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The Compelling Case for Bank of America

Bank of America is probably one of the most hated and reviled corporations in America right now. They are the poster boy for just about everything that’s wrong with the American financial system – from corporate greed, TBTF banks, excessive compensation etc. However, with all the emotions involved, it is important for us to take a step back and examine whether the relentless pressure on BAC is truly deserved.

Market Capitalization of BAC – Has it really lost 2/3 of its value in a year?

Here’s a disclaimer, if you’re going to consider in BAC, you should at least have a basic understanding of how the banking system works, and how banks in general generate their revenue. Furthermore, it’s important to at least have a grasp of the underlying failures of the financial system that eventually led to the subprime crisis, and an understanding of the credit cycle.

I will be attaching some links at the end of my post to provide further reading if you’re interested.

Brief Summary of BAC:
BAC 2010 Operating Results:
Net Income: -$2.238 billion
EPS: -$0.37
Book Value Per Share: $21.62
Return on Assets: -0.16%
 
Current Valuation:
P/B: 0.3
Industry Average: 0.7
BAC 5 Year Average: 1.0
 

 The central thesis for investing can be summarized:

“…Its earnings power has been disguised by the intense provisioning for loan losses. But when the provisioning gets back to a normal level, you’ll start to see that incredible earnings power come down to the bottom line. And it’s as simple as that.”

Bruce R. Berkowitz, November 25, 1992

Interestingly enough, Bruce Berkowitz and Warren Buffett made a similar investment in Wells Fargos during 1992 when the housing bubble in California bursts, leading to similar write downs by Wells.

Here’s a simple overview of what Bruce Berkowtiz is driving at:

Despite the massive write downs on their real estate assets, Bank of America is an immensely profitable company with significant earning power. Almost every American institution or citizen does some form of business with BAC and it’s an integral part of the financial institution. Charge offs have been steadily declining since late 2009, and once BAC clears through its legacy loans, the underlying profitable businesses of BAC will be realised.

Bank of America now is vastly different from the Bank of America in 2008. The CEOs have changed and the company has gone from its “merger” mentality to one of consolidation and restructuring. They are making massive charge offs on their non-performing loans and assets. They are also selling off assets and shoring up capital.

Loans made in recent years are much stricter than they were before. One of the reason (though not the only) why people find it difficult to get loans these days is because the criteria for  making a loan has gone from incredibly easy to being infinitely hard. However, these means that the overall quality of loans that BAC has been making has drastically improved.

Now, BAC still has legacy loans made by Countrywide, one of the most notorious subprime lenders. However, it’s important to note that all loans have “half-lives” and BAC is slowly burning through these legacy loans.

Under normal circumstances, it’s not unreasonable to expect BAC to earn a 1% return on asset, or 10% return on equity which works out to be roughly around $2 per share. Contrast this to its current $6 a share price. Furthermore, BAC is selling at a 40% discount to its tangible book value (excluding goodwill and intangible assets), which works out to be about $15. Under normal operating conditions, it’s not unreasonable to expect BAC to sell for at least tangible book value, giving us a base price of around $15.

Even so, there are many challenges that are involved in investing in financial institutions:

a) We still do not fully understand or trust the numbers
b) Financial regulatory reform may reduce earning power
c) New Basel rules may require more capital and reduce profits
d) There may be a double dip recession
e) The unemployment rate may go higher and create more defaults
f) Commercial real estate prices may fall dramatically
g) Banks are still not marking loans in their books properly
h) Residential real estate prices may fall further
i) States and municipalities are in bad shape
 
- Francis Chou Semi Annual Report 2010
 

It’s important to note that investing in BAC requires a long term horizon of at least 3 – 5 years as there remains many unresolved issues.

Concluding thoughts:

Many people are familiar with Graham’s view on investing, and the strict definition that he placed upon it. However, he went into great lengths to disabuse the notion that all speculation was inherently bad. There is after all intelligent speculation just as there is intelligent investing. Situations which involve unintelligent speculation include:

  • speculating when you think you are investing
  • speculating seriously when you lack proper knowledge and skill for it
  • risking more money in speculation than you can afford to lose

Any investment in Bank of America involves a leap of faith that most at the very least, makes it speculative. However, I believe that as at least for the next few years, the quality of earnings on banks will improve, and that management will be far more risk adverse considering the fragile state of the economy.

Notes on how I structured my investment in Bank on America:

Small percentage of portfolio – currently 2.5 – 3%, potential to move up to 5% if the price is attractive
Current price: $6
Estimated intrinsic value: $15 – $30 (1x – 2x tangible book value)
Holding period – 5 – 8 years
 

I have a certain aversion when investing in financial institutions as they are inherently more complex than the average company. If there is one thing that I learnt from the subprime crisis, it is simply impossible (and foolish) to be absolutely sure whether a financial institution can whether the storm. Obviously, due diligence is done as humanely possible beforehand and the basic leverage ratios/long term debt holdings are examined.

As a result, I decided to purchase a protective put option. Let me illustrate it with the following example (date taken from the close on 21/11/2011).

BAC: $5.49
BAC Put Option, $4 Strike Expiring Jan 2013: $0.87
Total cost (100 shares): $6.36 * 100 = $636

A put option gives you the right to sell 100 shares of BAC at $4 before the strike date in January 2013. Think of it as an insurance policy that you pay for in the event that BAC collapses. The price that you pay represents the premium that someone would need in order for him to take that risk.

There are 3 main scenarios that might happen:

BAC hits the bottom range of our expected price – $15
Our profit per share is
$15 – $5.49 – $0.87 (price paid for the put option) = $8.64, representing a return of 135%
 
BAC hits the top range of our expected price – $30,
Our profit per share is
$30 – $5.49 – $0.87 (price paid for the put option) = $23.64, representing a return of 371%
 
BAC goes bankrupt and the common stock becomes worthless,
Exercise PUT option, sell shares for $4 per share.
Our loss per share is
$6.36 – $4 = $2.36, representing a loss of 37%
 

In this way, I structured my investment such that the risk reward ratio is heavily skewed towards my favour. Most of my capital is substantially protected in the event that BAC gets wiped out. However, in the event that BAC returns to its normalized operating profit, and earns a reasonable rate of return, I stand to earn a significant return on my investment.

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