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Opportunity in Bank Stocks

August 28, 2011 | About:
Warren Buffett recently invested in Bank of America and this provided renewed confidence to the public about the opportunity in the bank given the recent sell-off. With that I decided to take a look at some of the banks that I have been eyeing.

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
  • Barclays


Citigroup (C)

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 (BCS)

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:
  • [list]
  • Blackrock – 19.99%. This accounts for $5.75 billion.
  • Absa – 56.4%. This accounts for $7.3 billion.
[/list]Thus the market is only assigning value of $17.3 billion for all the remaining operations. Looking at PBT, Barclays is earning around 6 billion pounds in 2010 of which 616 million pounds were from Absa (which we should exclude since we accounted for it above). Hence the PBT is 5.4 billion pounds. Assuming 25% for tax (this is the tax rate they used for 2010) and 1 billion pounds for non controlling interests, PAT is around 3 billion pounds or $4.8 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.

Conclusion

  • 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.

About the author:

Rajeev Agr
Individual investor interested in growing my portfolio and over time manage money for others using Value approach.

Visit Rajeev Agr's Website


Rating: 3.4/5 (25 votes)

Comments

nashkamalie
Nashkamalie - 2 years ago
you are darn right good job and comment i love it
shaved_head_and_balls
Shaved_head_and_balls - 2 years ago
Buffett's preferred shares are a bet on the US Government propping up BAC in the next recession and downward leg of the housing market. If you do some research on housing, you'll find that many markets (e.g. most of California) are still hugely overpriced relative to the income power of the average homeowner. There is plenty of reason to believe such markets will continue to fall (and exacerbate foreclosures). BAC has plenty of exposure. A deeper recession will again drive BAC into the ground and you'll have another national discussion of nationalizing and liquidating BAC assets. Buffett believes in the worst case, BAC will be bailed out again. Depending on the political winds, he might be wrong. Perhaps this is why Buffett wanted defacto bonds (preferreds) rather than common.
Sivaram
Sivaram - 2 years ago


SHAVED HEAD AND BALLS: "Perhaps this is why Buffett wanted defacto bonds (preferreds) rather than common."

I don't think that's correct. You can't say preferred shares are anything like bonds. Buffet's preferreds are at least cumulative preferreds but, nevertheless, they are nothing like bonds. Shares can get wiped out, not to mention severely diluted, more easily than bonds.
rajeev_agr
Rajeev_agr - 2 years ago
Agree with the comments above that there are still significant risks out there. However, there is a capital cushion of the Equity on the Balance sheet for BAC to burn through before Buffett suffers any of the losses. At the same time Buffett has locked in a significant upside in case the above doesn't come to pass. This is the classics Heads I win, Tails I don't loose.

Any comments from readers on C and BCS?
superguru
Superguru - 2 years ago
I have been thinking to replace my BAC holding by BK. I will look into BCS as well. Thanks
sjzhao2003
Sjzhao2003 - 2 years ago
Excellent work!

But I don't quite agree with you on BAC. It's incredibly cheap since the entire market cap of the company is roughly about the value of the investment banking division, so you get the wealth management and the #1 deposit franchise for free. True, the company is facing mortgage litigations, perhaps more to come, but these will pass in a few years time. NYT has an article discussing the possibility of spinning off the former Countrywide, which is the target of these litigations. Moynihan is turning around the ship by divesting non core assets, most of which are results of previous acquisitions. But the management needs time and market confidence to get the job done, which Buffett's investment should help. Over time, BAC has a very high chance of pulling it through. Also, it's selling for about 4x normalized after tax earning.

As for C, i don't know the company that well. But one thing that bothered me about pandit is that one of the first things he did as the CEO was to take a month long vacation in India in the midst of the financial crisis. Hardly the kind of leadership I can trust as a shareholder.

I don't know BCS well either. From your description, it certainly looks interesting. One concern is their high leverage (on average 40-50x for the past 10 years. Can they maintain the leverage level after BaselII? Personally i think trading-oriented businesses are less predictable and more opaque.
rajeev_agr
Rajeev_agr - 2 years ago
Thanks Sjzhao. I do think that BAC is quite cheap. However, my main concern is that management did a very expensive deal with Buffett and the rationale for the deal is not clear to me. They weren't trying to raise additional capital (since they didn't issue additional stocks other than to Buffett), they weren't in a situation that the bank was a few days/weeks away from being unable to meet its obligation (since they have a huge cash hoard on their BS). So the main reason was to stabilize their own management positions by having Buffett vouch for that.

