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The Case For Bank of America

December 21, 2011 | About:
Josh Zachariah

Josh Zachariah

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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.

1118573482.jpg

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).

*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

About the author:

Josh Zachariah
I credit my father and Warren Buffett for molding me into the investor I am today.

Rating: 3.7/5 (23 votes)

Comments

superguru
Superguru - 2 years ago
problem is, I have no way to figure out if BAC at these prices is value or value trap.

Chances are it will do well 5 years from now as Govt. will not let it go under.

Even Buffet did not swing at it. He chose safe and sound tech IBM.
Josh Zachariah
Josh Zachariah premium member - 2 years ago
It is difficult to value with the uncertainty, but it is trading at a huge discount. If you believe the company will become profitable in a couple years then it is very hard to refute a 25% price to book value. You can't be too greedy on the margin of safety.

Buffett certainly got a special arrangement, but even his preferred shares were much more expensive than it is today. The warrants had an exercise price well above $7 also. I'm sure he pushed for that because he believes the stock will be much more valuable than $7 in 5 years time

In the case of IBM, though it is a great business, the "safeness" is being eroded with the appreciation of the stock price. Buffett himself said in a CNBC interview he would not be purchasing any more IBM stock when it had eclipsed $190 a share.

Josh Zachariah
kirrct
Kirrct - 2 years ago
Thanks for sharing your thoughts. I'm long bac. Short thesis: fears and the benefit of time. I would add a long thesis if i was using something other than one finger on an apple ipad keyboard.

I am looking forward to the results from the fed stress test. why in the world would the fed require public disclosure in this market unless the results were better than most people believe? See related article below.

http://online.wsj.com/article/SB10001424052970204531404577054532366267166.html

Matt Blecker
Matt Blecker - 2 years ago


My one reservation with taking a significant long position in BAC is the risk associated with their derivatives exposure. Very hard to quantify. However, I do feel the balance sheet is in good shape, the loan portfolio is improving, the lawsuit impact will not be as great as anticipated due to payments being made over time, and that the bank has well over $2.00 of earnings power per share in a normalized environment.

Instead of taking a long equity position, we have bought some out-of-the-money long-dated call options, where upside potential is still substantial but downside risk is minimized.
vgm
Vgm - 2 years ago
Interesting article. Thanks.

Let's be clear about what Buffett has said. While admitting that it would take time for BAC to work off its excesses, and that its challenges would be in the media headlights for some time to come, he also said that his investment in BAC was a vote of confidence in Brian Moynihan and the bank. He spoke of its "wonderful underlying business" that would express itself and be "highly profitable" in the future. And he has stated on several occasions that he believed Moynihan was doing the right things.

That's pretty strong endorsement coming from Buffett.
jbobfleming
Jbobfleming - 2 years ago


Thx....I have looked at their financials in detail . Assuming that both the assets (ex-intangibles) and the liabilities are fairly stated, one then sees that the market has fully written off the BAC goodwill (Countrywide, Merrill) which is huge. In addition, the market is then reserving an additional 75 billion (give or take) for litigation (guess). All in all, that is fairly compelling. However, BAC is not making money. BAC is not revenue challenged, not at all, it has huge revenues and one of the better net interest results of the banks I look at. The core problem then is the expense base. The expenses are huge even after backing out the temporary expenses cited by Berkowitz. So, in summary, BAC becomes an attractive investment (to me) when its management presents itself as being fully committed to rationalizing the expense base - I do not see this commitment as of yet. BAC is so large that management of the company and instituting change could be as difficult as the U.S. getting its fiscal house in order. However, I am keeping an eye on it...Thx again
superguru
Superguru - 2 years ago
"That's pretty strong endorsement coming from Buffett." - VGM

If that endorsement was followed by buying of BAC common stock I would have believed it. He found better risk/reward with IBM.

dolphin00
Dolphin00 - 2 years ago


BAC is not a value trap in my opinion. This stock will either be a 5 to 10 bagger or be broken up in a messy protracted downward spiral.

Long A share warrants
vgm
Vgm - 2 years ago
Superguru - if as Warren Buffett, he can get the kind of sweetheart deal he did, while BAC was under siege by the market, why would he not do it? Buffett is totally honest and we can believe his words, but he is the ultimate capitalist also. And capitalism is a hard discipline. My take is that he got a brilliant on-going deal as well as the opportunity to be a future major shareholder in what he describes as "a wonderful business" at what I believe will in retrospect be a steal of a price.

He bought IBM under completely different circumstances. Comparing BAC with IBM, he has once again demonstrated his versatility.
traderatwork
Traderatwork - 2 years ago
For option trader, we could write 2014 Jan $12 Put option for 6.70 (collect $670/contract), so the cash reserve at the brokerage firm is 5.30(or $530 per 1 option contract). We have 2 years to wait for BAC to reach $12 or over till 2014 Jan and we made 126.41%. That means double our money in 24 months, worst case scenario is BAC bankrupt and we lost 100%. The question now is will BAC bankrupt?

At the mean time we could buy a 2014 Jan $2 call option for 3.90 and we'll be in positive if BAC above 5.90 from today's price and if it goes to/above $12, we'll be making $103%+ on our money in 2 years or like a lot of option book said - "unlimited upside"

Personally I think BAC will not bankrupt and probably will worth more than 7.50, and the percentage of gain is pretty good too.

aintpopularbut
Aintpopularbut - 2 years ago
Still am surprised at how things are presented both by gurufocus as a website and by its readers and posters. Warren Buffett, to the best of my knowledge which comes from the printed word, has bought more Wells Fargo since the recent crisis, not Bank of America.

Berkshire Hathaway has a preferred committment that is convertiable- in Bank of America. Berkshire Hathaway is a large US corporation but it is not Warren Buffett and the distinction is clear.

One of the things Alice Shroeder profiled both in her book and the video she has posted on Mr. Buffett is that he pretty much only invests - with rare exceptions and particularly with large committments - where there is no chance of losing money. The tech stock he bought personally where he did so well is the prime example.

Again, Buffett has bought Wells not Bank of America, right?

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