Warren Buffett (Trades, Portfolio)’s annual letter to shareholders of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) was published earlier this week, and over the last few days, investors have been scanning the document for nuggets of advice from the Oracle of Omaha – as well as trying to predict what his next moves will be.
One of the standout points made in the letter relates to Berkshire’s ownership of Bank of America (BAC, Financial) warrants and preferred shares. This bet by Buffett is in itself fascinating because it was made post the financial crisis and is a great testament to Buffett’s desire to be greedy when others are fearful.
The Bank of America position
The Berkshire Bank of America position is comprised of two parts, preferred shares and stock warrants. Preferred stock amounts to $5 billion and pays Berkshire $300 million per year in interest making it a nice little earner for the conglomerate.
Attached to the preferred stock is a warrant allowing Berkshire to purchase 700 million common shares of Bank of America for $5 billion at any time before Sept. 2, 2021. In his annual letter, Buffett notes that executing this warrant at year-end 2016 would have delivered a profit of $10.5 billion. Today, with Bank of America trading at just under $25 it’s likely the profit from such a deal would be closer to $13 billion.
Buffett goes on to write that Berkshire will consider exercising its warrant if Bank of America’s common stock dividend rises above 44 cents per share before 2021. At this point, Berkshire would “anticipate making a cashless exchange of our preferred into common.” If this benchmark is never reached Berkshire will likely “exercise the warrant immediately before it expires.”
This could be interpreted as a tip from Buffett that now is the time to buy Bank of America’s stock; I believe it is anything but.
Buffett has always had a preference for preference shares. In many of his most lucrative trades he has used preference shares to gain equitylike exposure to a company but with bondlike cash flows. By using this approach, Berkshire becomes a priority creditor for companies and will continue to receive dividends no matter what management decides to do with the common stock payout. What’s more, by using preference shares Buffett can limit his downside thanks to the hefty annual cash flows produced. Most investors are not able to invest on such preferable terms, and they certainly will not have access to the preference share-warrant exchange deal Buffett was able to negotiate.
A preferable deal
When the deal was struck in 2011 (a time when most investors were fleeing the banking sector fearing a new wave of regulation, continued bad-debt problems and capital raisings), Buffett negotiated a 6% annual dividend on the $5 billion of preferred stock as well as allowing Bank of America to buy back the preferred shares at any time for a 5% premium. As the deal was first publicized in the third quarter of 2011, Berkshire has received five full years of preferred stock dividends for a total of $1.5 billion. Why should Buffett give up this lucrative income stream unless the return on offer is greater than that already being received?
If Bank of America’s common stock dividend exceeds 44 cents, this will be the case. But Buffett is prepared to wait and while executing the warrants will make Bank of America one of Berkshire’s largest positions, it seems Buffett is not overly keen to expose himself to common stock volatility. Yes, the warrants are now worth substantially more than the $5 billion preferred stock investment, but as anyone who has watched Buffett for a long time will know, he’s never in a rush to make an investment and prefers guaranteed returns over those that may be more speculative. Investors who believe Buffett’s mention of Bank of America in his annual letter is a recommendation to go and buy the stock should bear that in mind.
Disclosure: The author owns no share mentioned.
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