Wednesday, July 27, 2011

Is Bank of America Undervalued? Bruce Berkowitz of Fairholme Thinks So.

Bruce Berkowitz of Fairholme Capital Management has been rather aggressive when it comes to financial stocks lately. In fact, Fairholme's portfolio has just under 75% exposure to financials. This is in stark contrast to Donald Yacktman, another capable equity mutual fund manager, who's funds have less than 5% exposure to financials.

In this speech back in June, Berkowitz first outlines the headwinds facing Bank of America (BAC) then goes on make his case for the bank.

The following are some excerpts from the speech:

"Bank of America generates before reserving for bad loans and before taxes, $45-50 billion a year. That's $4.50 to $5 a share for a company that's selling for $11 and change, before provisioning for bad loans, and before taxes. That's $3.50 to $4 per share before taxes. It's going to be a long time before they pay taxes, given that they have to blow through $80 billion roughly of past losses. Which means the next $80 billion that they make, they don't pay any taxes on. So, that's $3.50 to $4."

So is it cheap?

The bank is actually now selling for just under $ 10/share. To me, the bank's balance sheet and relative ability to absorb losses via earning power is not nearly as robust as stronger banks like Wells Fargo (WFC) or U.S. Bancorp. (USB).

"...the period that we're in right now is very reminiscent of the early 90s. I remember having a gigantic position in Wells Fargo. Everyone thought they were going to go bust, because they had all of these empty commercial buildings in California and all over the place. They didn't go bust."

That was around the time that Warren Buffett first bought Wells Fargo.

Those who bought Wells Fargo in the early 1990s and held on saw their investment increase in value, including dividends, roughly 10x over the next decade or so. Buffett has, it's worth noting, added substantially to that position in recent years and often at higher than recent market prices.

More from Berkowitz:

"If I use the money just to buy back stock, and the stock for some reason stays where it is for 10 billion shares, it would take them six years. In six years, they'll buy the entire company back that started in 1794 and had hundreds of billions of dollars of acquisitions that probably touches one out of every two people in the United States. Given the fact that they're not going to pay taxes, they'll probably buy back all the stock in five years."

One big risk (among others) is that a new crisis emerges in the financial sector before Bank of America can get most of its current headwinds behind it. I'm not willing to put a whole lot of capital at risk in a bank less able to withstand the financial stress. Still, if bought near recent prices and if they do get past their current problems, Bank of America will likely make investors a very nice return.

"This is how we do it. And usually it means buying something that's hated. And something where the newspaper everyday is going to tell you, 'You're wrong.' And your friends are going to tell you, 'You're wrong.' There's going to be something else that is hot and juicy, some new thing which you are going to want to get in on, and you usually feel pretty lousy about it. Because, when you're early, you look wrong. You make your most money when times are at their toughest. You just don't know it at the time."

A year ago the valuation gap between Wells Fargo, the significantly sturdier bank, and Bank of America was small. Bank of America might now be relatively cheaper but seems quite likely not built to withstand heavy losses in the way that Wells Fargo can if an unforeseen crisis emerges. I've referenced the following quote before but how cheaply a bank obtains its money is important to consider in this context:

"If you're a copper producer, and copper is selling for two dollars a pound, and you want to measure the stress of copper going to $1.30, for a guy whose production cost is $1.50, you know, he's got problems. If his cost is a dollar, he doesn't have problems. And Wells, in terms of its raw material costs, is better situated than any large bank, by some margin. So, it's built to sustain a lot." - Warren Buffett talking to CNBC on May 2, 2009

Bank of America has higher "raw material costs". That, all else equal, makes it the more vulnerable bank. So while under the right circumstances Fairholme's investment thesis is likely to work out just fine, I'll take Wells Fargo or U.S. Bancorp on a risk/reward basis over the long haul.


Established long positions in Wells Fargo and U.S. Bancorp at substantially lower than current market prices. Currently building a small long position in Bank of America.
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