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Under the terms of the deal that Warren Buffett struck with the CEO of Bank of America (BAC) over several phone calls in August 2011, for $5 billion, Berkshire Hathaway (BRK.A), received (i) $5 billion of preferred shares of Bank of America that will pay a 6% annual dividend, and (ii) the warrants to buy 700 million common shares of Bank of America that can be exercised over the next 10 years at a price of about $7.14 per share (hereinafter the "Warrants"). Bank of America has the option to buy back the preferred shares at any time for a 5% premium, but the Warrants shall remain outstanding until the 10th anniversary of the issuance date. Buffett apparently still likes this deal. In a recent interview, he said that he should have invested $10 billion instead.

The price of the common shares of BAC has zigzagged since then. It was traded below $6 at the end of 2011, went up to as high as around $9.80 in March 2012 and now came back to around the exercise price of the Warrants now. Of course there have been many factors that affected the price of the common shares of Bank of America, but what could average individual investors like you and me deduce from Buffett's $5 billion investment in Bank of America? Or to put it more directly, should you buy the common shares of Bank of America now that it is traded below the exercise price of the Warrants?

One thing that I think we can know for sure is that Buffett has got a fantastic deal that you and I cannot get from Bank of America as average individual investors. So it is not a brilliant idea to buy the common shares of Bank of America from the open market just because the Oracle of Omaha has invested $5 billion into that company. And here are the reasons:

First and probably the foremost, in the absence of a bankruptcy of Bank of America, Berkshire Hathaway will definitely get its $5 billion back, plus 5% of that if it is Bank of America that wants to buy back the $5 billion preferred shares. You and I cannot be assured that the cash we put down to buy the common shares of Bank of America will be returned to us in its entirety, even in the absence of a bankruptcy of Bank of America.

Second, you and I cannot get the 6% annual dividend that Berkshire Hathaway gets for the preferred shares, which again is virtually guaranteed in the absence of the bankruptcy of Bank of America as there is a contractual obligation on the part of Bank of America to pay such dividend. We average investors of the common shares of Bank of America may or may not receive any dividend from the company. If we receive any dividend, as we do now, it is probably much less than the 6% annual dividend that Berkshire Hathaway receives.

Third, you and I cannot get anything extra by buying common shares of Bank of America, by that something extra I mean the Warrants. The Warrants came at (almost) no additional cost but huge upside potential for Berkshire Hathaway. Why? So long as the price of the common shares of Bank of America is above $7.14 at any time before the 10th anniversary of the issuance of the Warrants, and so long as Berkshire Hathaway chooses to exercise the Warrants at such time, Berkshire Hathaway will capture the difference between the exercise price (around $7.14 per share) and the then-prevailing market price per share of the common shares without incurring any additional cost. Suppose the common share is traded at $10.14 per share at any time during the next 9 years or so; that represents $2.1 billion net gain for Berkshire Hathaway. Not too shabby for a $5 billion investment, right? It is no wonder that the grandfatherly Buffett cannot even hide his boyish smile when talking about this deal.

Of course you can ride along Buffett's investment in Bank of America by buying the shares of Berkshire Hathaway (BRK.B). I think, however, you can consider buying the common shares of Bank of America as well, and below are the reasons:

First, Buffett's $5 billion investment clearly indicates that he is confident that Bank of America will not go bankrupt, because if that happens, all bets are off, including his. Why? As I pointed out above, for Berkshire Hathaway to get its $5 billion investment back in cash and receive the 6% annual dividend, Bank of America needs to stay afloat. If Bank of America is not bankrupt, its common shares will not be traded at zero. I know that is not a lot of comfort, but it is something, and something that Buffett is banking on. Everything else being equal, why should you invest in another company's common shares if you cannot be assured that it will not go bankrupt, when Buffett has bet his $5 billion that Bank of America will not go under?

Second and more importantly, Buffett is not someone who is content with the 6% annual return (i.e., the annual dividend on the preferred shares) for his investments. So he is counting on the Warrants to deliver additional returns on the $5 billion investment. Now let's suppose that Buffett expects a 20% annual return for this investment, which means at the end of the 10-year period, the $5 billion will become around $31 billion, an increase in value by $26 billion. After we take out the $3 billion dividends, the Warrant has to be worth about $23 billion. Since the Warrants give Berkshire Hathaway the right to buy 700 million common shares of Bank of America, for the Warrants to be worth $23 billion, each common share will appreciate by about $32 from $7.14 in 10 years.

Ihope this has made you interested in the common shares of Bank of America. If Buffett expects a 15% annual return for the $5 billion investment, it translates into an appreciation by about $17.5 from $7.14 in the next 10 years. I can live with this kind of return, especially if there is also some decent dividend for the common shares in the future. Even if Buffett only expects a 10% annual return on the $5 billion investment, it translates into an appreciation by about $7 per share from $7.14 in the next 10 years for the common shares. This is not a fantastic return but I can accept that my retirement savings double in the next 10 years. Of course no one can give you the assurance that Buffett can deliver even 10% here, but I'd bet my money on that.

You may point out that Buffett may not keep the Warrants for the next 10 years. But so long as he holds the Warrants, you can hold on to your common shares because by not exercising the Warrants, Buffetts expects more appreciation for the common shares. On the other hand, if he does exercise the Warrants, you should consider selling the common shares.

To sum it up, your investment into the common shares of Bank of America is different than (or bluntly put, inferior to) Buffett's $5 billion investment in the same bank made last August. However, if his investment works out reasonably well, so should yours, if your common shares are bought at prices not to much higher or better yet, lower than the exercise price of the Warrants.

Source: Should You Invest In Bank Of America Because Buffett Did?