In this article let's take a look at Warren Buffett (Trades, Portfolio) who is the most respected and successful investor in history and is the primary shareholder, chairman and chief executive officer of Berkshire Hathaway (BRK.A) (BRK.B). Buffett has been extremely bullish on banks since U.S. recession. Although Berkshire's largest bank investment remains a $21 billion stake in Wells Fargo (WFC), here we are going to analyze the deal reached with Bank of America (BAC).
Preferred Stock and Warrants
In August 2011, Buffett invested $5 billion into Bank of America, the second-largest U.S.-based financial holding company, with March 31, 2014 global assets of $2.15 trillion. The investment had two components: 50,000 preferred shares yielding 6% and 700 million warrants to buy common shares at $7.14 per share.
Buffett will earn a 6% annual dividend for 50,000 shares of the preferred stock, redeemable at a 5% premium, which means that the bank can buy back at any time by paying the guru a 5% premium.
Moreover, he will receive warrants to buy 700 million shares of common stock within 10 years of the transaction's closing date (September 2021). Now, with the stock up more than 120% since the purchase it seems to be a very lucrative deal. Let´s imagine the stock at half the crisis level, Buffett’s 700 million warrants will gain $14 billion, which I think it is not bad.
The preferred shares don't qualify as Tier 1 capital, which is core capital and includes equity capital and disclosed reserves. In that sense, the bank modified the terms of the deal. The two modifications were: The preferred dividends will no longer cumulative, which means that does not pay the holder any unpaid or omitted dividends, this obviously makes them riskier for Buffet. The second change refers to the timing, the preferred stocks, which were originally redeemable at any time at a 5% premium, will only be redeemable after the fifth anniversary of the effective date of the amendment. This means the bank will wait at least five years before redeeming the preferred stock. The aim of the changes was to bank´s regulators to treat favorably the investment.
The shares will continue to pay a 6% dividend, but the dividends will no longer be cumulative, meaning BofA won't be penalized if it misses a payment due to financial difficulties. The last closed of the stock is at $15.54, meaning that the Oracle of Omaha has already more than doubled his money if he exercised the warrants now. Think that a warrant is like a long call option position, so an investor believes that the stock will rise in the future or your warrants will finish with a loss. According to Yahoo Finance, the one year target price is $17.19, so it's easy to see why Buffet is still holding it.
Buffett told in a recent letter that "it is important for you to realize that Bank of America is, in effect, our fifth largest equity investment and one we value highly". There is no doubt that the guru was confident about Bofa´s management, the success of its businesses model and of course, he was optimistic about its future. The crucial question is: Should you be too?
Other hedge fund gurus that have been investing in the bank in the first quarter of 2014 are David Dreman (Trades, Portfolio), Richard Snow (Trades, Portfolio), Bill Frels (Trades, Portfolio) and Murray Stahl (Trades, Portfolio).
Disclosure: Omar Venerio holds no position in any stocks mentioned.