Allco is being flogged for three main reasons. First, AFG stock...

Allco is being flogged for three main reasons. First, AFG stock is trading on US sub-prime sentiment. So, as US banks suffer share price declines on the back of huge sub-prime related write downs, AFG has followed suit. The odd thing about this is that AFG has virtually no sub-prime exposure, and so it is difficult to see why AFG would need to incur any meaningful write downs. Nevertheless, and unlike other Australian investment banks, AFG has actually suffered percentage price declines in line with the worst declines of the big US investment banks – even though AFG is not exposed to sub-prime.

Second, some analysts think AFG overpaid for Rubicon by as much as 10%. So the Rubicon acquisition has caused AFG to temporally fall out of favor with at least two analysts. But even if AFG did overpay for Rubicon by 10%, management have stated that the Rubicon deal will be EPS neutral for AFG in FY08 and EPS positive going forward from FY09. So while the Rubicon deal might not yet be a buy catalyst, it also provides no valid reason to sell.

Third, AFG management have refused to give any firm guidance for FY08, except to say that they expect profit/EPS growth in 08, and that the Rubicon acquisition will be EPS neutral in 08. This has made it difficult for analysts to value the company and created more uncertainty for AFG than other wise would be the case. Especially during this period of sub-prime anxiety, the absence of hard forecasts tend make people assume the glass is half empty.

Despite all of the above, in my view, AFG is massively oversold. Even if we assume no increase in the dividend for 08, and a relatively flat growth outlook, AFG at current prices is still paying close to 7% and is trading on a PER of around 9.5. While the credit-market fall out will make new deals somewhat more difficult and more expensive, AFG has enough capital and warehousing facilities to ride out the credit market mess. (US analysts are expecting the US bank sub-prime related write downs to be more or less complete by Q208, and expect tight credit markets to last only through Q1).

The key point here is that, at the present point in time, there is no factual basis upon which to conclude that AFG is under any earnings stress at all. Indeed, there is no reason why AFG could not put in a strong result for FY08.

All we have is non-AFG-specific negative sentiment.

I'm expecting AFG to remain volatile for the next few months, but, given the news and facts available to date, I also see $6.50 (=FY08 PE of around 9) as a pretty firm base. I'm also betting that the Dec half results will be a catalyst for a significant re-rating of the stock. Once US sub-prime tensions ease (probably in Q2 08), and assuming there are no nasty surprises in AFG's december results I think there is a high probability that AFG will be trading north of $12 by the middle of next year. We should be mindful of the fact that AFG has a duty to keep the ASX informed of any dramatic changes to management's earnings expectations, and that all of AFG's recent announcements have been neutral or good news.

So, I see a realistic potential 100% gain for AFG over the next 9-12 months. Certainly, at current prices, and with the available information, upside risk far outweighs downside risk.