BAC-WT - Bank of America Warrants

[Uccmal]

I get 7.4% as the borrowing cost.

Here is how:

 

Warrant price today is $20.05, strike price is $42.40, so total is $62.45

 

Stock price today is $61.47. Assume that the business is exactly valued and there is no growth. Each year the $1.54 in dividends would reduce the stock price by exactly $1.54 or $6.16 in four years. So in four years, JPM's stock price would be $57.47 (less by $6.16).

 

You are paying $20.05 today. In four years, you borrow $42.40, buy one share of JPM and sell it in the market for $57.47. At that point you are left with $15.07. Market price is $57.47 and you repaid the $42.40 loan, incurring a 33% loss on your initial $20.05 investment.

That works out to 7.4% a year for four years.

 

 

 

That is the right idea, except the dividend adjustment will be far less.  The exercise price is only adjusted by the difference between the dividend and the dividend threshold. 

 

for reference:

 

http://www.marketwatch.com/story/jpmorgan-chase-announces-adjustment-to-warrant-exercise-price-2014-07-01

[Uccmal]

Vinod, I get the confusion. 

 

Warrant Value at expiry = stock price - exercise price - cost to buy warrant initially

 

If it expired tomorrow with a stock at 61, exercise of 42.40 and the warrant cost of 20

it would look like this:

 

Warrant value = 61 - 42.40 - 20 = (1.40)

 

If it expired tomorrow at 80, exercise at 42.40, and warrant cost of 20

 

Warrant value = 80 -42.40 -20 = 17.60  The warrant cost was 20 so you lose 2.40

 

If it expired in 2018 at 80 you would get 17.60 for the warrant and would lose the 2.40 : you might be close to breaking even with the dividend adjustment  Buying the warrant at 20 - selling it at close to $20.00.

 

If the stock was $90 in 2018:

 

Warrant value = 90 - 42.00 - 20 = 28.00; the value today is $20, so you only make 8.00.  I rounded it too high up above.  Anyway somewhere just above $90 the warrants start outperforming the common.

 

To me that is quite a hurdle to overcome with the possibility of a year or two of sub par performance from low borrowing in there somewhere. 

 

 

[ERICOPOLY]

I get 7.4% as the borrowing cost.

Here is how:

 

Warrant price today is $20.05, strike price is $42.40, so total is $62.45

 

Stock price today is $61.47. Assume that the business is exactly valued and there is no growth. Each year the $1.54 in dividends would reduce the stock price by exactly $1.54 or $6.16 in four years. So in four years, JPM's stock price would be $57.47 (less by $6.16).

 

You are paying $20.05 today. In four years, you borrow $42.40, buy one share of JPM and sell it in the market for $57.47. At that point you are left with $15.07. Market price is $57.47 and you repaid the $42.40 loan, incurring a 33% loss on your initial $20.05 investment.

That works out to 7.4% a year for four years.

 

Due to the leverage involved, the annualized loss on your equity invested (which is what you are computing) will be higher than the annualized cost of the synthetic loan (which is what I am computing) that is embedded within the warrant.

 

You could create a new warrant with a higher strike and it would have even more embedded leverage.  Using your method, the resulting figure will be greater still (because you are assessing the leveraged impact on your invested equity).

 

[vinod1]

Vinod, I get the confusion. 

 

Warrant Value at expiry = stock price - exercise price - cost to buy warrant initially

 

If it expired tomorrow with a stock at 61, exercise of 42.40 and the warrant cost of 20

it would look like this:

 

Warrant value = 61 - 42.40 - 20 = (1.40)

 

If it expired tomorrow at 80, exercise at 42.40, and warrant cost of 20

 

Warrant value = 80 -42.40 -20 = 17.60  The warrant cost was 20 so you lose 2.40

 

If it expired in 2018 at 80 you would get 17.60 for the warrant and would lose the 2.40 : you might be close to breaking even with the dividend adjustment  Buying the warrant at 20 - selling it at close to $20.00.

 

If the stock was $90 in 2018:

 

Warrant value = 90 - 42.00 - 20 = 28.00; the value today is $20, so you only make 8.00.  I rounded it too high up above.  Anyway somewhere just above $90 the warrants start outperforming the common.

 

To me that is quite a hurdle to overcome with the possibility of a year or two of sub par performance from low borrowing in there somewhere.

 

Uccmal,

 

Forgive me, I might be too dense from sleepless nights with an infant, but I still do not understand why you would insist on deducting the price paid for  the warrant to get the value of warrant at expiry. You calculate it as Warrant value = 61 - 42.40 - 20 = (1.40). Why do you deduct $20 to get the value of warrant?

