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Bruce Berkowitz Details His Thesis On BAC

July 26, 2011 | About:
Bruce Berkowitz detailed his investing thesis on Bank of America (NYSE:BAC) in a speech given at AAII in June. He is confident with Bank of America and his other positions in AIG (NYSE:AIG) and MBIA (NYSE:MBI). As of March 31, Bruce Berkowitz’s firm Fairholme Capital Management owns more than 92 million share of Bank of America. His average cost is around $15 a share. He has lost one third of his investment on Bank of America.

These are the excerpts from his speech at AAII. For the complete speech, click here.

A Great Time to Be in Banking Sector

It gets at what I would call perception versus reality. I will give you an example. I am all in right now in the U.S. banking sector. I think, what a great time to be here.

I just seem to always suffer from, what I could call premature accumulation. I would buy and I would buy too soon. I would buy more, and more the way some people would buy their favorite product on sale at the department store. This requires fortitude, courage, confidence and conviction.

An example is Bank of America which is a very large position of the fund, it’s a billion dollar plus position. We would own more if we could, but the rules for a mutual fund are you can’t be have more than 5% of your fund because of the broker deal elements.

Banking is a Cyclical Industry

Bank of America, from my reading of the papers, single-handedly caused the housing crisis. That is the company they purchased, Countrywide Financial, and they’re getting kicked around pretty hard right now.

But it’s banking, it’s a cyclical industry. Every 5 to 10 years, the banks blow up. There’s tremendous uncertainty. People have lost decades of performance with the banks.

Banks Are the Financial System

On the positive, Bank of America, so you know, is part of the financial system of the United States. The United States does not work without Bank of America. Now, I don’t know if you’ve ever visited the United States Treasury or the Federal Reserve. They’re not very big buildings. There aren’t that many people in them. It’s Bank of America, Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), and a handful of others. They are our financial system. Nothing works without their financial system. We seemed to have forgotten that. Bank of America is global in scale, global in geography.

I like Brian Moynihan, the new CEO

I like Brian Moynihan, the new CEO. He’s ahead of the curve. He actually lowered late fees. Without being recognized, he’s taking all the right steps for consumers. He’s working out the mortgages. There’s probably another two years to go.

The Earnings, Cash Flow and the Book Value

I don’t understand why it’s so hated, because today the company is making money, about a dollar a share. It’s selling for $12.25. But they’re still in the midst of problems. They have 30,000 extra people working on the mortgage issues, refinancing, re-mediating, foreclosure, trying to figure out an end to this problem. They’re still digesting the issues of 2007, 2008. People have to understand that that’s going to come to an end. People don’t think it’s going to come to an end.

For example, if you understand the nature of retail loans, consumer loans, floating rate, fixed, they have an average life. Let’s say most loans are between five and seven years. For 2007, loans which were a very bad deal causing a lot of the problems, they only have 48% of those loans left. Think about a python eating a pig. It gets digested, slowly digested. Or think about it as vintages with wines, the way you look at years. In 2007, they only have 38% left. In 2008, around 48% left. As every month goes by, those problems are taken care of. And 2009, 2010, they put on tremendously great loans. So we have a business which is at an inflection point. I’m going to stop with the qualitative stuff. I’m just going to give you the numbers now. Bank of America generates before reserving for bad loans and before taxes, $45-50 billion a year. That’s $4.50 to $5 a share for a company that’s selling for $11 and change, before provisioning for bad loans, and before taxes. That’s $3.50 to $4 per share before taxes. It’s going to be a long time before they pay taxes, given that they have to blow through $80 billion roughly of past losses. Which means the next $80 billion that they make, they don’t pay any taxes on. So, that’s $3.50 to $4. So what does that mean?

And then, when they blow through the $80 billion, there’ll be a little bit of growth, and they’ll still be making that. But after tax, GAAP numbers would be about $2.50 a share.

I’m sure people have talked to you about tangible book value. Tangible book value is the real assets of a company after you get rid of it. The goodwill, the fluff it used to be called, the extra that you pay for business. It’s very unusual but the Bank of America’s tangible book value is lower than liquidation value. It’s $13.21. Its book value is $20-something.

If you look at the history of banking in a normalized period, it’s not unusual to see a 1% to 2% return on assets. It’s not unusual to see 10% to 15% return on equity. Any way you look at it, it’s fascinating.

