Is AGO a useful bet on the Financials sector in this market?

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Starting into the fourth quarter of 2019, the market seems to be a bit on edge. It’s been a year since the market saw its last significant correction, dropping almost -20% before finding a bottom on Christmas Eve 2018. Continuing questions about trade, increasing scrutiny around impeachment hearings, and questions about whether the economy is actually slowing enough to warrant another highly anticipated interest rate cut by the Fed this month are all contributing to an increase in volatility. That has folks wondering if the end of 2019 could see a repeat of the last quarter of 2018, or even worse, finally be the tipping point to force the U.S. economy into a long overdue period of economic contraction – or dare I say it – recession.

All of these questions seem to be weighing on stocks in a variety of industries. The result is that a lot of investors are starting to look for ways to “flee to safety” – meaning that they’re moving their money into financial instruments that they perceive as offering greater stability. The longer the uncertainty lasts – and, given that this kind of uncertainty has been going on for roughly the past year and half, I don’t think this is unreasonable  – the more likely investors are to also settle for lower yields in exchange for stability. That means that even very low yields on instruments like savings accounts, CD’s, short-term Treasuries and money markets can start begin to look more attractive to more and more investors.

The question in these kinds of conditions that every investor has to answer for ourselves is whether the same “flight to quality” is the right move for you, or whether there are other ways to keep using the market to your own advantage and benefit. Even in a bear market, for example, there are still sectors and industries of the market that will still increase in price; there are also different areas of the market that are less susceptible to economic risk during a bear market, or even a recession, than others.

The Financial sector is an interesting place to watch. Consumer and investment banks, lending institutions, insurance companies and even mutual funds and brokerages are all sensitive to interest rate fluctuations, and so in many ways it isn’t surprising to see these stocks responding in a volatile fashion when the path of interest rates – or the sustainability of its current path – looks uncertain. At the same time, there are also segments of the sector that I think could be better-suited to ride through even difficult economic conditions than others.

Assured Guaranty LTD (AGO) is an example of what I mean. This is a stock that is categorized in the Insurance industry, but whose products aren’t geared to consumers. Instead, this is a company that specializes in credit protection products for the companies that supply debt instruments. That is a very interesting niche to occupy, because it means that the points where default risks are the most elevated – which are generally in periods of economic decline – this company’s products are the most attractive. I think that’s part of the reason the stock is up about 14% year to date, and it is also something that could keep the stock attractive if the market does turn bearish. What about the company’s worth relative to its stock price? At what price would the stock offer a compelling value argument? Let’s find out.

Fundamental and Value Profile

Assured Guaranty Ltd. is a holding company. The Company, through its subsidiaries, provides credit protection products to the United States and international public finance, including infrastructure, and structured finance markets. It applies its credit underwriting judgment, risk management skills and capital markets experience primarily to offer financial guaranty insurance that protects holders of debt instruments and other monetary obligations from defaults in scheduled payments. It markets its financial guaranty insurance directly to issuers and underwriters of public finance and structured finance securities, as well as to investors in such obligations. It guarantees obligations issued principally in the United States and the United Kingdom and also guarantees obligations issued in other countries and regions, including Australia and Western Europe. It also provides other forms of insurance that are in line with its risk profile and benefit from its underwriting experience. AGO has a current market cap of $4.3 billion.

Earnings and Sales Growth: Over the last twelve months, earnings grew impressively, by 109%, while sales increased a little over 20%. In the last quarter, earnings increased by a little over 68% while sales grew almost 36.5%. AGO operates with a very healthy margin profile; in the last twelve months, Net Income was 46.8% of Revenues and increased to 53% in the last quarter.

Free Cash Flow: AGO’s Free Cash Flow is a point of significant weakness, at -$180 million. That number dropped from about about $450 million at the beginning of the year.

Debt to Equity: AGO has a debt/equity ratio of .18, which is very conservative and indicates the company works with a very conservative level of debt. Their balance sheet shows $1.35 billion in cash and liquid assets versus $1.233 billion in long-term debt. Their balance sheet, along with their robust operating profile suggests that, despite the negative Free Cash Flow, they should have no problem servicing the debt they have.

Dividend: AGO pays an annual dividend of $..72 per share, which at its current price translates to a dividend yield of about 1.65%. Their dividend payout ratio is also conservative, at less than 25% of their earnings over the last year.

Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but one of the simplest methods that I like uses the stock’s Book Value, which for AGO is $66.18 per share. At the stock’s current price, that translates to a Price/Book Ratio of just .66. It’s tempting to say that the stock is undervalued by 34% on the basis of its Price/Book ratio alone; however, the stock’s historical average Price/Book ratio is also .66, implying that the stock is actually fairly valued at its current price. That also puts the stock’s real value price at just $35 per share – a level the stock hasn’t seen since July of 2018.

Technical Profile

Here’s a look at the stock’s latest technical chart.

Current Price Action/Trends and Pivots: The chart above displays the past two years of price activity for AGO. The stock’s peak at $48 came in early May, with a big drop within a couple of weeks down to about $41 by the middle of that month. The stock has trended somewhat higher from that point, with swings between higher lows and higher highs defining that trend that have expanded in the last month and a half of $2 to $3 per share. Current support appears to be at the stock’s most recent pivot low at around $43 per share, but could also be around $42 where the 38.2% Fibonacci retracement line sits. Resistance is also just a little above the stock’s current price around $44, with secondary resistance at around $45.50. A break above $45.50 could see the stock test its two-year high at $48; but a drop below $42 could see it drop quickly to around $39 at the 61.8% Fib line.

Near-term Keys: From a long-term perspective, it’s hard to see a lot of long-term upside in AGO, despite its generally strong fundamental profile. The company’s negative Free Cash Flow could be a temporary anomaly, or it could be indicative of larger problems that aren’t reflected in the other fundamental measurements I’ve covered. That means the best opportunities to work with the stock are with short-term, momentum-oriented trades. If you want to be aggressive, look for the stock to continue its current bounce off of support around $43 as a signal to buy the stock or work with call options with a target price at around $46 per share. A drop below $42 would be a good signal to consider shorting the stock or working with put options with an eye on $39 as an exit target for a bearish trade.

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