BCS leverage has come down to 20x from the earlier 40-50x. Their tier 1 capital ratio is now in the 9-10% range which is pretty good for a European bank.

Regarding C, I didn't hear about the month long vacation. Thanks for the pointer.
AlbertaSunwapta
AlbertaSunwapta - 2 years ago
Buffett initiated the call?

"Bank of America is a strong, well-led company, and I called Brian to tell him I wanted to invest in it," said Berkshire Hathaway Chairman and Chief Executive Officer Warren Buffett."

Buffett sees a bright future?

"I am impressed with the profit-generating abilities of this franchise, and that they are acting aggressively to put their challenges behind them. Bank of America is focused on their customers and on serving them well. That's what customers want, and that's the company's strategy."
noblepaladin
Noblepaladin - 2 years ago
The Buffett deal with BAC is a bit startling. I think they are well capitalized, as well as most bank analysts (even perma-bear Meredith Whitney says they are very well capitalized). It will be very hard to say if it is the right thing to do or not. I can understand bringing Buffett in because it completely nipped the nonsense idea that BAC is insolvent (most of the people who say it have no evidence to back it up other than the future is uncertain, so they will exercise mark-to-zero accounting and assume the bank is worthless). The coupon on the preferred is reasonable (below the market rate of comparable securities). But the warrants effectively gives up about 7% of all future earnings to Mr. Buffett. BAC is still very cheap by my valuations, but as Buffett says, "I feel poorer after the deal". But it does avert the worse case scenario where BAC is healthy, but a "run on the bank" type event happens. But the Buffett stamp of approval came at a very steep price.

One thing I am wondering is if BAC management did the deal to save their own behinds. Lots of people are disappointed at BAC management because of the lagging stock performance. I think the management team is doing a good job. They've always done a great job running the operations. Other than the two stupid deals, Countrywide and Merrill Lynch, they were probably the most healthy bank going into 2008-2009, along with WFC. Great operations, poor acquisitions (which is not current management's fault). Buffett support ensures that management sticks around for a little while longer. I think management benefited from the deal a lot more than stockholders. But in terms of having a team to run the bank operations, they are a top notch team. And when things get bad, even top notch people who are doing everything right cover their own asses first. Charlie Munger would probably be the first person to point out how that incentive works.
shaved_head_and_balls
Shaved_head_and_balls - 2 years ago
If a prolonged recession strikes and foreclosures mount, the cumulative effect of various litigation, leveraged exposure to bad credit, the mortgage issue, and many other loss-producers will bring BAC to insolvency again. If the government decides to prepackage a bankruptcy of BAC and sell its assets, the preferred shareholders might pick up some crumbs and morsels, like bondholders.

I don't know how any of the BAC lovers on this message board can say BAC is "cheap". And I find it hard to believe that Buffett waded through the morass of BAC's balance sheet and potential litigation costs. He claimed to get the idea during a morning bath. The fact is that BAC is a black hole of potential losses with an asset/liability mix that is mind numbing.

Buffett dumped his prior BAC common stock holding late last year at a large loss. He probably threw it into the "too hard to understand" dumpster. With the deal he got on the preferreds, he only needed to know one thing: he'll get his dividends as long as the federal government keeps them on life support--a virtual certainty with our corrupted political system.

BAC is no longer a "great franchise". Countrywide was a "great franchise", as was Washington Mutual. The previous "great franchises" are untouchable now. Can you imagine anyone paying big money for the rights to use even the name of Countrywide or Washington Mutural now. Bank of America is a tarnished brand. Many Americans would like the management of these three great brands to share a room with Bernie Madoff. They'll never come back. Too big to fail, too big to jail.
shaved_head_and_balls
Shaved_head_and_balls - 2 years ago
It looks like the litigation against BAC is just now rolling in, and the stock is again getting crushed. Without government financial assistance once again, this stock will go to $0. The only reason it is not at $0 today is because everybody believes the government won't let it fail. That's not exactly a reason to invest in Bank of America unless you get a Buffett-like deal on preferreds.

Buffett got his BAC idea after taking a bath. If his government cronies don't have the votes and power to prop up BAC, he might take another bath, this time on his BAC preferreds.
paulwitt
Paulwitt - 2 years ago
How can I invest in law firms? It looks like a growth industry!

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