Friday, September 9, 2011

Buffett And Berkowitz Show Us It's Time To Buy Bank Of America

I’ve been struggling with an internal battle over the past couple of weeks as the market and the financial sector especially have sold off. My gut tells me that I should be following the lead of some very smart investors and buying Wells Fargo (WFC), Bank of America (BAC) and Citigroup (C). My brain tells me that I don’t understand the balance sheet of those companies well enough to risk money on them.

As an investor of moderate intelligence I am aware that I have two advantages on Mr. Market, with IQ not being one of them.

The first is that I have reasonable control of my emotions. If the financial networks are screaming that the sky is falling I’m able to sit on my hands when my investments plummet in value and wait for better days. My education from Buffett has given me this gift. I know that the value of business can be completely unrelated to the behavior of the stock price at any point in time and stay that way for an extended period of time. I proved to myself that I have a handle on my emotions in 2008/2009 when I dearly wanted to end the pain of the daily drubbings to my net worth and sell. But I didn’t, and I reaped the rewards in fairly short order later.

My second advantage on Mr. Market is that I am aware that I’m not the sharpest knife in the drawer. And because of that I’m willing to say no thank you to a lot of investment ideas. When I watch the financial networks I am extremely aware that being aware of my limitations is a huge advantage as seemingly anyone on television is willing to offer an opinion on ANY subject. I know what I don’t know, and I’m not afraid to say so. I’m starting to think that is a fairly unique trait.

With these two advantages in mind I keep asking myself the following two questions about investing right now in the financial sector and Bank of America specifically:

What emotion is driving me toward the financial sector? The answer clearly is greed, as some of these companies could have multi-bagger upside. And I think I’m ok with that because Mr. Market is clearly feeling fear, and I want to feel the opposite of my emotional opponent.

If I enter into this sector am I really using my second advantage, which is the discipline of not straying from my circle of competence? And the answer here is that I think that I am unquestionably straying outside my circle. And that is what is still holding me back.

Buffett and Berkowitz Version 2.0 Tells Me It is Time to Buy Bank of America
There is a major complication to me and my “stick to my circle of competence” plan. There are some investors who are just so good, and who make so few mistakes that I’m almost willing to follow them blindly into some ideas. When two of these world class investors converge on the same idea at the same time when nobody else is interested I get up on the edge of my seat.There are no style points in investing. No extra credit for finding your own ideas. All that matters is making money, so if you can borrow from another investor successfully then that is the right course of action.

We have two exceptional investors who we can follow today with Bruce Berkowitz and Warren Buffett and the financial sector. Specifically Bank of America, but also Goldman Sachs (GS), and Wells Fargo (WFC).

To add further intrigue to their shared interest is that the last time Buffett and Berkowitz were getting greedy with the same bank stock the result was an overwhelming success.In the early 1990s the Bank of America of the day was Wells Fargo. Wells had huge exposure to California commercial real estate that had plummeted in value. The company was undeniably feeling some serious pain and not surprisingly so was the stock price.

But Berkowitz and Buffett both could see that through the gloom on the other side was a bank that would have an earnings power that once again would be revealed once trouble loans were dealt with. That earnings power was grossly underappreciated in the stock price.Buffett makes the decision to invest in Wells Fargo in a big way sound so simple in his 1990 shareholder letter:

Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled - often on the heels of managerial assurances that all was well - investors understandably concluded that no bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings. 

Wells Fargo is big - it has $56 billion in assets - and has been earning more than 20% on equity and 1.25% on assets. Our purchase of one-tenth of the bank may be thought of as roughly equivalent to our buying 100% of a $5 billion bank with identical financial characteristics. But were we to make such a purchase, we would have to pay about twice the $290 million we paid for Wells Fargo. Moreover, that $5 billion bank, commanding a premium price, would present us with another problem: We would not be able to find a Carl Reichardt to run it. In recent years, Wells Fargo executives have been more avidly recruited than any others in the banking business; no one, however, has been able to hire the dean.

Of course, ownership of a bank - or about any other business - is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.

None of these eventualities can be ruled out. The probability of the first two occurring, however, is low and even a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans - not just its real estate loans - were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even.

A year like that - which we consider only a low-level possibility, not a likelihood - would not distress us. In fact, at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity. Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990. Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices.

Buffett kept buying Wells Fargo for Berkshire through 1992 as the stock price stayed low while the problem loans were worked out. By the time he was done buying early in 1993, Berkshire had almost $423 million invested. By the end of 1996 that $423 million investment was worth more than $1.9 billion. By the end of 1998 it was worth $2.8 billion. He made $2.4 billion for his shareholders in roughly five years on a $423 million investment. Now I know why my gut wants to follow him into financials this time.

