The opportunity in crisis-mauled stocks

Investment writers are often asked about big picture ideas that we personally think make the most sense in offering opportunities for profit.

Having spent years following the activities of fund managers and sell-side analysts, the best idea I've recently come across is investing in companies that imploded during the global financial crisis, but now stand a decent chance of not only surviving, but prospering.

While the shares of many of these companies are showing some zip, they remain dream stocks for deep value investors because they are still bargain-priced. Their prices carry the taint of the financial disaster of five years ago, even though the crisis is rapidly receding in the rear-view mirror.

The investment greats who've selectively been taking positions in some of these unloved companies include Prem Watsa at Canada's Fairfax Financial, U.S. money management impresario Bruce Berkowitz, and of course, Warren Buffett, of Berkshire Hathaway fame.

The formerly bombed-out stocks include a diverse group of companies, with an emphasis on the bank and insurance businesses, which is to be expected because they were at the epicentre of the financial crisis.

A handful that come to mind are Bank of America, Citigroup, GM, Assured Guaranty, Ambac Financial, and – one that is in my own portfolio – insurance giant AIG, the former poster child for the blowout.

Most of the compelling buys are U.S.-based, because the United States was the scene of the accident. But there are also companies in Europe, such as Lloyds Banking Group (its shares recently approached the level that would allow the U.K. government to sell the shares it acquired in its bailout of the institution without losing a penny for taxpayers) and Bank of Ireland, a personal favourite of Mr. Watsa's.

Mr. Buffett, for his part, has taken a big stake in Bank of America through warrants and preferred shares. Even though it has rallied sharply, the giant U.S. bank still trades at only about two-thirds of its book value per share.

Mr. Berkowitz is a fan of AIG, and has staked his reputation on it by backing up the truck and loading up on the stock. Trying to face down the skeptics, he outlined his investment thesis in a publicly available web posting that highlights the great value he sees in the insurer. He's the firm's largest shareholder, with a stake worth $3.8-billion (U.S.), and he continued to buy more in the first quarter, according to regulatory filings.

These companies are by no means exhaustive of the entities that were maimed during the crisis and now are recovering, exhibiting another attractive feature of this investment theme: It's a scalable concept, or one where following the thread of the idea can lead to many more investment prospects.

Another attraction is that looking at damaged financial-crisis stocks as a group isn't yet an idea that's gained currency on financial markets, suggesting it's an under-appreciated theme. Most of the big investment pros, such as Mr. Watsa, who've scooped up beaten down names, are going for one or two companies, not looking at the wider array impacted by the implosion.

One of the few sell-side analysts looking at these companies as a group is Mark Palmer, a former distressed-debt specialist at New York-based institutional broker BTIG, which says he continues to spot compelling values emerging from the wreckage of the financial crisis.

He's issued reports on more than half-a-dozen companies that he contends remain deeply undervalued and should reward patient investors when recognition of their improving prospects become better reflected in share prices.

Among them are lender CIT Group, real estate investment trust iStar Financial, and a diverse number of insurers, included Assured Guaranty, Ambac Financial Group, CNO Financial and Voya Financial.

"While the investment opportunities resulting from the still ongoing corporate cleanup in the aftermath of the global financial crisis will be exhausted at some point, we have not quite reached that point yet," Mr. Palmer said recently in a note to clients extolling the virtues of Voya.

Most investors can be forgiven for not having heard of Voya, the re-branded name for the spinoff of ING Groep's U.S. insurance and money management assets. The company isn't a fly-by-night enterprise and has more than $215-billion (U.S.) in balance sheet assets. Mr. Palmer is the first analyst and one of only two in the world to issue a report on Voya, so it's a pretty fresh idea.

ING is being forced to sell under a deal struck with European regulators for approving a bailout from the Dutch government during the worst of financial crisis. Mr. Palmer says it's a forced sale because the U.S. division is one of ING's crown jewels and managers didn't want to unload it.

Underwriters sold 25 per cent in the IPO that began trading earlier this month at $19 (U.S.) a share. The offering was a flop, given that the price was well below pre-sale estimates of $21 to $24. Even though the shares have recovered from their initial weak pricing to around $26, Mr. Palmer believes the stock is conservatively worth $31, which is equal to only 0.8 times its book value at the end of 2012.

ING has to divest its remaining 75 per cent by the end of 2016. Given the weak reception to the IPO, Mr. Palmer says ING may try to sell the company outright, which would presumably carry a nice takeover premium.

In an interview, Mr. Palmer said estimating the value of companies recovering from the crisis is complicated, a factor that leads to them being undervalued.

As a case in point, there is Ambac, the municipal-bond insurer that recently emerged from bankruptcy. Mr. Palmer has a $31 target price, but the company could ultimately be worth a lot more. The current market capitalization is $1.2-billion, but has an estimated $2.5-billion in claims against big U.S. banks to recover insurance payments made on allegedly faulty mortgages. Even a 50-per-cent recovery (most claims are being settled for more) would exceed the current market capitalization. Then the company also has more than $4-billion in tax loss carry-forwards, another valuable asset.

Mr. Palmer recently upped his target on business lender CIT to $55 from $45. He believes it is a takeover candidate, with Canadian banks the most likely acquirers. A Canadian bank, with its high credit rating, would be able to fund CIT's loans at a lower cost, boosting profits.

To be sure, the notion of investing in the detritus of the crash could still be undone. Mr. Palmer says a return of the housing bust or a recession would hurt many of these companies. That doesn't seem likely right now, however. And if the economy tanks again, almost all stocks, and not just these, would be hammered.