For me, the period that we’re in right now is very reminiscent of the early 90s. I remember having a gigantic position in Wells Fargo. Everyone thought they were going to go bust, because they had all of these empty commercial buildings in California and all over the place. They didn’t go bust. It was a rough time, and they made seven times money. I don’t think its going to happen that way. But if people who are in the banks during this doom and gloom period made 5 to 10 times their money, history repeats itself.

By the way, Bank of America, they supply a lot of what we’re doing right now. I’m just going to give you one solid example. They’re going to make in a more normal period which they’re getting to, $2+ per share. They will not need the capital in about 12 months’ time. They are already stronger than I’ve even seen them. Balance sheet’s great. The reserves are unbelievable. They’ll probably need another 12 months to get to this over-capital position which everyone will be forced to, as the pendulum gets to the extreme before it starts to go the other way.

No Need to Pay Tax; Dividend and Share Buybacks

Then, they’ll be able to take every penny of those earnings- that cash earnings- and give it to you in the form of a dividend or a share buyback. If it becomes a dividend which will slowly build…you’re talking about $2 a share dividend.

Think about it another way. If I use the money just to buy back stock, and the stock for some reason stays where it is for 10 billion shares, it would take them six years. In six years, they’ll buy the entire company back that started in 1794 and had hundreds of billions of dollars of acquisitions that probably touches one out of every two people in the United States. Given the fact that they’re not going to pay taxes, they’ll probably buy back all the stock in five years.

I won't talk to you about how long it will take if it wasn't $2 but $3. Or there's a combination. They eventually pay you a 5% dividend, and it takes them 10 years to buy all the stock back. But of course, as they buy back, the earnings go up. The price goes up. It's a vicious cycle. So you end up with a company with good dividends, good capital gains, and very little downside. Those are the companies we're trying to look at for Fairholme and the Fairholme Funds. We're up to here with these companies right now.

I Have Done This Before

Not exactly the same way but if you understand, critical to the functioning of this country, critical to job growth, critical to the safety and security of our nation, they have to succeed. Even if they succeed in a non-excessive way, with a very reasonable profit, one would do quite well based upon the price.

Very reminiscent of the start in the late '80s, and it went to the '90s, 1992, 1993, it went up, it came down. People didn't understand. They lost money again, and then boom! Because of this consolidation, there were fewer players; so tremendous uncertainty which should diminish over the next 12 months, big bias. This is how we do it. And usually it means buying something that's hated. And something where the newspaper everyday is going to tell you, "You're wrong." And your friends are going to tell you, "You're wrong." There's going to be something else that is hot and juicy, some new thing which you are going to want to get in on, and you usually feel pretty lousy about it. Because, when you're early, you look wrong. You make your most money when times are at their toughest. You just don't know it at the time.

It's not easy; it's a painful process. You climb this wall of worry eventually over a multi-year period. You get sharp drops like we had today in the market-place. You have to deal with this crazy accounting that companies have now.

So, a year from now, you will know whether I’m sane or insane. Five years from now, you’ll know whether I’m lucky or good. We’ll save when to sell for another day.

About the author:

GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 4.2/5 (39 votes)



Superguru - 5 years ago
He is almost 25 % down YTD compared to SEQUX which is another fund I track.

Being contrarian can be real tough on value investors. I am still long FAIRX.
Cubsfan premium member - 5 years ago
Agree, I own FAIRX as well. It's tough going against the crowd and sentiment.

He's a great investor and is likely right, but timing makes him look bad.
Tighanx - 5 years ago
Banks are really hard to analyze, unfortunately, Mr. Bekowitz didn't give us any insight
Cubsfan premium member - 5 years ago
I just read the attachment as well - the AAII speech.

It's very good , and the Q&A is really outstanding.
Rgosalia - 5 years ago
Mr. Berkowitz talks with OID about his Wells Fargo thesis when he had 30% of his net worth invested in it during the S&L crisis in '92.

- Rishi
David Pinsen
David Pinsen - 5 years ago
I was at this presentation, and wrote it up the next day here. I didn't get a chance to ask Bruce a question, but I happened to be sitting next to Charlie Fernandez, who was nice enough to answer a few questions about JOE.
Davidchulak premium member - 5 years ago
Cubsfan says: It's tough going against the crowd and sentiment.

He's a great investor and is likely right, but timing makes him look bad.

That says it fairly well, but I don't think it makes him look bad. As a Cubs fan, you certainly understand going against the crowd and sentiment!!!

It is difficult at best to study banks. A lot gets hidden in those books unless you can spend the time necessary and even then....the most proficient investors will probably miss something in the mass of reports. As a former owner of Washington Mutual, I'm a little gun shy, though I actually got out before I got burned.

