How Truly Long-Term Investors Should Approach Bank Of America

In the 2013 letter to shareholders of Berkshire Hathaway, Warren Buffett noted this: “It is important for you to realize that Bank of America is, in effect, our fifth largest equity investment and one we value highly…We can buy 700 million shares of Bank of America at any time prior to September 2021…We are likely to purchase the shares just before expiration of our option.” Even though Buffett’s terms on the deal are much, much better than what any investor could get by going online, typing in the ticker symbol BAC, and clicking the purchase button, the fact that Buffett values the position highly and will likely make Bank of America such a meaningful portion of the Berkshire Hathaway investment portfolio seven years from now indicates positive sentiment about the long-term future of the bank.

The response to this news could be two-fold: Perhaps the best answer is to buy Berkshire Hathaway stock, so you can directly tap into that $7.14 per share strike price for 700,000,000 shares of Bank of America that Buffett had arranged as a special class of warrants. All this means is this: In September 2021, Buffett or whoever is running Berkshire will have an opportunity to pay just under $5 billion (700,000,000 x $7.14) to purchase 700,000,000 shares of Bank of America stock. If the price is above $7.14, the warrants are called “in the money” because that is the point at which purchasing the stock/exercising the option would make you money. If the stock traded at $3 in 2021, the options would expire worthless and Berkshire would get nothing on this component of the deal because why would you exercise the right to pay $7.14 for something that trades at $3? It would be like going to a cashier at Wal-Mart and saying, “I don’t want to pay the $3 price for this ice cream. I have a coupon to get it for $5!”

Now that Bank of America’s dividend is on the mend, the story gets a little more complicated because the special arrangement between Berkshire and Bank of America involves deductions for the dividend payments. So for each dividend above $0.01 that Bank of America pays out (they just raised it to $0.05), the strike price of the warrants lower to compensate for the cash that Bank of America chooses to return to its shareowners. Considering that Bank of America could likely pay considerable dividends between now and 2021, this will affect the strike price significantly.

In the case of Bank of America, here is a brief summary of what is going on: This year, they will make a little over $10 billion in actual profits before you get into its litigation costs (we’ll get there in a minute). $2 billion of those profits come from the management of its customers’ investments (led by the Merrill Lynch division, which may be a lucrative spinoff someday), another $2 billion comes from extensive trading operations that churn stocks all day (contributing to what Charlie Munger calls the greatest waste of human capital he has ever seen), a little over $3 billion of the profits come from what we would consider the old-fashioned banking and loan division, a little over $2 billion comes from global commercial investing (e.g. a manufacturing business that is privately held wants to start inventorying profits and making common stock investments, so Bank of America assists with that), and the remaining $500 million comes from real estate loans (namely, the mortgages that are the legacy of that Countrywide acquisition during the financial crisis).

It is that real estate loan division that has wreaked havoc on investors, explaining why someone who bought $100,000 of Bank of America stock in 2007 would have only $35,000 today. The Countrywide acquisition has now cost Bank of America over $67 billion in legal fines (justly earning its reputation as the worst U.S. acquisition, ever) and forcing Bank of America to raise capital during the crisis, so that the share count from 4 billion to 10 billion.

The reason why Bank of America has been unable to raise its profits, and grow its dividend, in the past six years is because these $60+ billion in fines, fees, restitution, and so on, related to the Countrywide acquisition, have prevented Bank of America from using its banking profits to enrich shareholders—it’s gone out the door in legal judgments instead. Recently, Bank of America management indicated that roughly 90% of the financial crisis litigation has been settled, and only $5-$10 billion in settlements remain.

Over the past few years, many shareholders have sold out, growing weary and worn out by seeing Bank of America’s litigation woes take center stage, quarter after quarter, year after year, since the financial crisis. For prospective shareholders now, we are in about the eighth inning of the litigation settlement ballgame. The crisis is finally fading, and those $10 billion (and growing) annual profits will soon begin to manifest themselves with higher profits, and the rising dividends and stock price that comes with that. The appeal of buying the stock now in the $15 range rather than later is that, once the dividend increases and profits-in-the-clear arrive, the opportunity to buy the stock at a value price will be gone. You have to be a bit like Gretzky and skate to where the puck will be, rather than where it is now.