 

Say the warrant expires with stock at $80. The value of warrant would be $37.6 ($80 - $42.4 strike price). You are paying $20 for the warrant, so your profit is $17.6 or 88% on your investment of $20.

 

Vinod

 

[cemadh]

Thanks Eric - yes - I am calculating the cost of my invested capital. At least, I got that simple calculation correct and cleared up the confusion in my head about the other posts :-)

 

uccmal - I am aware of the dividend threshold. I chose $1.54 (as did Eric) because, as long as JPM pays exactly $0.38 in dividends per quarter, there is no price adjustment to the warrant strike. In other words, there is a "leakage" of $1.54 per year (or cost) to the warrant holders. If JPM pays 40 cents in a quarter, the warrant strike price gets adjusted downward by only 2 cents. It is a simpler calculation to keep it at 38 cents and calculate the imputed borrowing cost as Eric did or the cost of invested capital as I did in my case.

[Uccmal]

Vinod, I get the confusion. 

 

Warrant Value at expiry = stock price - exercise price - cost to buy warrant initially

 

If it expired tomorrow with a stock at 61, exercise of 42.40 and the warrant cost of 20

it would look like this:

 

Warrant value = 61 - 42.40 - 20 = (1.40)

 

If it expired tomorrow at 80, exercise at 42.40, and warrant cost of 20

 

Warrant value = 80 -42.40 -20 = 17.60  The warrant cost was 20 so you lose 2.40

 

If it expired in 2018 at 80 you would get 17.60 for the warrant and would lose the 2.40 : you might be close to breaking even with the dividend adjustment  Buying the warrant at 20 - selling it at close to $20.00.

 

If the stock was $90 in 2018:

 

Warrant value = 90 - 42.00 - 20 = 28.00; the value today is $20, so you only make 8.00.  I rounded it too high up above.  Anyway somewhere just above $90 the warrants start outperforming the common.

 

To me that is quite a hurdle to overcome with the possibility of a year or two of sub par performance from low borrowing in there somewhere.

 

Uccmal,

 

Forgive me, I might be too dense from sleepless nights with an infant, but I still do not understand why you would insist on deducting the price paid for  the warrant to get the value of warrant at expiry. You calculate it as Warrant value = 61 - 42.40 - 20 = (1.40). Why do you deduct $20 to get the value of warrant?

 

Say the warrant expires with stock at $80. The value of warrant would be $37.6 ($80 - $42.4 strike price). You are paying $20 for the warrant, so your profit is $17.6 or 88% on your investment of $20.

 

Vinod

 

 

Vinod, never mind your sleepless nights.  You're the one who is on the ball.  I have worked this around so much that I got myself twisted.  You are correct.  The sale price of the warrant at $80.00 would be 37.60 for a 4 year profit of 88%. 

 

That means that you are correct about $66 in 2018 being the point at which the warrants profit faster than the common for the same dollar value invested. 

 

Sorry about that, I am overthinking it. 

 

Al

[Uccmal]

Thanks Eric - yes - I am calculating the cost of my invested capital. At least, I got that simple calculation correct and cleared up the confusion in my head about the other posts :-)

 

uccmal - I am aware of the dividend threshold. I chose $1.54 (as did Eric) because, as long as JPM pays exactly $0.38 in dividends per quarter, there is no price adjustment to the warrant strike. In other words, there is a "leakage" of $1.54 per year (or cost) to the warrant holders. If JPM pays 40 cents in a quarter, the warrant strike price gets adjusted downward by only 2 cents. It is a simpler calculation to keep it at 38 cents and calculate the imputed borrowing cost as Eric did or the cost of invested capital as I did in my case.

 

Gotcha, thanks. 

[Liberty]

Moynihan:

 

http://www.veracast.com/webcasts/baml/banking2014/id02101110345.cfm

[vinod1]

Is there a significant margin of safety still in BAC?

 

It had been a return to mediocrity thesis and as it got closer to $20, I have reduced my allocation to a fraction of the earlier size. As the allocation had primarily been in LEAP's, the risk reward does not seem so overwhelmingly attractive as before.

 

My own expectations for earnings were something like below

 

2015 $1.5 to $1.6

2016 $1.7 to $1.9

2017 $1.9 to $2.1

 

Please see attached document for a little more detail. I expect normalized cycle average losses to be around $7 to $8 billion, much more than the estimates in the document, but the next few years should see below average losses simply due to the stage of the credit cycle we are at.