And if you were wondering how Bruce Berkowitz did on his Wells Fargo investment in the early nineties check out this interview (pdf) where he reveals that he had 33% of his net worth in Wells Fargo immediately before it quintupled over the next 5 years.

This time around as we work through another (and even larger) banking crisis Buffett has added to Wells Fargo and now has an investment in Bank of America as well. Berkowitz of course is the poster boy for being early into Bank of America.

When I wake up in the morning to start my investing day I find myself thinking, what better signal could there be to tell me to buy the financials than Berkowitz and Buffett again going in first ? I can’t think of one.

The last time they were in the same place at the same time they made 5 times their money in a few years. I’ve watched them make countless other intelligent investments over the last twenty years. Why would Bank of America be any different ? I think my gut is starting to win my brain over.

I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Comments (12)
  • Didn't Buffett just buy BAC preferreds? So even if the Co. goes BK and the equity is wiped clean he still gets first priority to the assets?
    8 Sep, 03:22 PM1
  • No No NO! Buffett again did one of his trademark convertible preferred deals with BAC.

    For bank common shares, Buffett's money is on USB and WFC, which make up 20% of his equity portfolio.
    8 Sep, 05:36 PM1
  • How does one quantify the legal risk as it appears there is a lawsuit coming in each day now.
    9 Sep, 12:16 AM1
  • Excellent article. And very clearly expressed. I do think it's perfectly possible to make money by following the best, when the price is right.

    Buffett adds to Wells at every available pricing opportunity.

    I've wondered if Buffett and Ajit Jain, Berkshire's insurance guru, had a long hard look at BofA's books and came to the conclusion that the risks from the mortgage mess are manageable.

    Disclosure...long BAC, WFC.
    9 Sep, 01:47 AM2
  • Good luck Charlie25!!!!!
    9 Sep, 03:08 PM0
  • VIGMA If they had they would have bought the common. As smart as they are even they would have trouble getting through the opaque books of BAC. Buffet sold BAC a PR deal, they can borrow money from the gov't a lot cheaper than they did from him. In reality it is just a loan not a stock purchase.
    9 Sep, 03:09 PM0
  • It makes you wish you had read Buffett's 1990 report at the time.. 
    I cannot help feeling, though, that the situation is very different now. It's not enough just to look at the balance sheet these days. Unlike in the 1990s, there is a huge and unpredictable series of lawsuits in the future of these major banks. I inherited my shares at near the all-time high, and am thoroughly FURIOUS at the way these banks behaved for the last ten years, leaving me with a huge hit on my investment portfolio. For me, BAC isn't really an investment any longer, but rather a sort of warrant.
    9 Sep, 05:32 AM1
  • Devon, I've been following you since ATPG days. I'd be careful about BAC here. Don't you read Zero Hedge? WFC escaped being one of the 17 banks sued by FHFA primarily because Buffett is a large stockholder, one who contributes handsomely to some primarily Democrat politicians. You are correct in that you do not understand bank balance sheets. Those loans have NOT been marked down to anywhere near where they should be based on the actual cash value of the underlying. I see you are also interested in Barclays. Barclays may have significant exposure to European bonds and these may well go belly up. I would avoid banks at this point, and concentrate on energy and commodities, both of which are needed, and both of which will appreciate against ever more diluted fiat dollars in the future. Enron was a steal when it got to $10, many thought.
    9 Sep, 10:30 AM0
  • I very much agree with your discussion about the advantages over Mr. Market and the mixed emotions about following the investment lead of others outside your circle of competency. I feel the same way and followed Berkowitz into C and AIG. I'm looking forward to the next five years as we emerge from these conditions.

    Good luck.
    9 Sep, 12:14 PM0
  • Stick to your "stay out of what you don't know" theory. First as someone above mentioned Buffet bought Preferred shares, i.e. basically bonds, from a credit perspective, second if the bank recovers his warrants will dilute the share price. Buffet may be a Democrat, but he is the ultimate capitalist, and when he is in a deal he does much better than the other share holders of the firm generally do. He has no socialist tendencies other than leaving his money to charity.
    9 Sep, 12:23 PM1
  • The 1990's was a time of investing based on value - today it's a world of electronic traders with no regard for the fundamentals.. Our market is managed by programmers who have automated the management of a stock portfolio..
    9 Sep, 12:30 PM1
  • Excellent analysis, but (like Buffett) I would only invest in the common stock of WFC. BAC has too many skeletons (Countrywide & Merrill Lynch) in the closet.

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