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Opening Position in BAC.WS.A 

October 5, 2010

The other day paging through GuruFocus (whose format I find distasteful but it does aggregate some interesting articles that I otherwise might miss) I came across a blurb entitled “Distractions for Fundamentals Value Investors” (which I think, no, I hope, is a typo) by Eric Houssels laying out the three things most distracting to value investors:

1)      Macroeconomics

2)      Politics

3)      Market predictions

I don’t know whether I agree 100% with the author, and certainly not with his priority of distractions, but, overall, I found myself agreeing with him in concept. In fact I have to thank him, though it was perhaps pure serendipity that I read his blurb at that moment, since I had just been thinking that perhaps I should add a little color to my blog with some thoughts on the economy. So thank you Eric! You saved me from immolating myself on some superfluous macroeconomic analysis that I might have developed on these pages. And, oh, if you’re reading this, you might thank Eric too as he saved you from having to read whatever bunk I might have come up with. If the multi-degreed economists and financial pundits can’t get it right, what chance would I have? Then again, maybe I would have gotten it right just because I’m not one of them. But in any case it would have been irrelevant to my investing success. Not only would I have had to get the macroeconomic forecast right I would have had to translate this into an investment idea. Too many ‘nested ifs’ in my book.

Where was I going with this line of thought? From Eric’s blurb I was then reminded of the recent CNBC interview with David Tepper of Appaloosa management (courtesy of Variant Perceptions), the hedge fund superhero of the hour. (By the way, you should really listen to it, as it’s a great interview, and I’m not a CNBC fan). In talking about his move into financials in 1Q 2009 he said the trade was ‘easy’, the premise being that the market was pricing the money center banks for potential government takeover while the government was saying that the banks were integral to the financial framework of the country (too big to fail) and that they would be purchasing equity in these institutions as above-market prices. If you could buy equity in these institutions at levels below where the government was willing to backstop these banks wasn’t that a ‘no brainer’?  The simplicity of the logic is what is important here. The fund’s biggest trade was based on simple logic, no fancy macroeconomic forecast, no complex discounted cash flow calculation, just simple logic. To my mind these are the best trades, investments, whatever you want to call them.

Can we use the same kind of logic for an investment in the banks today? Well, not really. Market prices have advanced from their extremes. TARP is ending, so no more backstop there. But the Fed has repeated that it will continue with quantitative easing (read low interest rates) for the foreseeable future, at least until the banks can rebuild their balance sheets (that last is my interpretation). Think about it. Banks can borrow at practically nothing and lend to much more creditworthy companies for an almost obscene spread. Yes, they do have to rebuild their balance sheets WITH all that slop that they created 4 or 5 years ago. But they are practically printing money and the credit markets are coming back, the slop is rising in value too. Not everything is bright. Real estate prices continue to fall. A lot of mortgage resets are coming up, with the potential for yet more mortgage defaults. Yet I do think, with all the pessimism around, that they will make it.

So is it once again time to buy money center banks? They are off their April recovery highs.

Well, I really hate banks as an investment. They have all the things I really don’t like. They borrow short and lend long which I’ve always held is a recipe for disaster. I can’t understand what’s on the balance sheet; they have all sorts of complex financial instruments that I have no way of valuing (and recent past experience shows They have no way of valuing). The financials scream COMPLICATED and I hate complicated. That said, I’m still intrigued. Many are trading at a fraction of what they were trading for pre-crash, and I have to believe that in the long run they will shed the fear and loathing attached to them at this moment and return to their rightful place in society. But how to invest? While reading through the Chou Fund semi annual report I came across a nice little chart of some of the TARP bank warrants. And it struck me. This is it! Of course it helped to know that Francis Chou was investing in these things; I follow his investments almost as religiously as I follow Prem Watsa’s. One series of warrants stood out to me particularly. The Bank of America A warrants, with a strike price of $13.30 (close to today’s market price), a long duration (8+ years) and a cherry! Incredible as it may seem these warrants adjust the strike price down by the amount of each quarterly dividend above the current rate ($.01).

My next step was to do a couple of back-of-the-envelope calculations as to what might be worst case scenarios. OK, OK, not really worst case, like the bank is left to go bankrupt, but more likely worst case, i.e. performance isn’t really that good over the next 8 years and the bank just stumbles along. For each scenario I computed low, medium and high BAC common stock price estimates and from these terminal warrant values. In the first scenario, book value doesn’t really grow. The bank just works off the unfavorable assets on its balance sheet and the market returns to its normal valuation of BAC at 1.6 to 2x book value. I calculated theses ‘normal’ book value multiples based on averages from the 2002/2006 5-year period; maybe not so normal, but we need some anchor here. Just to make things really conservative, I’ve assumed all the cash flow goes back into building up the balance sheet, no increase in dividends. Using this approach the warrants have a modest return of 6.5%- 12% per year. Then I took another scenario. I assumed the bank was able to pay out a dividend in 2018 of $1.20 a share or 50% of what it paid out in 2007. Using this and the average dividend yield on the common stock over the 2002/2006 5-year period I computed a stock price, again with low, medium and high versions and from these computed the terminal warrant values. In this scenario the warrant strike price is reduced by the dividends paid (I assumed dividends increased at a linear rate, not all in the last year). This gave me somewhat more meager returns on the warrants, in the 3.8%-8% range. Still not too bad if things don’t go so well. If I combine both scenarios, which I think a bit more likely, i.e. book value doesn’t grow, the bank is able to pay out some dividends (50% of 2007 levels) and normalcy returns, we begin to get a more respectable return of 9% -14%.

