Bank of America (BAC)
BAC stock has has suffered the most in the recent downturn in bank stocks. The biggest concern has been the significant unknowns about its mortgage exposure. BAC has set aside almost $20 billion to account for losses from various settlements. However, there are significant unknowns:
- Its settlements of $8.5 billion with a group of mortgage investors is currently being challenged in court.
- There are various lawsuits by states against the big banks. NY state attorney general has been among the most aggressive and it is likely that those lawsuits can have a big drag on the bank’s results.
- There are questions about BAC capital adequacy ratio given that BAC request to pay dividends was rejected by the regulators. This implies that regulators are not very comfortable with the capital levels.
Countering the above factors there are a few positives:
- BAC has significant franchise earnings power. There have been various range of estimates but in general I have not seen those estimates too far below $2 a share.
- BAC is in all the key business areas – retail, mortgage, investment banking, corporate banking and wealth management. Thus as the U.S. economy picks up, the bank has enough firepower to fire on various cylinders.
- Tangible book value of the stocks is above $12 a share versus it current market value below $8 a share.
The recent investment by Buffett provides an interesting additional pointer. While the investment in BAC has been portrayed as a good deal for BAC, I have my reservations. BAC didn’t raise any additional capital when Warren invested in BAC. Thus BAC didn’t benefit from raising the capital as both GS and GE did when Warren provided that capital. So really the purpose was to bump the stock price in the short term. However, this will have the exact opposite consequence in the long term as I prove below.
BAC gave Buffett a free 10-year call option at a strike price of $7.14. If I look at the traded price of BAC call options, a call option maturing in January 2013 with a strike price of $7.50 is worth $2.35. Hence, the value of the option is significantly more than the above $2.35 since the option doesn’t mature in 2013 but matures in 2021. Some people have estimated that the value of the option is $5.49 at the following link. I do think the price is even higher but Black Scholes is not a good way of measuring long dated options as Buffett has said multiple times.
The above coupled with the fact that Buffett has taken no risk with it (preferred shares are higher in the capital structure than the equity capital and yet have all the upside because of warrants) is classic Buffett. That he got the deal despite it not being 2008 is even more commendable. This also speaks poorly of the current management.
Bottom line: I think that the current investment by Buffett is a very expensive deal for BAC current shareholders. Management has taken the deal to preserve themselves and get endorsement from most one of the most savvy investors. This investment doesn't do any good to the existing shareholders.
However, given the above, can we find other investments in the banking that could potentially fit the bill of savvy investments? The two that I have in mind are:
Citigroup went through a lot of churn in 2008. The stock price that used to be around $50 in 2007 has now fallen to $3 (accounting for the 1:10 reverse split in 2011). The company also wrote down a lot of the items on its balance sheet which makes it more than likely that its current book value truly reflects the value of the company. A few key factors:
- Tangible book value is upwards of $40 a share vs its market value of $30 a share.
- Yearly earnings capacity of $10 billion versus $87 billion of market value thus resulting in PE of 8.5.
- Extensive presence in emerging markets where the growth is likely to be much higher than in the more mature markets of the U.S. and Europe.
The above factors coupled with the leadership of Vikarm Pandit who has done a good job of leading the bank could provide a good opportunity to get into this bank.
Barclays went through a similar churn in 2008 as Citi. However, unlike Citi, Barclays never required any bailout from governments. They were able to get private investors from the Middle East to enhance their capital. A few interesting factors for Barclays are:
- Barclay’s book value is only 0.36 of its market value. While book value includes some of the intangibles that are still on the balance sheet, .36 is a very low ratio for the bank.
- Barclay’s market value of $30.5 billion also includes the stake that bank has in the following entities:
- Blackrock – 19.99%. This accounts for $5.75 billion.
- Absa – 56.4%. This accounts for $7.3 billion.
Thus one can buy Barclays at 4x earnings given that the market value is only $17.3 billion for the remaining operations.
Finally, looking at the price at which some of the investors did the deal with Barclays in 2008, the warrants were received for 197 pence versus 155 pence that the shares are now available for on the London FTSE market.
The above factors coupled with the leadership of Bob Diamond makes buying BCS a good deal. The risk is that Europe could go down the tube and that that could impact Barclays. Bob Diamond has clarified that they don’t have big sovereign risk in Europe. The main risk is in Italy where they are the top 10 banks. However, since they are a retail bank, they borrow and lend there so the risk of getting impacted should be limited.
- BAC is not a good investment opportunity for ordinary investors at this time. Management actions have not been shareholder friendly.
- C is a good opportunity given that its balance sheet is clean and C has significant presence in emerging markets.
- BCS is cheaper than C. However, BCS has higher risk as well since there could be a contagion effect from Europe situation.
Disclosure: I own BAC and C stock currently. As prices move I will look to add C and BCS.
Disclaimer: All views expressed in this article are the author’s own views. They don’t represent the views of any company or organization that the author may be affiliated with. This is not a recommendation to buy or sell a stock. You need to do your own diligence before buying or selling a stock.