 

To me it looks like this is at most a 15% annual gain type of investment over the next few years. Say to $25 in three years or $33 in five under reasonable expectations.

 

What are your earnings expectations and do you see BAC earning much more over the next few years?

 

Thanks

 

Vinod

BAC.pdf

[Uccmal]

Is there a significant margin of safety still in BAC?

 

It had been a return to mediocrity thesis and as it got closer to $20, I have reduced my allocation to a fraction of the earlier size. As the allocation had primarily been in LEAP's, the risk reward does not seem so overwhelmingly attractive as before.

 

My own expectations for earnings were something like below

 

2015 $1.5 to $1.6

2016 $1.7 to $1.9

2017 $1.9 to $2.1

 

Please see attached document for a little more detail. I expect normalized cycle average losses to be around $7 to $8 billion, much more than the estimates in the document, but the next few years should see below average losses simply due to the stage of the credit cycle we are at.

 

To me it looks like this is at most a 15% annual gain type of investment over the next few years. Say to $25 in three years or $33 in five under reasonable expectations.

 

What are your earnings expectations and do you see BAC earning much more over the next few years?

 

Thanks

 

Vinod

 

I have no quibble with your estimates.  There is upside potential from rising interest rates, and downside potential from other areas such as a recession.  I have sort of a terminal price of $22.00 per share subject to change as things unfold. 

 

I am not buying any Leaps at the moment.  I am running at 50% of my peak holdings now.  I would buy 2017s if the stock price dips substantially.  Otherwise, I am leaving it alone.  I am avoiding taking any more profits until the new year as well.  A holding pattern. 

[Sunrider]

Quick question - aren't there still some fairly sizeable NOLs that you don't seem to take into account as you're showing fairly standard taxes? That would increase earnings somewhat in the next 2 - 3 years?

 

Edit - maybe I glossed through your doc too quickly, but wasn't there also another 1.5bn in annual savings out of ordinary expenses (NEW BAC II) that they had promissed by end 2015?

 

Is there a significant margin of safety still in BAC?

 

It had been a return to mediocrity thesis and as it got closer to $20, I have reduced my allocation to a fraction of the earlier size. As the allocation had primarily been in LEAP's, the risk reward does not seem so overwhelmingly attractive as before.

 

My own expectations for earnings were something like below

 

2015 $1.5 to $1.6

2016 $1.7 to $1.9

2017 $1.9 to $2.1

 

Please see attached document for a little more detail. I expect normalized cycle average losses to be around $7 to $8 billion, much more than the estimates in the document, but the next few years should see below average losses simply due to the stage of the credit cycle we are at.

 

To me it looks like this is at most a 15% annual gain type of investment over the next few years. Say to $25 in three years or $33 in five under reasonable expectations.

 

What are your earnings expectations and do you see BAC earning much more over the next few years?

 

Thanks

 

Vinod

[ni-co]

I think at the end of the day, it's all about the multiples you're willing to attach to BAC (or comparable banks). I don't understand why a stable business with good ROE and a normalized payout ratio of 100% should trade at a below market multiple. The historical PE of the S&P 500 is 16. Now look where we are with interest rates. Taking into account that rising rates will hugely help BAC's earnings, I don't see why an earnings yield of 8-9% should be considered a fair valuation, when you get 2.4% on the 10 year US government bond and inflation is not on the horizon. People are still scared of another financial crises, because the last one was so huge. Yet, they are thereby over-discounting the risks inherent in (traditional) banking. If you're going to sell BAC at a multiple of 12 on $2 earnings you're going to sell it below the IV of its business.

[Sunrider]

To which I would add (also with reference to post above) that if you believe $2/share by Jan 2017, and attach a 10x (seems low?) then it's a $20 stock. 20/17.3 = ~15%, not great for two years, agreed. However, there's a bit of upside. Also, you mentioned LEAPS - but I didn't quite follow. With the leverage in the options you may end up with perhaps 25% - 35% to the $20 mark ... so getting more attractive or are you looking for a much higher number?

 

I think at the end of the day, it's all about the multiples you're willing to attach to BAC (or comparable banks). I don't understand why a stable business with good ROE and a normalized payout ratio of 100% should trade at a below market multiple – in this interest rate environment. And if interest rates go up, so will earnings. People are still scared of another financial crises, because the last one was so huge, and are thereby over-discounting the risks inherent in (traditional) banking. If you sell BAC at a multiple of 12 on $2 earnings you're selling below the IV of this business.