Bruce is in an unenviable position. Does it make him look bad? Not a chance. Give the man credit. he knows value and is sticking with it. He's probably guilty of nothing more than bad timing. Two years from now, he will.....so to speak....be laughing all the way to the bank.

Now, from a small investors standpoint, what should I do about owning BAC? I know it's cheap. I can see that the book value is around $23 and BAC is selling around $10. I can read what everyone is saying about it....good or bad. The average fair value at GuruFocus is around $24. If we are inclined to invest in it, we should never as value investors worry about timing. With that said, caution is the name of the game and so is preservation of capital. We don't know what's ahead, but even Bruce thought that recovery was a few years off. I think it's prudent to wait till BAC shows some sort of life or better numbers. Would it be terrible to own it after it has skyrocketed to $12? It's been at $15 only for a day or two this year. Maybe wait till then? I still would have my margin of safety.

Bruce will be fine, regardless of what some think about his decision.


Botbgrt - 5 years ago
David, what will a $15 price tag tell you that the current price isn't telling you now??

You pay for certainty and value is hidden in uncertainty.
Davidchulak premium member - 5 years ago

Your right. It's undervalued and now is a good time to buy. I'm only stating that for those inclined to own it...if they need an added cranial margin of safety in addition to the normal mos....waiting for it to start going up isn't going to hurt. But you won't get an argument from me. You are right on.
Koheleth - 5 years ago
And as Sir John Templeton once said: "...if you wait until you see light at the end of the tunnel, you're already past the best bargain days."

Dealraker - 5 years ago
Bank of A actually may be somewhere between a 1992 Wells Fargo and banks overall in the 1930's. Enlarged loan losses during the Great Depression kept going for years all the way up to WWII.

Rgosalia - 4 years ago

I pulled data from FDIC's website and found the following:

net-charge-off/net loans

1934 3.42%

1935 1.61%

1936 0.87%

1937 0.31%

1938 0.58%

1939 0.42%

1940 0.26%

1941 0.15%

1942 0.06%

1943 -0.06%

1944 -0.07%

1945 -0.04%

So, I am not sure why you say that banks had enlarged losses that kept going for years all the way up to WWII. From the above, the trend for charge-off improved quite a bit.

For a bank levered 10:1, charge-off of 1% would mean a reduction in book value by 10%. But, if you can buy that bank for half the book value, you should be well protected for at least 5 years even in the case that bank cannot grow its book.

Any thoughts?

Dealraker - 4 years ago
I was using info passed along to me. Looks to be erronous info from what you have posted.
Dealraker - 4 years ago
Bank board director- a CPA- sent me an email last night: He expects loan losses from his well-run 2 billion dollar bank to be 2% this year and 2% next year.
Noblepaladin - 4 years ago
So according to Berkowitz's thesis, BAC is halfway through their old pre-2007 loan portfolio. The loans made since are all good loans. So BAC contains half "good loans" and half "bad loans". If you buy BAC at half of book value, you are effectively discounting all of the "bad loans" already, as if they are completely worthless. But it is likely that the "bad loans" have some value. They are not going to be completely written off. So unless the "bad loan" portfolio has some derivatives of mass destruction that can nuke the entire company, it looks pretty safe to buy BAC.
Gokou3 - 4 years ago
Dealraker: how does the 2% estimate compare to what BAC currently has?

Noblepaladin: I think you have mixed up asset and equity (book). If the bad loans are worthless (which I don't think is the case) then BAC will be significantly in the negative equity territory.

Rgosalia - 4 years ago

This might be a technicality, but a bank could have 2% loan loss but have reserves for all of it or some of it. So the important question is what is the ratio of loan loss reserve / loan loss, because that is what will determine the impact on book.

Dealraker - 4 years ago
The bank I mentioned is adequately reserved but not excessively so. They've done an admirable job in that their net interest income has gone up each year and nearly each quarter without an interruption. But they too were surprised by the loan losses they encountered.

Their tangible book is higher than when the crisis started and they were able to raise cash at slightly above that tangible book- which was pretty heroic around here. Only one other bank this size- which didn't have to raise cash at all- did better in this respect. The rest of the bunch either raised cash at less than half of tangible book- or all the way to 1/4 of book- others are just zombies waiting for the shut down or somebody to take it....for something....- and then there are a couple that haven't had to raise cash and sit at half tangible book with net interest income falling continually.

As of yet I've not seen one bank management take a cut in pay. The FDIC insures more than just deposits!