         
    Low Medium High
Price/Book      
  5 year average 1.6   2.0
  Share price based on no      
  growth in BV by 2018 $35.00 $40.50 $46.00
         
Dividend Yield      
  5 year average 4.6% 4.1% 3.6%
  Price based on 50% of      
  2007 div by 2018 $26.28 $29.22 $32.88
         
         
Price/Book scenario (no incr. in div)    
  Strike Price $13.30 $13.30 $13.30
  Warrant value $21.70 $27.20 $32.70
  Annual Return 6.5% 9.5% 12.1%
         
Dividend Yield scenario      
  Strike Price $8.50 $8.50 $8.50
  Warrant value $17.78 $20.72 $24.38
  Annual Return 3.8% 5.8% 8.0%
         
Both        
  Strike Price $8.50 $8.50 $8.50
  Warrant value $26.50 $32.00 $37.50
  Annual Return 9.2% 11.8% 14.0%
         

Then, of course, if we contemplate a scenario in which the full 2007 dividend is reinstated by 2018 and the bank is also able to grow book value, the returns quickly get over 20% annually. So my handicapping goes this way: 10% total loss on the warrants, 40% low return outcomes (like those above), 50% chance of  ‘return to normalcy’ or better (giving me returns of greater than 20% annually).

Generally, I don’t go for this kind of investment. I like good hard book value. It’s outside of my sphere of competence and it kind of stinks, but there’s just something about it in a ‘plain vanilla’ kind of way that I just had to bite.

Successful investing to all, and remember, do your own due diligence; I’m most likely wrong!

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13 Comments
  1. Walter permalink

    What made you choose BAC over the other banks? I think the JPM and COF warrants seem a bit cheaper… like if you assume the stock doubles from here, the JPM warrant will triple as opposed to the BAC warrant that doubles.

  2. Walter,
    Thanks for the comment. I have to admit I didn’t do a rigorous comparison between all the bank TARP warrants. What attracted me about the BOA A warrants in particular was that they provide the most book value dilution protection. All the bank TARP warrants adjust the exercise price down by quarterly dividend amounts over certain thresholds as laid out in the Chou Funds chart I referred to in the post. But note that all the dividend thresholds are substantially higher than today’s payouts EXCEPT the BOA A warrants threshold. This means that management of BOA cannot dilute the A warrant value by paying out additional dividends (up to the threshold amounts). I view these warrants as having superior downside protection which I prefer to the greater leverage of the other warrants. The way I looked at it if the BOA share price goes nowhere for 8 years but the company increases its dividend at least I am ‘earning’ the dividend.

  3. asim permalink

    Where did you find that the strike price will be adjusted lower. I understood that the warrant price which is quoted will be adjusted by any dividend over one penny.

    • I’m not quite sure what you mean by the warrant price being reduced. The warrants are priced by Mr. Market at whatever he feels like paying at the moment. Bank of America, the SEC, the federal government et al have no control over what Mr. Market is willing to pay. The only thing they could and did establish were the terms of the warrant, i.e. the initial strike price of the warrant and how and when that strike price changes over the warrant’s life; in this case the BAC A warrant strike price is adjusted downward by the amount of each quarterly dividend that exceeds $.01. Hopefully Mr. Market should acknowledge this by increasing the amount he is willing to pay (but he’s not always that rational). If you look at the Chou Fund chart referenced in my blog you will see that the last column is titled “strike price adjustment”. However, if you really want to be sure, you can go back and read through the SEC documents.

  4. gerard permalink

    Thank you for your analysis. Previously I bought Wells Fargo Warrants
    because Mr Market kept increasing the price .Not so with these BAC W.and Mr Warren Buffet .
    I am intrigued by your BAC W ,work. I will be buy some and monitor .

  5. gerard permalink

    it is now june 2011, any changes in your thoughts about these warrants?

    • No change. The long term thesis that this bank is a critical part of the US financial system still holds. I am thinking about increasing my position if the warrant price falls below $6.

  6. I am eyeing the Class A warrants as a major portion of my portfolio. Although, being of the value mind set, I am investigating the underlying equity.

    What is hammering the BAC common’s price is the bad mortgage risks outlined in this blog entry:

    http://www.economist.com/blogs/schumpeter/2011/06/mortgage-backed-securities-scandal

    As Mr. Market continues to sell BAC due to these potential risks, based on my calculations, all of this bad news will be discounted from the BAC common stock when hits 9.00.

    At that point, I’d like to begin building a position in the Class A warrants.

  7. Gerard permalink

    I bought today Class A warrants at $3.

    • Same here. My avg. price is 2.94.

      We are in the same boat now, Jay. I am convinced that the boat is sturdy, but the waters are choppy.

      This too shall pass.

  8. I am aware that this is premature for a warrant expiring in 2018—

    Congratulations to everyone who decided to take the plunge!

  9. Roger Sorensen permalink

    Not for nothing, but if the strike price gets down to $8.50 the number of warrants you hold will increase proportionally.
    I am surprised this is never mentioned. Check the Prospectus.

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