Buffett Backs Bank Of America

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Warren Buffett is Bank of America's Most Notable Shareholder due to his preferred stock & warrant investment in the bank.

Bank of America is trading at a 28.3% discount to its book value.

Bank of America has settled 95% of the unpaid principal balance of all RMBS litigation brought against all Bank of America related entities.

Bank of America reduced its operating expenses by 6% year-over-year in Q2 2014 versus Q2 2013.

When Warren Buffett stepped in with a $5B investment in Bank of America (NYSE:BAC) in 2011, the company was reeling from its misguided acquisition spree under former CEO Ken Lewis. When Warren Buffett made a $5B investment in Bank of America on behalf of Berkshire Hathaway (BRK.A, BRK.B), Bank of America's share price was trading at a 68% discount to its book value and it was suffering from revenue declines and a recurring incidence of "non-recurring charges". Although its credit losses peaked in 2009 and declined since then, its FY2011 credit losses of $13.4B were much higher than its pre-crisis loan losses of $5B in 2006. At least Bank of America's new CEO Brian Moynihan is steadily refocusing the company on its core operations. Bank of America's shareholders are hopeful that Brian Moynihan will not repeat Ken Lewis's empire building mistakes again.

Source: Morningstar Direct

Despite Bank of America's best efforts to control its non-interest expenses, its efficiency ratio (non-interest expenses/total revenue) still increased from 47.28% in 2006 to 85.59% in 2012 before declining to 77.07% in 2013 and 69.5% on an adjusted basis in H1 2014. At least this shows that Bank of America has the opportunity to reduce its expenses as a percentage of its revenue in the future and investors should agree with Brian Moynihan when he said that Bank of America has not approached its true earnings potential. Bank of America's shares still represent a good value to investors as its share price is trading at a 28.3% discount to its book value per share of $21.16, though it is also at a 6.5% premium to its tangible book value.

Source: Bank of America Investor Relations

Bank of America's Regulatory Capital Ratios exceed the new BASEL 3 capital ratio requirements. Bank of America's Common Equity Tier 1 Capital Ratio under the BASEL 3, fully phased-in approach was 9.5% as of Q2 2014, which exceeds the 8.5% minimum ratio requirement by 2019. Bank of America's Holding Company Supplementary Leverage Ratio is above 5%, which exceeds the 5% by 2018 minimum ratio requirement and its Banking operation SLR is above 6%, exceeding the 6% by 2018 minimum ratio requirement. Bank of America earned $.19/share in the quarter on a reported basis and $.41/share adjusted for litigation charges incurred during the quarter. On July 15, Bank of America executed a definitive agreement with AIG to resolve all outstanding mortgage-backed securities litigation. Bank of America would pay AIG $650M, which is covered by litigation reserves the company set aside in previous quarters. We expect that Bank of America should be allowed to increase its dividend next year from the meager $.01/share per quarter and even be allowed to repurchase $1B worth of its shares by the Federal Reserve.

Bank of America's performance in H1 2014 is showing some signs to its investors that its mortgage-related clouds are clearing up, particularly since it has incurred $10B in charges to settle old mortgage-related issues. At the risk of beating a dead horse, clearly Ken Lewis should not have acquired Countrywide Financial in 2008, not even if it was offered for a token amount of $1 (One Dollar) instead of the $4.2B that Bank of America paid. Bank of America's net interest revenue declined by 5.25% in H1 2014 versus H1 2013 and its non-interest income declined by 2% reported. However, its non-interest income increased by 4.5% adjusted for the exclusion of reduced mortgage banking income as of the result of fewer loan originations and lower servicing income due to a smaller servicing portfolio.

Excluding litigation expense, noninterest expense declined 6% from Q2 2013 to $14.6B in Q2 2014, reflecting continued progress by the company to realize cost savings in its Legacy Assets and Servicing business as well as Project New BAC. Bank of America reduced its FTE headcount by 9.3% year-over-year throughout 2013. Although Bank of America's revenue declined by 3.5% in H1 2014 versus H1 2013, at least it was better than Citigroup's (NYSE:C) Citicorp operations (-4.06%) and J.P. Morgan Chase (NYSE:JPM) (-5.7%) though not as good as Wells Fargo (-2.2%).

Source: Morningstar Direct

Although Warren Buffett's Berkshire Hathaway is the largest stakeholder in Bank of America based on its $5B preferred stock investment in 2011, it is not the only notable value investor in the company. In 2011, Berkshire Hathaway invested $5B in Bank of America's preferred shares, which yield 6%. As part of Berkshire's preferred stock investment in Bank of America, it received 700M common stock warrants that matured in 2021 with a strike price of $7.14/share. Berkshire's BAC warrants generated a $5.65B profit so far (if Berkshire were to exercise its warrants for stock) and Berkshire's preferred shares generated $900M in dividends. Furthermore, Berkshire Hathaway was able to exclude 59.5% of the dividends it received from its Bank of America preferred stock investment by holding it in one of its many property/casualty insurance subsidiaries. Other notable investors (as of Q1 2014) in Bank of America include the following:

  1. Harris Associates (108.2M shares of Bank of America worth $1.6B)
  2. Fairholme Fund (98.9M shares of Bank of America worth $1.5B)
  3. Voya Investments, LLC (89.4M shares of Bank of America worth $1.36B)
  4. Fisher Asset Management (39.9M shares of Bank of America worth $607M)
  5. Paulson & Company (38.9M share warrants and shares of Bank of America representing $592M of its stock)
  6. AQR Capital Management (8.5M shares of Bank of America worth $130M)

In conclusion, it is not too late to take a position in Bank of America. Bank of America's share price is at a 28.3% discount relative to its book value and it is settling its outstanding mortgage-related litigation issues and steadily decreasing its operating expenses. We believe that Bank of America has not yet realized its true earnings potential and that it has the opportunity to generate positive operating leverage in order to improve its operating margin. We can see why Warren Buffett and other leading investors have invested significant amounts of money in Bank of America's shares and believe that investors should steadily accumulate a long position in Bank of America, especially since it has the lowest P/B ratio of its peer group.

Source: Morningstar Direct

Disclosure: The author is long BAC, C. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.