My view is consistent: We consitently reward the wrong occupations with excessive pay in this country. This capital mis-allocation is our BIGGEST problem. We pay CEO's so much that they can't think straight. Wine, women, and song is about all they can handle when you pay someone enough in one year to last a lifetime!

Ha! How's that? Funny!

Don't even get me started about financial planners and mutual fund runners - the "take 1-2% bunch in a 5% return world?" Give me a break. Nobody retires, except them!

Sivaram - 4 years ago
RGOSALIA: "I pulled data from FDIC's website and found the following:

net-charge-off/net loans

1934 3.42%

1935 1.61%

1936 0.87%

1937 0.31%

1938 0.58%

1939 0.42%

1940 0.26%

1941 0.15%

1942 0.06%

1943 -0.06%

1944 -0.07%

1945 -0.04%


For a bank levered 10:1, charge-off of 1% would mean a reduction in book value by 10%. But, if you can buy that bank for half the book value, you should be well protected for at least 5 years even in the case that bank cannot grow its book."

As someone above already pointed out, and you sort of answered it by suggesting that you are assuming reserves are adequate(?), but I'll reiterate it because it's important... If what you were saying were true then 1934, which was a disastrous year for financials, would have been ok too: 3.4% times 10 = only a 34% loss. Yet it wasn't. Even the best banks would have been happy with a 34% book value markdown back in 1934.

Rgosalia - 4 years ago
Here is data for the depository banking business of Bank of America (based on quarterly call data filed with FDIC) for last 12 quarters.

Quarter Total Total Total Total Charge NPA TDR TX

Assets Equity Loans Allowance Offs Ratio

08 Q2 1.67T 176B 919B 17.0B 3.97B 15.36B .20B 14.32

08 Q3 1.80T 192B 996B 20.3B 4.62B 24.15B 1.89B 20.45

08 Q4 1.82T 190B 980B 23.0B 5.84B 34.86B 1.23B 27.64

09 Q1 1.87T 200B 996B 29.0B 7.25B 45.82B 2.84B 30.02

09 Q2 1.75T 194B 971B 33.6B 9.07B 47.11B 6.59B 30.19

09 Q3 1.69T 202B 933B 35.8B 9.84B 51.77B 9.06B 31.44

09 Q4 1.65T 201B 917B 37.1B 8.85B 67.85B 10.45B 33.16

10 Q1 1.75T 198B 980B 46.3B 11.25B 73.64B 11.31B 35.87

10 Q2 1.77T 200B 967B 44.6B 10.07B 70.15B 12.45B 32.87

10 Q3 1.74T 200B 941B 42.9B 7.70B 69.43B 13.42B 32.70

10 Q4 1.74T 211B 955B 41.3B 7.34B 67.30B 14.81B 30.30

11 Q1 1.68T 207B 938B 39.4B 6.73B 68.76B 28.22B 36.34


Income (annualized)

08 Q2 3.78B 0.85 8.02

08 Q3 4.36B 0.86 8.24

08 Q4 .56B 0.02 0.21

09 Q1 -11.87B -2.15 -20.50

09 Q2 -5.93B -1.52 -13.94

09 Q3 -0.33B 0.09 0.79

09 Q4 -0.97B -0.17 -1.41

10 Q1 2.09B 0.50 4.29

10 Q2 1.68B 0.47 4.21

10 Q3 3.30B 0.89 7.88

10 Q4 3.73B 0.98 8.47

11 Q1 3.97B 1.00 8.44

The two big loss quarters (Q1 09 and Q2 09) were due to charge-offs in credit card portfolio and home equity loans.

Non-performing assets (NPA) have grown from 15B to 68B and charge-offs from 4B to a peak of 11B and back to 7B. But at the same time, total loss allowance has grown from 17B to 40B.

So is BAC adequately reserved? And what hit the book value take in case of enlarged losses from here. I have provided the data, you can make your own conclusions!

The data above is only for the business regulated by FDIC. So, one would also have to analyze the rest of the business.

You can get more interesting pieces of data from FDIC's website and searching for quarterly call data reports, uniform bank performance reports or going to bankregdata.com


Anders - 4 years ago
No disrespect to david but I couln't resist.

Davidchulak wrote -- "I know it's cheap"....."I think it's prudent to wait till BAC shows some sort of life or better numbers."