[Viking]

The challenge with valuing BAC is they have had no 'normalized' earnings since 2007. Two large acquisitions. Large litigation payouts. Large regulatory changes.

 

One key will be an end to the large litigation payouts. Another key will be what they do with excess capital; I am hopeful they plow it into share buybacks like what Apple has done the last 15 months.

[Uccmal]

To which I would add (also with reference to post above) that if you believe $2/share by Jan 2017, and attach a 10x (seems low?) then it's a $20 stock. 20/17.3 = ~15%, not great for two years, agreed. However, there's a bit of upside. Also, you mentioned LEAPS - but I didn't quite follow. With the leverage in the options you may end up with perhaps 25% - 35% to the $20 mark ... so getting more attractive or are you looking for a much higher number?

 

I think at the end of the day, it's all about the multiples you're willing to attach to BAC (or comparable banks). I don't understand why a stable business with good ROE and a normalized payout ratio of 100% should trade at a below market multiple – in this interest rate environment. And if interest rates go up, so will earnings. People are still scared of another financial crises, because the last one was so huge, and are thereby over-discounting the risks inherent in (traditional) banking. If you sell BAC at a multiple of 12 on $2 earnings you're selling below the IV of this business.

 

Vinod's question was in regards to the margin of safety.  Does BAC still have enough of a margin of safety or are we relying on growth and PE expansion? I would say the margin of safety on Leaps is no longer there.  Saying it should trade at a premium to book does not make it so. 

 

Its probably a good GARP stock.

[jay21]

Quick question - aren't there still some fairly sizeable NOLs that you don't seem to take into account as you're showing fairly standard taxes? That would increase earnings somewhat in the next 2 - 3 years?

 

Edit - maybe I glossed through your doc too quickly, but wasn't there also another 1.5bn in annual savings out of ordinary expenses (NEW BAC II) that they had promissed by end 2015?

 

Is there a significant margin of safety still in BAC?

 

It had been a return to mediocrity thesis and as it got closer to $20, I have reduced my allocation to a fraction of the earlier size. As the allocation had primarily been in LEAP's, the risk reward does not seem so overwhelmingly attractive as before.

 

My own expectations for earnings were something like below

 

2015 $1.5 to $1.6

2016 $1.7 to $1.9

2017 $1.9 to $2.1

 

Please see attached document for a little more detail. I expect normalized cycle average losses to be around $7 to $8 billion, much more than the estimates in the document, but the next few years should see below average losses simply due to the stage of the credit cycle we are at.

 

To me it looks like this is at most a 15% annual gain type of investment over the next few years. Say to $25 in three years or $33 in five under reasonable expectations.

 

What are your earnings expectations and do you see BAC earning much more over the next few years?

 

Thanks

 

Vinod

 

Yes, I was reviewing two presentations/transcripts around Sept and BAC stressed multiple times they expect to build capital at a pre-tax rate given their NOLs. So if you think in terms of capital generation, the EPS estimates might be low for the next few years.

[vinod1]

Is there a significant margin of safety still in BAC?

 

It had been a return to mediocrity thesis and as it got closer to $20, I have reduced my allocation to a fraction of the earlier size. As the allocation had primarily been in LEAP's, the risk reward does not seem so overwhelmingly attractive as before.

 

My own expectations for earnings were something like below

 

2015 $1.5 to $1.6

2016 $1.7 to $1.9

2017 $1.9 to $2.1

 

Please see attached document for a little more detail. I expect normalized cycle average losses to be around $7 to $8 billion, much more than the estimates in the document, but the next few years should see below average losses simply due to the stage of the credit cycle we are at.

 

To me it looks like this is at most a 15% annual gain type of investment over the next few years. Say to $25 in three years or $33 in five under reasonable expectations.

 

What are your earnings expectations and do you see BAC earning much more over the next few years?

 

Thanks

 

Vinod

 

I have no quibble with your estimates.  There is upside potential from rising interest rates, and downside potential from other areas such as a recession.  I have sort of a terminal price of $22.00 per share subject to change as things unfold. 

 

I am not buying any Leaps at the moment.  I am running at 50% of my peak holdings now.  I would buy 2017s if the stock price dips substantially.  Otherwise, I am leaving it alone.  I am avoiding taking any more profits until the new year as well.  A holding pattern.

 

Thanks! I am at 1/10 of my peak size primarily because, it had been a massive position for me.

