from here, then shares will move into the doghouse.
-- David Sterman
David Sterman has worked as an investment analyst for nearly two
decades. He started his career in equity research at Smith Barney,
culminating in a position as Senior Analyst covering European
banks. David has also served as Director of Research at Individual
Investor and has made numerous media appearances over the years,
primarily on CNBC and Bloomberg TV. David has a master's degree in
management from Georgia Tech. Read More...
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.