The Financial Times described yesterday the rationale as to why Bank of America is trading below $5 a share or about 38% of tangible book value (tangible book value is book value net of any intangibles such as goodwill).
The paper wrote that investors either expect the bank to be understating its liabilities or overstating its assets. Future liabilities are certainly hazy as Bank of America is front and center in the mortgage-related litigation. But the bank is expected to lose about $0.48 a share this year and that loss would debit its already low $12.15 tangible book value. However, it would still trade on a deep discount even if it were to lose a similar figure next year, even though it is expected to make money.
The argument that the bank's assets are less than what they proclaim may have some truth to it, but consider this fact. The assets the bank has eventually mature and new ones at even more favorable prices are written. The new loans are being written on assets (homes) that are priced at values that are the lowest in many years. Throw in the fact that construction of new homes is lagging new household formations and you have a recipe for tremendous price appreciation in the long run.
Bruce Berkowitz gave an excellent presentation on Bank of America earlier this year:
“It’s selling for $12.25 [June 2011]. 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.”
Berkowitz is right on in appreciating the bank as a going concern. I would extend those comments and say that today is an exceptional time to be in banking. Yes, loan demand is poor, but I would argue that the vintage of loans that are being written today will be performing at a very high rate.
Let me go on a tangent and put in perspective exactly how attractive real estate prices are. When I’m not contributing to GuruFocus I’m working in the property management business. Our business has residential real estate throughout Northern California. I’m in the process of closing on a property in Manteca not far from the ground zero of U.S. foreclosures that is Stockton. The price is $105,000 and comparable properties rent for no less than $1,100 month. Excluding all expected expenses I arrived at a pre-tax return to equity (down payment of $20,000) of 25%*.
A couple points are in order. One is that rents can still go down. If unemployment increases in the area housing demand will surely decrease. A second consideration is the possibility that other investors may pile into the market and rent out houses thereby plummeting asking rents.
Amazingly, just the opposite has happened. As the below chart will show, homeowners are increasingly making up a greater percentage of sales in San Joaquin County and other counties. And second, rents have remained fairly robust in comparison to house prices. The intuition on that is as people get foreclosed on they still need a place to live.
But even more astounding is how many other houses are available at comparable returns throughout the county. The barriers to entry most likely are the high costs and good credit necessary to obtain a loan. Now, I know this is not the same across the U.S., but these prices will eventually reach a state of equilibrium closer to the cost to build a new house in addition to the cost of rent.
In Stockton where many respectable houses sell for around $100,000 (many sell for half as much); permit fees to build a new house can cost up to $50,000. For that reason it would not make much sense adding new supply to a market when the cost to build the home is so much greater than the cost to obtain one in the market.
For those that can avail themselves of the opportunity, they will likely be making a lot of money for both themselves and the bank that lends them the funds. In my case that would be Bank of America (BAC, Financial).
*The 25% pre-tax return to equity excludes any price appreciation of the house. Of course prices will move and Robert Shiller (Case-Shiller House Price Index) says they move at a real rate of between 1-2%. Tack on a 2% annual increase and because of the leverage (5:1) you get an additional 10%. I exclude this because it is purely speculative. Cash flows are always the salient point in value investing.
Disclosure: Long BAC
Josh Zachariah
The paper wrote that investors either expect the bank to be understating its liabilities or overstating its assets. Future liabilities are certainly hazy as Bank of America is front and center in the mortgage-related litigation. But the bank is expected to lose about $0.48 a share this year and that loss would debit its already low $12.15 tangible book value. However, it would still trade on a deep discount even if it were to lose a similar figure next year, even though it is expected to make money.
The argument that the bank's assets are less than what they proclaim may have some truth to it, but consider this fact. The assets the bank has eventually mature and new ones at even more favorable prices are written. The new loans are being written on assets (homes) that are priced at values that are the lowest in many years. Throw in the fact that construction of new homes is lagging new household formations and you have a recipe for tremendous price appreciation in the long run.
Bruce Berkowitz gave an excellent presentation on Bank of America earlier this year:
“It’s selling for $12.25 [June 2011]. 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.”
Berkowitz is right on in appreciating the bank as a going concern. I would extend those comments and say that today is an exceptional time to be in banking. Yes, loan demand is poor, but I would argue that the vintage of loans that are being written today will be performing at a very high rate.
Let me go on a tangent and put in perspective exactly how attractive real estate prices are. When I’m not contributing to GuruFocus I’m working in the property management business. Our business has residential real estate throughout Northern California. I’m in the process of closing on a property in Manteca not far from the ground zero of U.S. foreclosures that is Stockton. The price is $105,000 and comparable properties rent for no less than $1,100 month. Excluding all expected expenses I arrived at a pre-tax return to equity (down payment of $20,000) of 25%*.
A couple points are in order. One is that rents can still go down. If unemployment increases in the area housing demand will surely decrease. A second consideration is the possibility that other investors may pile into the market and rent out houses thereby plummeting asking rents.
Amazingly, just the opposite has happened. As the below chart will show, homeowners are increasingly making up a greater percentage of sales in San Joaquin County and other counties. And second, rents have remained fairly robust in comparison to house prices. The intuition on that is as people get foreclosed on they still need a place to live.
But even more astounding is how many other houses are available at comparable returns throughout the county. The barriers to entry most likely are the high costs and good credit necessary to obtain a loan. Now, I know this is not the same across the U.S., but these prices will eventually reach a state of equilibrium closer to the cost to build a new house in addition to the cost of rent.
In Stockton where many respectable houses sell for around $100,000 (many sell for half as much); permit fees to build a new house can cost up to $50,000. For that reason it would not make much sense adding new supply to a market when the cost to build the home is so much greater than the cost to obtain one in the market.
For those that can avail themselves of the opportunity, they will likely be making a lot of money for both themselves and the bank that lends them the funds. In my case that would be Bank of America (BAC, Financial).
*The 25% pre-tax return to equity excludes any price appreciation of the house. Of course prices will move and Robert Shiller (Case-Shiller House Price Index) says they move at a real rate of between 1-2%. Tack on a 2% annual increase and because of the leverage (5:1) you get an additional 10%. I exclude this because it is purely speculative. Cash flows are always the salient point in value investing.
Disclosure: Long BAC
Josh Zachariah