 

Vinod

[vinod1]

Quick question - aren't there still some fairly sizeable NOLs that you don't seem to take into account as you're showing fairly standard taxes? That would increase earnings somewhat in the next 2 - 3 years?

 

Edit - maybe I glossed through your doc too quickly, but wasn't there also another 1.5bn in annual savings out of ordinary expenses (NEW BAC II) that they had promissed by end 2015?

 

Is there a significant margin of safety still in BAC?

 

It had been a return to mediocrity thesis and as it got closer to $20, I have reduced my allocation to a fraction of the earlier size. As the allocation had primarily been in LEAP's, the risk reward does not seem so overwhelmingly attractive as before.

 

My own expectations for earnings were something like below

 

2015 $1.5 to $1.6

2016 $1.7 to $1.9

2017 $1.9 to $2.1

 

Please see attached document for a little more detail. I expect normalized cycle average losses to be around $7 to $8 billion, much more than the estimates in the document, but the next few years should see below average losses simply due to the stage of the credit cycle we are at.

 

To me it looks like this is at most a 15% annual gain type of investment over the next few years. Say to $25 in three years or $33 in five under reasonable expectations.

 

What are your earnings expectations and do you see BAC earning much more over the next few years?

 

Thanks

 

Vinod

 

NOL's would add back about $4 billion each to cash earnings for the next two years over reported net income. The document I attached is a portion of the report that I had written and I had modeled the NOL's in another section. Since this is a one off item and does not show up in net income, from a purely "market price" perspective, I am thinking this would not be given much credit by Mr. Market.

 

In the recent quarter comments, they declared New BAC done and complete!

 

Vinod

[jay21]

NOL's would add back about $4 billion each to cash earnings for the next two years over reported net income. The document I attached is a portion of the report that I had written and I had modeled the NOL's in another section. Since this is a one off item and does not show up in net income, from a purely "market price" perspective, I am thinking this would not be given much credit by Mr. Market.

 

In the recent quarter comments, they declared New BAC done and complete!

 

Vinod

 

I somewhat agree. Capital generation does matter though. They are going to turn that asset into capital. This has two effects: 1. more capital to return and 2. able to replace a non-income producing asset with income producing ones.

[vinod1]

I think at the end of the day, it's all about the multiples you're willing to attach to BAC (or comparable banks). I don't understand why a stable business with good ROE and a normalized payout ratio of 100% should trade at a below market multiple. The historical PE of the S&P 500 is 16. Now look where we are with interest rates. Taking into account that rising rates will hugely help BAC's earnings, I don't see why an earnings yield of 8-9% should be considered a fair valuation, when you get 2.4% on the 10 year US government bond and inflation is not on the horizon. People are still scared of another financial crises, because the last one was so huge. Yet, they are thereby over-discounting the risks inherent in (traditional) banking. If you're going to sell BAC at a multiple of 12 on $2 earnings you're going to sell it below the IV of its business.

 

Very good question. If you look at large cap bank stocks, even before the crisis they always traded at a discount to market. Even safe banks that operate  conservatively with top notch credit risk performance like US Bancorp and M&T Bank, trade at a discount. Their IV is perennially below market price. So would you try to use likely market price which a discount to IV, or stick to IV which they would never reach?

 

Vinod

 

 

[ni-co]

To which I would add (also with reference to post above) that if you believe $2/share by Jan 2017, and attach a 10x (seems low?) then it's a $20 stock. 20/17.3 = ~15%, not great for two years, agreed. However, there's a bit of upside. Also, you mentioned LEAPS - but I didn't quite follow. With the leverage in the options you may end up with perhaps 25% - 35% to the $20 mark ... so getting more attractive or are you looking for a much higher number?

 

I think at the end of the day, it's all about the multiples you're willing to attach to BAC (or comparable banks). I don't understand why a stable business with good ROE and a normalized payout ratio of 100% should trade at a below market multiple – in this interest rate environment. And if interest rates go up, so will earnings. People are still scared of another financial crises, because the last one was so huge, and are thereby over-discounting the risks inherent in (traditional) banking. If you sell BAC at a multiple of 12 on $2 earnings you're selling below the IV of this business.

 

Vinod's question was in regards to the margin of safety.  Does BAC still have enough of a margin of safety or are we relying on growth and PE expansion? I would say the margin of safety on Leaps is no longer there.  Saying it should trade at a premium to book does not make it so. 

 

Its probably a good GARP stock.

