Bank of America

Warren Buffett has always been interested in financial sector stocks. But especially during the last two years his exposure to this sector has grown more than 15%, to nearly 50% of the total investment portfolio.

After the long bullish market period many conventionally thinking investors may find it surprising. Common belief is that banks perform poorly during recessionary periods for many reasons. Consumers are more reluctant to borrow because of general uncertainty and investments of many companies will decline significantly during the downturn due to the lack of attractive prospects. But perhaps most strongly declining interest rates have inevitably led to a fall in profits as net interest margins compress. And this is exactly what has happened as the Federal Reserve has cut the interest rates twice in the last three months.

Despite this, Buffett’s investing vehicle Berkshire Hathaway is seeking approval from the U.S. central bank to increase its stake in Bank of America beyond the threshold of 10%. Although this is not the first time Buffett has had to ask permission from authorities to increase his position in a financial sector stock (he once owned up to 25% of American Express), this action was big news.

Naturally, following the news share price of Bank of America bounced right away. It’s always difficult to know exactly buffett’s strategy, but it is plausible to conclude that he believes Bank of America was highly attractive at that share price he bought it. Buffett’s own words, “so, if we like 9.5% of a company, we’d like 15% better, and you may see us behave a little differently on that in the future.”

Should we follow Buffett to Bank of America or is it already too late? Actually, BAC is still pretty cheap – at least compared to its quality and long-term expectations. Company’s PE ratio is 12 (well below the long-term average 15-16). What is more importantly, ROE has risen to the 10% level and ROA is 1.2. Both are high quality bank figures. Dividend yield is not more than 1.9%, but during the past 3 years dividends growth rate has been 39% per year and payout ratio is under 0.25. So, it leaves a lot of room for dividend growth.

In addition, book value is growing steadily about 5% per year and BAC is buying back shares quite aggressively (company’s shares buyback ratio is 7.56%). This is great information when the company repurchase its undervalued shares, as in the case of Bank of America. Buffett’s own comment hits the point, “When a company grows and outstanding shares shrink, good things happen for shareholders.”

As we live in a time of low interest rates, banks have to earn their profits in other areas besides variable-rate credit products. It’s good to know that Bank of America has a diverse stream of revenue. Interest income constitute approximately 50% of the revenue. The other 50% of the revenue was from non-interest income or income from service charges and other fees.

Management at Bank of America led by CEO Brian Moynihan is working on reducing risk and becoming more efficient while enhancing the customer experience. For a bank, non-interest expenses are similar to overhead costs for other companies. To be successful, bank has to manage well its non-interest expenses while growing revenue. This means that it expects its credit losses to be lower going forward, even while it’s increasing the loans to credit cards and to consumers. This is a great sign for the bank because it shows it’s managing credit risk effectively considering the backdrop of lower yields and lower economic growth.

Although, general investing public sentiment have been against investing in financial sector and especially banks, we have many reasons to share the same opinion with Buffett. Financial sector pessimism is likely to have been oversized and pushed industry prices down too much. Already recent results from major US banks provide some indication of this. Now is a good opportunity to take advantage of this situation and Bank of America is high quality bank in an excellent position to deliver attractive long-term returns.