Bruce Berkowitz detailed his investing thesis on Bank of America (BAC, Financial) in a speech given at AAII in June. He is confident with Bank of America and his other positions in AIG (AIG, Financial) and MBIA (MBI, Financial). 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 (C, Financial), Goldman Sachs (GS, Financial), Morgan Stanley (MS, Financial), 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.
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 (C, Financial), Goldman Sachs (GS, Financial), Morgan Stanley (MS, Financial), 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.