Berkowitz speaking about WF in OID article Nov 25, 1992 -- "And you know what the sign is? The greatest sign in the world is when everyone agrees, but they think they can call the turn. A lot of people think they can do that with Wells Fargo. That's why they're not there. Lots of people are bullish on Wells Fargo long-term. But lots of them are going to wake up one day and just find that they missed it. Of course, someone who is there is Warren Buffett. I saw that he bought something like 550,000 more shares at an average price of $66."


I find this remarkable!

I'm buying now, not later.. I don't care if it takes 1,2 or 10 years.. It will be an outstanding investment over time, all facts point to it. In the future, history will repeat itself (or rhyme) with a lot of people wishing they bought it years ago.


Superguru - 4 years ago
With BAC and AIG, Bruce sure knows how to go against the crowd. LOL. Why is BAC not getting rid of its Countrywide acquisition?

PHILCIR - 4 years ago
This guy has finally met his waterloo. He's very over rated as are most value guys. Value investors for the most part are delusional. Their opium is a misapplication of Graham and they cling to the notion that they've exploited a profit gap that's probably not there. Don't get me wrong - Graham had some briliant insights but the mainstream valuists don't follow his path. they are too dependent on predicting future cash flows and earnings that are just too slippery.

value has merit but only during the final stage of the bear market when there is indeed a real gap. Most of these guys like Davis, Nyrgren, hawkins, berkowitz, miller have either drunk too much kool-aid or believe their own BS. Bear markets ravage these guys and they have no defensive game plan. In my view, they have too big a hole in their swing to justify investing with them.

Berkowitz has some really bad picks that are not going to survive. BAC does appear to be reasonably valued. I think HCBK might be a better value selection from a pure safety standpoint.
Superguru - 4 years ago
FAIRX is down 28.22 % so far this year. I understand 6 months of under performance does not mean much but under performing peers by 25% may not be that easy to overcome.
PHILCIR - 4 years ago
Yeah 28% is one thing and workable if the market bounces. He looks smart -- but he could easily go to (75%) if the market blows up to Dow 4500. that's my point.

Why don't value oriented investors just use Dow theory and get the hell out in the early stages of a bear market instead of clinging to their subjective suppositions?
David Pinsen
David Pinsen - 4 years ago
Alternatively, why don't they hedge?

Or, at the very least, look at hedging costs?

Take a look at this article of mine, published on April 21st, which shows hedging costs as of April 20th for BAC and the rest of the Dow components: Hedging the Dow. BAC closed at $12.27 on 4/20.

The cost of hedging BAC against a >20% drop over the next 7 months on 4/20 was 4.89% -- not only high in absolute terms, considering that the VIX was only at about 15 then, but also the highest in relative terms, compared to the other 29 other Dow components. In hindsight, maybe that should have been a red flag.

Flash forward to 6/27: The VIX is at 20, BAC is at $10.85, and it's still the most expensive stock in the Dow to hedge -- except now the costs of hedging it against a >20% drop over the next several months are 7.28%.

In hindsight, those look like pretty big red flags. If the cost of hedging your stock is really high, maybe Mr. Market (options version) knows something you don't know. Maybe you ought to unload the stock, or if you're going to hold it, hedge. Even if you're willing to take the stock-specific risk, why take on that and the market risk? Look at the hedging costs for the Dow-tracking ETF on 4/20 and 6/27 at those two links. If Bruce picked up some of those optimal DIA puts, his P&L on them right now would be offsetting a big chunk of his sagging stock returns today.

Superguru - 4 years ago
Yes, I also wonder why many value investors do not hedge. I guess they believe they buy with margin of safety hence no hedging needed and stock will eventually bounce back to IV.
David Pinsen
David Pinsen - 4 years ago
Even if you think the stock will eventually bounce back to your estimate of its IV, hedging can still be worthwhile. When the stock plummets, you're hedge will spike in value, and if you really think the stock's drop is just Mr. Market being crazy, you can sell your appreciated hedges and use that cash to buy your stock when it's beaten down (or, in the case of a fund manager like Berkowitz, use the cash to meet redemptions so you aren't forced to sell the stock for a loss).
David Pinsen
David Pinsen - 4 years ago
Incidentally, I fleshed out my idea above (about how the high optimal hedging costs on BAC might have been a red flag) in a Seeking Alpha article today, High Optimal Hedging Costs: A Red Flag?

Something interesting I noticed, going back to that April 10th list of optimal hedging costs of Dow components: the 4 stocks with the lowest hedging costs significantly outperformed the Dow, and the 4 stocks with the highest hedging costs (BAC being one of them) significantly underperformed.

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