 

There surely is another way of looking at it but for me a PE multiple ~40% below the average market multiple represents in itself a large margin of safety. I pay less attention to book value and more to average earnings for valuing banks (though tangible book is kind of a liquidation value and therefore sometimes interesting).

[vinod1]

NOL's would add back about $4 billion each to cash earnings for the next two years over reported net income. The document I attached is a portion of the report that I had written and I had modeled the NOL's in another section. Since this is a one off item and does not show up in net income, from a purely "market price" perspective, I am thinking this would not be given much credit by Mr. Market.

 

In the recent quarter comments, they declared New BAC done and complete!

 

Vinod

 

I somewhat agree. Capital generation does matter though. They are going to turn that asset into capital. This has two effects: 1. more capital to return and 2. able to replace a non-income producing asset with income producing ones.

 

Do not disagree at all. When we are talking about BAC however, this would just cover one more large litigation settlement  :)

 

Vinod

[ERICOPOLY]

Very good question. If you look at large cap bank stocks, even before the crisis they always traded at a discount to market. Even safe banks that operate  conservatively with top notch credit risk performance like US Bancorp and M&T Bank, trade at a discount. Their IV is perennially below market price. So would you try to use likely market price which a discount to IV, or stick to IV which they would never reach?

 

Vinod

 

However, if you look at risk-adjusted returns...  the TBTF banks ought to trade at higher multiples today vs before the crisis.

 

The multiple paid for $1 of earnings from a very highly-levered company should be lower than the multiple paid for $1 of earnings from that very same company after going through a process of cutting leverage in half.

 

That doesn't meant it should trade as high as the market, but it should be more richly valued than prior to the restructuring.

 

The invisible hand that drives this process is the collective pool of investors who will see these as low-risk financial utilities that generate market-beating returns with ease (all those mutual fund managers who need to "beat the market").  The less risk in the strategy, the more attractive.  This would tend to drive them to "overweight" the sector until the difference in earnings yields becomes too tight to be worth bothering with.  However, the approach will not be attractive as long as legal settlements threaten to destroy an entire year of earnings (like for BAC this past year).  Personally though, I think we're past those legal threats.

[Uccmal]

The real question around the 2017 Leaps is if the stock will rise enough in two years to make them worthwhile. 

 

We had a couple of legal settlements again last week, related to the fx price fixing.  As long as this overhang is still around, we wont see alot of price appreciation.  300 m here, 300 m there, adds up. 

More than the cash is the reputation damage.  Until there are a clear two or three quarters of results, a dividend increase toward what JPM and WFC payout, and some buybacks, I dont see the stock going up too fast.  It would be nice but I have learned to temper my expectations. 

 

I am neither buying nor selling my existing Leaps, in any big way, subject to change if there is a correction or run-up. 

 

 

[vinod1]

Very good question. If you look at large cap bank stocks, even before the crisis they always traded at a discount to market. Even safe banks that operate  conservatively with top notch credit risk performance like US Bancorp and M&T Bank, trade at a discount. Their IV is perennially below market price. So would you try to use likely market price which a discount to IV, or stick to IV which they would never reach?

 

Vinod

 

However, if you look at risk-adjusted returns...  the TBTF banks ought to trade at higher multiples today vs before the crisis.

 

The multiple paid for $1 of earnings from a very highly-levered company should be lower than the multiple paid for $1 of earnings from that very same company after going through a process of cutting leverage in half.

 

That doesn't meant it should trade as high as the market, but it should be more richly valued than prior to the restructuring.

 

The invisible hand that drives this process is the collective pool of investors who will see these as low-risk financial utilities that generate market-beating returns with ease (all those mutual fund managers who need to "beat the market").  The less risk in the strategy, the more attractive.  This would tend to drive them to "overweight" the sector until the difference in earnings yields becomes too tight to be worth bothering with.  However, the approach will not be attractive as long as legal settlements threaten to destroy an entire year of earnings (like for BAC this past year).  Personally though, I think we're past those legal threats.

 

I agree that banks deserve a higher multiple going forward. I think however that it might take a long time on the order of 5-7 years for this re-rating to take place.

 

In such a case, where you are expecting good returns but not great returns, do LEAPS make sense? The time value lost would eat up a chunk of the gains from the leverage.

 

I guess this is a more general question, when do LEAPS stop making sense? My experience in LEAPS is from investing in various financials from 2011 on, when the expectation is a double or triple on these stocks over 3-4 years. This is not the case anymore. Now, using LEAPS I would just be levering up on a moderately undervalued stock (a leveraged financial at that) to generate returns.

 

Vinod