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Posts Tagged ‘Warren Buffett’

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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A few people commented to me that the market looks “volatile” & “dangerous” in the next few months and that we should wait and see before things get better.

Well, I understand how it might seem. The unrest in the Middle East, Libya, the Tsunami in Japan, the end of QE2 etc. The list goes on and on.

However, I would like to point out three problems with trying to predict the future.

Firstly, why didn’t you tell me this 3 months ago? Secondly, considering that you couldn’t predict the market 3 months ago, why would you be right this time round? And finally why on earth would the market be better 3 months later?

No matter what the media/newspaper/friends/books have you believe, very few people actually are able to predict the future with any degree of certainty that is useful to you or me. I would be extremely suspicious of anyone claiming to be able to do so in any capacity.

And the truth is, predicting the future is not a prerequisite of successful investing.

If your going to invest for the long term, through out the traditional definition of risk. Risk is not measured by beta, standard deviation etc.

Risk is the permanent loss of capital. 

My advice?

Take a moment to look through your analysis again if need be. Run through the calculations to make sure they make sense. Than, once your done, close your books and turn off the TV.

As Warren Buffett once said  -

Wall Street makes it money on activity. You make your money on inactivity.

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Microsoft is one of my favorite companies. It has a solid track free cash flow generation, decent growth and almost no debt on its balance on its sheets. And best of all, its trading at a ridiculously low valuation over fears that its lagging behind in the technology industry.

Look here if you want a great presentation by Whitney Tilson on Microsoft:

Whitney Tilson Presentation on Microsoft

While I agree that some of the criticism of Microsoft is valid, people seem to be forgetting that Microsoft has an incredible franchise with Offices and Windows. I won’t go into the details (you can find it in the presentation) but suffice to say, I feel that Microsoft is trading at an attractive valuation relative to its current performance.

Let’s look at the fundamentals of the company:

 

Despite all the negative flak,  Microsoft has been growing its bottom line really well over the past few years.

Its average annual growth rate in earnings per share is 13.7%.


Microsoft has done really well in this respect. It has little debt on its balance sheets and recently issued long term bonds at record low interest rates.


Returns on Invested Capital averaged 27.4% over the past few years.

Similarily, Free Cash Flow has been growing a steady rate of 9.3% on average per annum.

Conclusion

One of the criticisms I hear about Microsoft is that the stock hasn’t moved anywhere for the past 10 years (its been hovering around $20 – $30). I would like to highlight an extremely important point in investing.

“Price is what you pay. Value is what you get.” – Warren Buffett

Prior to 2008, Microsoft was trading at an average PE of 25 i.e. it was trading at an extremely generous price relative to its intrinsic value. One of the key principles of value investing is to always demand a margin of safety.

Always remember, no investment is ever worth overpaying for – no matter how good it looks.

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I just updated my main webpage to include a financial report of Johnson & Johnson so do check it out.

Johnson & Johnson Report

Also, its come to my attention that I didn’t update the Lubrizol Corporation link properly on the right hand side of the page. I have since corrected it.

Before investing in pharmaceutical companies, its important to know the pros and cons of the industry.

Big pharmaceutical companies typically have wide moats and attractive financial strength. Most of the global pharmaceutical  companies post Returns on Invested Capital of > 20%. They also have little debt on their balance sheets and plenty of free cash flow generation.

However, developing drugs is extremely costly and time consuming. Clinical testing phases of drugs can take upwards of a decade. Whats worst is that these expenses does not guarantee the success of a drug. A company can pump in a considerable amount of money into research with no guarantee of return.

Once a drug is developed and approved by the FDA, they normally enjoy patent protection. This typically lasts about 8 – 10 years.

Armed with this knowledge, one should look for the following traits in pharmaceutical companies:

  • Companies which have a diverse range of drugs, and that have considerable patent time left.
  • Companies that are actively developing new drugs to refill their pipeline.

Due to their strong financial positions, many pharmaceutical companies are choosing to acquire smaller companies to replenish their pipeline. This really illustrates why free cash flow and low debt levels are so important. Companies that are highly leveraged and generate little free cash flow would be unable to fund such acquisition’s easily.

Conclusion:

I am bullish on healthcare companies in the long run. As we face an aging population in developed nations around the world. Furthermore, as developing countries improve their standards of living, there will also be a corresponding increase in demand for better healthcare.

However, it’s important (to me anyway) not to get too carried away with macro trends. Always ensure that the companies you invest in are trade at a reasonable valuation no matter how rosy the outlook maybe.

The author is long JNJ.

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As promised, I did up a financial report of Challenger Technologies.

Let’s go through the qualitative aspects of the company first

If your living in Singapore, you pretty much know everything there is to know about Challenger. Its a simple business model – selling a wide array of electronic goods throughout the island. Loo Leong Thye has done an impressive job of growing Challenger from its store in Funan to recognizable brand around Singapore.

I really like businesses that have great franchise models (think McDonalds, Starbucks, KFC). A proven success formula is always preferable to a business model that is tested & unproven.

Now, lets look at the quantitative data -

Revenue & Earnings

Revenue & Earnings have been increasing steadily over the years. This is probably due to the expansion of Challenger Technologies into different parts of Singapore.

Return on Equity

Challenger has also done exceedingly well on this front.

Its Average Return on Equity over the past few years is 31.2%.

Financial Leverage

What really liked about Challenger was that it had almost no debt on its balance sheets.  Returns on capital are almost identical for that reason.

Free Cash Flow Per Share

Free Cash Flow – like Revenue and Earnings has grown comfortably over the past few years.

Always look out for companies with consistent and healthy free cash flow. Free Cash Flow allows companies to fund their acquisition’s/expansions/capital expenditures easily without much debt.

Always remember – Cash is King.

Conclusion:

I like Challenger Technologies a lot.  Before the run-up in price, I found Challenger trading at an extremely attractive valuation. Its price has since appreciated around 50% in the last 3 months (mainly due to the shares issue) so it offers a much smaller margin of safety than before.

Nonetheless, I recommend keeping it on a “To – Watch List” for any price dips. I think that Challenger will continue to growth steadily over the years without much hiccup.

Disclaimer:  The author is long Challenger.

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