I had occasion last night to sit out at the picnic tables with a bunch of curmudgeons. The big news of the day was Warren Buffett (Berkshire-Hathaway [BRK.A]) investing $5,000,000,000, yes as in B for Billion, into Bank of America. Upon the announcement and shortly after the market opened, the stock went up to over $8.50 from around $7.01, and then settled for the day around $7.50. This caused me to think long and hard about this stock, the foundation of the company, and this news announcement. As always, it never is what meets the eye. I love these moves, and I love figuring things out. You will read here my analysis of this transaction, broken into two parts. One is my initial take, and then today when I was e-mailed more news about this new deal.
The reason this is important to me right now, is two-fold:
1) I've been writing about the stock as a covered call candidate. The options were really good, about 10% for the September calls. Example, the stock was $7.01 and the $7 calls were going for about 70 cents. You could buy the stock, and then sell to someone the risky option for 70 cents. If you owned 1,000 shares, and then sell 10 contracts of the options, you'd take in $700. Now the stock will rise, stay the same, or go down. Whatever, you get to keep the $700. If you sell the stock at $7 you would lose $10, that's the one cent. This scenario is not that important to this discussion, but it proves a mighty powerful point about option pricing, which I'll share as one punchline at the end of this blog.
2) This is a piece of Americana---both Bank of America and Warren Buffett---and add to that the deal that was made, you too will say, "Only in America." It's brilliant or it's crazy, you decide.
To summarize: The first announcement just said that Warren Buffett is buying $5 Billion of Bank of America stock. What would you think if you owned this stock? It's going to go up, right? It's a bullish sign for American Banks. Other bank stocks might also go up. $5 Billion dollars in the market place will do a lot of good. You would have been mostly wrong.
I've noticed that so many people just read the Headlines. Everything on TV is condensed to sound-bites, headlines flashing across the screen. OnE constant in the stock market is that everybody over-reacts. They over-react when the news is good, and buy. They over-react when the news is bad, and sell. It all works out after people read the whole article, get more news, and delve into the details.
BACK TO LAST NIGHT
I said to everyone last night, that the news was not what it seemed. This was not an open-market purchase. The only way a deal like this (a guaranteed 6% return, and the right to buy the stock at $7.14) would go down, is if there was a new SEC filing, new stock created, etc. This type of trade will be like the Oil Sheiks buying stock when banks were in need of cash ten plus years ago. Everyone asked what it means. I tried to explain preferred stock, and warrents, and then book value and negative book value. I tried to shed some light on GAAP (Generally Accepted Accounting Principles), and how America works at the Billion Dollar level. It made sense to me and I hope I can help you see this. The effort is worth it. Believe me, this type of knowledge is very powerful.
NOTE TO READERS: This is where I'd like to explain how some of the accounting principles work, and how the banking accounting is different. I need to explain, "Marked to Market," and the like. The deal is powerful because this is a purchase of an under-valued stock, as you will see. In the next blog I will share some very powerful information that will help a lot of this make more sense. Usually I interrupt an article and wind along a winding road to get to the destination, but this information is supplemental, though interesting and casually important to this topic. If you like connecting the dots, go there, read it and come back here and pick up this story.
Moving On: Here was the infomation gleaned from the first pass at the news. Warren Buffet is investing $5 Billion in Bank of America. He will receive a guarenteed 6% each year, or $300,000,000. He will be able to buy the stock at $7.14. The market reacted, the stock shot up. Later in the day the details became apparent and the stock backed off.
My thoughts were that this had to be a new class of stock. Also, Bank of America was getting the money. Why, you might ask? They have $400 Billion cash on hand, and they're sitting on deposits of over $1 Trillion dollars. Out of a Barron's article (Jacqueline Doherty) we learn that they made $6 Billion last quarter. Within the article is the statement that banks stocks are near the cheapest they've been in history, based on Book Value and P/E ratios. Why do they need $5 Billion from Mr. Buffett? The truth from my perspective---THEY DON'T. So why the deal? To bolster the stock price. PR. To show Mr. Buffet is the investor of last resort. More PR.
To summarize part of the information of Book Value and P/E ratios, look at this. BAC is trading at 57% of tangible book value (Ibid. Doherty) and at 4.9 times next years estimated earnings. Remember 20 times earnings is about average for a New York Stock Exchange stock. Yes, banks stocks are down, but this is way down. Look at the Book Value. A little over 50 percent. That means this company has assets (based on their last earnings filing) where their stock is trading at a percentage of their listed assets (57%). In reality that means that the stock could and should be trading at a $12 to $14 price. Think of this. If you wanted to buy real estate or a company and could get it for 50% or so of its value, would that not be a heck of a bargain? And remember, these asset values ("Cost Basis or Market Value, whichever is less) are much lower than their worth in the real world.
So, from Mr. Buffett's point of view, he's getting the company for 50% or realistically 20% to 30% of the real value. Now let me share a paragraph from a news article. Then I'll do my best to parse the words so it makes sense.
"The terms of the deal were favorable to Buffett. He received 50,000 shares of cumulative perpetual preferred shares costing $100,000 each that will pay a 6% annual dividend, which is a good return in a low-return world in which the Treasury note yields 2.23%. Buffett's Berkshire Hathaway will net $300 Million in dividends per year."
"Buffett also got warrants, or the right over the next 10 years to purchase shares of BofA common stock at a price of $7.14 per share."
MY EXPLANATION
- Preferred Shares are a special breed. They act like debt in some ways. If the company liquidates, for example, preferred shareholders would be paid in advance of creditors. Notice that this 6% is called a dividend, not interest. This avoids double-taxation (one of my pet peeves, which we'll save for another day); and keeps the transaction off the books as debt, or a loan, unless Mr. Buffett has a special arrangement with Mr. Obama's IRS. They have become pretty chummy lately.
- This transaction looks more like a convertible debenture. But does it quack like a duck?
- The stock did not go into the market and buy shares like the rest of us have to. This deal came from a cigar-filled backroom. It has a smell to it.
- The money goes to B of A. They have $5 Billion to add to their balance sheet.
Here's how I see it. Mr. Buffett loans (invests) $5,000,000,000. He buys 50,000 shares of a type of preferred stock for $100,000 each. Everyone here who read the article missed the word "each." He gets 6% or $300,000,000 a year in interest (OOPS---in dividends). He has 10 years to convert these shares into 700,000,000 shares of common stock at $7.14 per share. $7.14 times 700,000,000 is $5,000,000,000, minus a little change for arbitrage.
He gets paid every year for the investment/loan. If the stock goes up, to say $15 to $20 (I think it can easily go to $30 over the next year or so, especially if Mr. O goes packing, back to the streets of Chicago). The stock is undervalued. If the Banking Authorities wise up, and get rid of the ridicules stress-test, and let banks run on good, solid banking principles, they will recover quite nicely.
He's taken a small fraction of the cash reserve of Berkshire Hathaway and added it to the huge cash reserve of Bank of America, and everybody benefits.
Yeah, the only conclusion is the PROMO trick and if they're successful, then everyone wins. I sure hope so.
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