Big Bargain Buffett Buy

We can seldom buy something that Warren Buffett has recently bought without paying a high premium. However, I've found an exception in Insurance Australia Group Limited ADRs (IAUGY).

First, let's quickly distinguish this company from American International Group , better known as A.I.G., with which it is sometimes confused. AIG is the New York-based insurance company that wrote extremely risky derivatives that, along with Lehman Brothers, nearly brought down the world financial system in 2008, until it was bailed out by U.S. taxpayers. AIG's stock is still down 96% from its all-time high.

Insurance Australia Group underwrites diverse types of personal and commercial insurance in Australia, New Zealand and Asia. It writes automotive, home owner, commercial property, construction and engineering, consumer credit, extended warranty, income protection, marine, professional indemnity and workers' compensation, as well as niche and specialty products.

Buffett's Berkshire Hathaway recently took a 3.7% equity stake in IAG and reinsured 20% of its liabilities. ("Reinsured" means it assumed the risk for those policies in exchange for a fee.) Buffett said in a video message, "Even though this contract runs for ten years I expect for decades and decades to come that both companies will benefit in many ways that we can't even visualize now."

Insurance Australia Group's EPS grew 47% last year, but keep in mind that earnings are unpredictable in insurance, since one never knows what claims expenses will be in any given year. The company's balance sheet is very solid with interest coverage at 18-times operating earnings. Buffett's typically exhaustive due diligence before buying is additional assurance that we're not missing anything important on or off the balance sheet.

The ADRs (American Depositary Receipts) represent five shares of the ordinary (common) shares traded on the Australian stock exchange. The common stock can also be bought in America under the symbol IAUGF, however, those shares are much less liquid. I would stay with the ADRs, which closed recently at $20.53.

The stock has a trailing P/E of 12. The dividend, based on last year's payments, yields nearly 5% with a payout ratio of 72%. Like most foreign stocks, the dividend may vary, partly because it is dependent on year-to-year earnings and CAPEX needs, and partly because of exchange rate fluctuations.

During his announcement about Insurance Australia, Buffett also said that he expected to buy Australian banks sometime in the next few years. At Insiders Plus, we've owned Westpac Banking (WBK) for several years and have done well with it. However, I would not buy it fresh at its current price. Tighter capital requirements are in store for Australian banks; they may bring with them secondary stock offerings and earnings dilution. I suspect that's why Buffett said he'd be looking to buy in the future instead of today.

There are only five major banks in Australia, so they have a bit of an oligopoly, albeit a well-regulated one. I'll be looking most closely at ANZ Banking Group (ANZBY), which has the least exposure to Australia's overheated residential real estate market, and National Australia Bank (NABZY), which has already gone through a capital raise and now has the best-looking balance sheet for the new regulations to come.

All three of the above-mentioned banks have dividend yields between 6.5% and 7%, based on total 2014 payouts. Westpac had the highest payout ratio at about 70%.

Reasons To Buy IAG:

1. Warren Buffett's investment provides strong proof of pedigree.
2. At 12-times earnings, the stock is at least 33% cheaper than the U.S. market
3. The 5% yield, though variable, should provide good income while the company grows.
4. Australian companies benefit from the higher growth in China and other Asian countries.

Insurance Australia Group is a buy up to $22.25.