Why Bank of America is a Long Term Buy

By Louis Liu - September 10, 2012 | Tickers: BAC, BRK-B, BRK-A | 0 Comments

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In my last article on Bank of America (NYSE: BAC), I analyzed Berkshire Hathaway's (NYSE: BRK-A) (NYSE: BRK-B) $5 billion investment in the bank to conclude that individual investors shall buy the bank's common shares at today's price. One of my colleagues read that article and pointed out that individual investors who followed Buffett's footsteps into General Electric Company (GE) and Goldman Sachs Group, Inc. (GS) have yet to recover from their losses. My colleague was factually correct.

In this article, however, I will reaffirm my long-term buy recommendation for the common shares of Bank of America because (1) the business fundamental of the bank continues to improve, and (2) Buffett's $5 billion investment in Bank of America, while structurally similar to his investments in G.E. and Goldman, is fundamentally different in that it represents more of a vote of confidence on the turn-around and long-term success of the bank, which may not be the case for his investments in G.E. or Goldman.

An individual investor should not buy the shares of a company just because Buffett invests in the same company. In the case of Bank of America, an individual investor also shall not buy the common shares of the bank solely because there is a common perception that the U.S. government will always backstop the bank in case of any systemic or institution-specific crisis. While it is very unlikely for the government not to step in to prevent the failure of a financial institution of the size of Bank of America, this does not mean that the equity of the common shares will necessarily be protected or preserved in that case.

The bottom line is that you should invest in the common shares of Bank of America because they are reasonably priced relative to the bank's business fundamental and long-term prospect, which I believe is improving, slowly but surely. Barring unusual developments in the global economy, the darkest days of Bank of America are probably behind us. Actually I will argue that the bank is in a much better shape than it was when Buffett made his investment. It has passed the stress test since then. CEO Brian Moynihan has been doing a decent job in improving its balance sheet and income statement. During the second quarter, the bank has improved its capital ratios and overall credit quality. Also the measures taken under the New Bank of America Project continues to contain the bank's operational cost and improve its operational efficiency by eliminating the least productive branches.

The bank's earnings shall further improve in 2013 as (a) the home foreclosure settlement, as well as the 2011 mortgage buyback settlement will probably be approved by then, and (b) the residential housing market, if not having bottomed out yet, shall stabilize and gradually recover. While there are risks and costs associated with the settlements, particularly the forced buybacks of mortgages, the settlements shall be a huge relief to the bank as it removes the uncertainty associated with underlying legal disputes. The stabilization and recovery of the housing market will slowly but surely enhance the bottom line of the bank. Also starting from 2014, the long-term interest rate shall gradually climb up from the historically low level it is at now, which will help grow the net interest income for the bank.

Currently S&P projects an EPS of $0.63 in 2012 and $1.03 in 2012. At the current price level, that translates into a 2012 year-end P/E of about 11.5 and a 2013 year-end P/E of 7.2, which compares favorably to its peers of forward four quarter P/E of 10. This is a very attractive valuation for a bank that has got a great depositor base.

Now let me come back to Mr. Buffett. His investment in Bank of America is rather different than his investments in G.E. and Goldman. Essentially, in the case of Bank of America, Buffett is more like a holder of the bank's common share who bets on the turn-around the long term success of the bank for the following two reasons:

First, the preferred shares he got from Bank of America only pay 6% annual dividends, as compared to the 10% annual dividends for the preferred shares he got from G.E. and Goldman. The preferred shares from Bank of America only pay a 5% redemption premium, as compared to the 10% redemption premiums of the G.E. and Goldman preferred shares. We know that Buffett is certainly not an investor who will be satisfied to only clip a 6% coupon. He probably had much better use of the same $5 billion than that. The same thing probably could not been said about the combination of 10% annual dividends and the 10% redemption premiums commanded by the preferred shares of G.E. and Goldman Sachs.

To a large extent, even in the case of G.E. and Goldman, Mr. Buffett would like to see the stocks of Goldman Sachs and G.E. appreciate because he has warrants to purchase common shares of those two companies at specific prices, which can be exercised through 2013. However, Buffett could afford not to care so much about the returns on the warrants from G.E. or Goldman Sachs because the 10% annual dividends plus the 10% redemption premiums were good enough by and in themselves. As a matter of fact, he had received about a 40% simple (as opposed to compounded) return on his investment on G.E. and Goldman already in about three years, without getting any paper gains or realized gains from the warrants issued by those two companies so far. Therefore, it was very likely that he did not see as much upward potential in the common shares of G.E. or Goldman as he saw in Bank of America.

Second, in the case of Bank of America, Buffett took a longer-term view of his investment. The warrants from the bank have 10-years of exercise period, while the warrants from G.E. and Goldman have only 5-years of exercise period. Buffett was willing to trade a lower annual yield from the preferred shares for a longer exercise period in the warrants. He did so because he was willing to give the bank more time to work out all of its troubles, improve its operational efficiency and profitability.

Simply put, Buffett's investments in G.E. and Goldman Sachs are more like two expensive lines of credit, but his investment in Bank of America is more like a less expensive convertible note. A holder of the convertible note of a company is, at least compared to the company's lenders, more like the company's common shareholders.

To sum it up, no one should invest in a company simply because Buffett did. However, in the case of Bank of America, an individual investor who purchases the common shares of Bank of America and the Oracle of Omaha to a large extent have their interests aligned as they are both betting on the same thing: the turn-around and long-term success of the bank. With the bank making steady progress to turn itself around, you should consider adding its common shares to your portfolio, especially if they are traded at prices not substantially above the exercise price ($7.14 per share) of Buffett's warrant.

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