(FORTUNE Magazine) – It's every value investor's fantasy: scooping up shares of a blue chip that are selling at a deep discount because of a scandal--and then enjoying the long rebound. Maybe you missed out on buying Tyco when it plummeted to $8 and then cursed yourself as it marched back to $30. These days you may be pondering tarnished insurance stocks such as AIG (AIG, $53), which has dropped 19% this year after revelations of questionable reinsurance deals. The good news is that analysts, including Morgan Stanley's Bill Wilt, recently upgraded AIG. But consider what passes for bullishness on the stock these days: Wilt expects only about a 10% rebound over the next 12 months--assuming no more major revelations--and his outlook on the industry is cautious. Still, Wilt, 38, who has made some good calls recently (he downgraded St. Paul Travelers before it announced a $1.63 billion charge, and he upgraded Allstate's stock ahead of a 28% jump) sees a silver lining in the AIG story.

Despite the recent scandals, you upgraded your rating on AIG. Why?

AIG still has risks: I don't think the stock or the company is out of the woods. But investors have punished the stock a bit more than it deserves. It has fallen some 25% since [news of New York attorney general Eliot Spitzer's investigation of AIG surfaced in February]. A lot of the stock's historical premium has been wrung out. It has been trading at a price to trailing book value of about 1.65. That's well below its historical average.

Will AIG's shares return to their 52-week high of $75?

We have a price target of $59, and we think the stock can get to that level in the next year or so. We don't assume it will recapture the historical premium that it once enjoyed but rather that it will get to a price to trailing book value of about 1.7 to 1.75. I think the premium is warranted because of the global depth and breadth of its underwriting operations.

They still have a global infrastructure that a lot of other insurers don't. They are selling products that a lot of others don't. They are still relied upon for a lot of hard-to-place insurance risks, and they still employ a lot of smart people to insure those risks. AIG is a good company that will probably come through this better than it was before.

How will AIG replace the $2.7 billion in net worth it announced was created largely by accounting shenanigans?

I don't think they will replace all of it. They were inflating operating income. Reversing that doesn't have an impact on book value. The $2.7 billion is clearly a meaningful number. But viewed in the context of their $80-some billion in shareholder's equity, it is manageable. I don't mean to diminish the significance, but they can handle the hit.

AIG keeps delaying the filing of its annual report. Couldn't there be bad news buried in the financials?

There could be. I don't want to shy away from highlighting the risk. We expect that the company would have used their recent press releases to highlight major sources of risk and any pending uncertainty. Of course, there is no guarantee that's the case.

What is your biggest worry about AIG?

We have concerns about the adequacy of the company's core reserves in its general insurance operations. There's a concern that the complicated web of companies that AIG has--and the weakness in the stock price--could lead to either the reality or the perception that some of their subsidiaries might be undercapitalized. They'd have to address this through asset sales or by unwinding their somewhat complicated web of intercompany holdings.

Will AIG's stock mimic the rebound of scandal-tarred Tyco?

We tracked stocks such as Fannie Mae, Freddie Mac, and Tyco, where there were regulatory inquiries and/or a CEO-level resignation. The conclusion was that few of them recaptured the premium valuations that they had previously enjoyed. We did this analysis when AIG's stock price fell through the mid-50s. We were getting a lot of calls questioning if we would miss the upside by not putting an overweight on the stock at those levels. Our analysis showed that other companies that had gone through something similar had fairly flat bottoms. They sold off sharply, stumbled along the bottom while the regulatory process unfolded, and then in some cases--like Tyco's--the share price started gradually to move up.

What other insurance stocks look promising?

We have an overweight on CNA Financial (CNA, $27), which has long been an underperformer. We think it is turning the corner. They've addressed a lot of the operational reasons for their underperformance. In the late '90s, their data systems--which are the lifeblood of most insurance companies--were in shambles. That has changed, and they've improved their management information systems.

But the company, which is 91% owned by Loews, just announced it will restate three years of results to correct improper accounting.

The stock trades at a 20% discount, based on our estimate of year-end 2005 book value. There still are balance-sheet risks, and it has a higher expense structure than many of its peers. But we think the risks may be more than adequately discounted.

Which personal insurance companies do you like?

Progressive (PGR, $92) is a great company that I think is going to be a long-term winner. Auto insurers have enjoyed very substantial profits the last couple of years. Now they are starting to lower their rates. When auto insurers lower their rates, consumers tend to shop less for insurance. You may not like your insurance company, but if they lower their rates by 5%, you are less likely to go elsewhere.

The post-9/11 insurance climate was called a "hard market." That's a good thing in your industry--prices go up and it is good for the companies. Are things softening now?

You want to be mindful because we're seeing cyclical peak earnings now. I think returns on equity are going down. A lot of companies still don't have the financial flexibility that one would expect at this stage of the cycle. I am cautious on the operating fundamentals. It's important to convey caution but not a doomsday outlook. A lot of factors are working for the industry. There has been legal reform and medical malpractice reform in a lot of states.

Warren Buffett recently said that the bad publicity and penalties from the insurance scandals will modify the industry's behavior. Do you agree?

I think they will. Companies, from a governance perspective on down to the individual level, will be more mindful of their duties.