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Norman Rothery is the value investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

When I explain the theory of value investing to people, they always love the idea. Everyone is excited by the notion of snapping up a dollar's worth of assets for 60 cents.

Then they see an actual value portfolio. And they recoil in horror.

I can understand their reaction. Buying ugly stocks with a discouraging history doesn't naturally appeal to most people. Neither does loading up on small, obscure companies or investing in some of the dullest enterprises known to humanity.

It's in those unloved areas, however, that value hunters spot opportunities. Case in point: American International Group (AIG), one of the stocks I've picked for my model portfolio in the new Globe and Mail Strategy Lab.

The U.S.-based insurer has been in the headlines in recent years for all the wrong reasons. During the 2008 market collapse, Lehman Brothers' bankruptcy nearly destroyed Wall Street. The next domino in line was AIG, an insurance company that had foolishly backstopped a big part of the market in credit default swaps on mortgage loans. It survived only because it was too big to fail. The U.S. government bailed it out and took a big chunk of its equity.

I like AIG these days for several reasons, notably the growing evidence that it is turning around. Earlier this month Washington sold nearly $20.7-billion (U.S.) worth of AIG's stock and celebrated the fact that it has made money on the bailout. That's good news for taxpayers (who still own 15.9 per cent of AIG's common stock) and it should give AIG a little more room to manoeuvre. The firm may even pay a dividend next year once the last of the government's shares are sold.

As a value investor, my eyes were drawn to AIG by its low price in relation to its book value. As you may know, book value is what's left over when you subtract a firm's liabilities from its assets. It's a rough guide to what a company might be worth based on its balance sheet. (Although a variety of accounting factors should be considered when using book value for this purpose.) Most companies trade well above their book value.

Value investors pay close attention to low price-to-book-value (P/B) stocks and history shows these equities tend to do quite well, as a group, over the long term. Many academics, including Kenneth French at Dartmouth, have glommed on to the approach and produced a slew of studies extolling the virtues of investing in low P/B stocks.

In terms of low P/B stocks, AIG is a star. It is now trading at just under 60 per cent of its book value based on its balance sheet from the end of the second quarter. That puts it well into classic value territory.

Of course, an investor should always look at a company's P/B in relation to others in the same industry. The comparison provides a gauge of what sort of multiple the firm might achieve should it straighten out its operations.

These days some of the better insurance companies trade at, or slightly above, book value, which indicates AIG's share price has lots of room to grow, especially if the market becomes more enthusiastic about insurers in the future.

It is worth pointing out that AIG bought back stock while the U.S. government sold. For instance, it repurchased $5-billion of the $20.7-billion worth of shares the government recently dumped. As a result, its book value will very likely climb next quarter.

AIG's earnings are also looking up. The firm has made money over the past 12 months (in part, thanks to a large positive tax development). It trades at just under 10 times the earnings that analysts expect it to generate over the next year.

Looking further into the future, analysts say the firm will grow its earnings by more than 20 per cent a year, on average, over the next five years. That's pretty good but you shouldn't be captivated by such projections – analysts have a habit of being too optimistic.

Still, even if things don't turn out quite as well as analysts expect, AIG has the potential to produce a nice profit for investors. I think it may prove to be a situation where value investors can buy at a low multiple, hold on while the firm grows, and then sell when the market becomes enthusiastic about AIG's prospects at a much higher multiple. That way they'll pick up a good one-two combination of growth plus multiple expansion, which can be very profitable.

It is not a sure thing. After all, it is possible that a boneheaded contract, or bad trade, will blow a hole in the company's balance sheet – again. But it seems likely that the disaster of 2008 helped to improve AIG's risk culture. As a result, I think the odds favour patient long-term investors.

See Norman Rothery's model portfolio here.

Watch and participate as our value, growth, dividend and indexing strategists look for promising investments in Strategy Lab.


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