BAC-WT - Bank of America Warrants

[vinod1]

I am hoping BAC's management/Buffett turns this into a cashless transaction thus not diluting current shareholders by 700 million shares.  Buffett has done this with other transactions as well so there is precedence. 

 

Hi Vinod: 

"When Bank of America (NYSE:BAC) was in deep trouble following the financial crisis, Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) came to the rescue with an enormous investment in the struggling bank. Part of this investment was the right to purchase 700 million shares of BAC at a strike price of $7.14 via warrants that expire in 2021. "

See: http://seekingalpha.com/article/2062273-buy-bank-of-america-like-buffett-warrants-offer-tremendous-value

Cheers, Granitepost

 

+1

 

Granitepost,

 

So assuming a price in the low $20s, the dilution would end up being around 500 million shares. So BAC would use the $5 billion received from Buffett to buy back around 200 million shares.

 

Vinod

[ERICOPOLY]

So seems like everyone is modelling around 1.8 EPS by end of 2018

 

at 11pe x 1.8 eps = $20  the warrants will be very poor investment

 

$20 - $13 strike = $7

 

$ 7 / $5.55  today is about 7% compound return until January 2019 !   

 

 

The only upside I see then is if the interest rate moves.

 

Gary

 

Don't forget to include the earnings between now and then.

 

So at your P/E 11x, by end of 2018 it would be maybe $1.50+$1.60+$1.70 in earnings over that period.

 

So $20+$4.80= $24.80.

 

Eric , what you say makes sense !

 

But I am simply thinking this:  this is now year 2018....  EPS is $1.7....  so the market valuation is 11x  ( 12.5 x for WFC)      so it should trade at 11x 1.7 in 2018... 

 

At $24.80 / 11  implies EPS of $2.25 by 2018 , no ?

 

No.

 

The dividends have been reducing your warrant strike price and conversion ratio.

 

The buybacks have been boosting the EPS by 2018 by reducing the share count.

 

It doesn't really matter whether it's buybacks or dividends -- same value occurs (except the dividends destroy value due to taxation).

 

Hopefully any remaining earnings not returned to shareholders are assigned fair value by the stock price.

[Rasputin]

Hi Vinod,

 

Thank you for responding.

 

1.  The fully diluted share count take into account Berkshire's warrants.  So that $1.72 eps number is fully diluted.

 

3.  BAC is in different spot vs other large US banks.  They have over-reserved on the consumer side.  Even with current oil and gas problems on the commercial side, they still released some reserves in Q3.  I think this conversation with Nancy Bush during Q3 call is a good explanation:

 

Paul Donofrio

 

We’re still seeing reserve releases on the consumer side of the bank that is certainly starting to moderate.

And consistent with loan growth we’re seeing some reserve additions on the commercial side of the

bank. And as I said earlier if you are looking for when those lines are going to cross we think provision

as Brian and I both said is going to be roughly sort of 800 million to 900 million in 2016, that’s kind of

where the conversion is going to happen, some place per quarter, that is some place in 2016.

 

Brian T. Moynihan

 

Nancy remember we still have massive risk coming off in consumer that we are not reserves

are going over the commercial side and some is coming out net of that 100 plus million this quarter. We expect that

to probably mitigate and then if you get loan reserve you’ll build reserves at some point but I think that is

still a bit out there.

 

Nancy Bush

 

So sometime in 2016, probably?

 

Brian T. Moynihan

It depends on what the loan growth is, it depends on the economic scenario. But I think it’s we’re

still repositioning reserves on the consumer side that are excess, as we can see in the credit statistics. We’re

carrying a healthy reserve for areas that have continued to come down in terms of risk.

 

When Buffett used 1% credit costs, PPTI as % of asset was a lot higher.  He was predicting Wells Fargo doing $40 B in PPTI about 5 years ago, with 1.5% credit costs ($10-$12 B), getting to $28-$30 B pre-tax income.  WFC did not do $40 B PPTI but their credit costs turned out much lower, so Buffett's $28-$30B pre-tax income prediction was still correct. 

 

In the current environment, BAC is more focus on after credit costs revenue, hence the much lower credit costs vs previous cycle. 

 

BAC is the most conservative trillionaire bank I know.  They deliberately forgo $1 billion of mortgage banking income per quarter by refusing to buy mortgages from brokers, providing mortgages only to service their clients.  Their conservatism is also reflected in DFAST.  Year after year (starting 2013 dfast) the fed hits them less on loan losses as % of loan portfolio vs other trillinaires (for 2015 DFAST BAC 4.9%) vs JPM (6.4%) C (7.2%)  WFC (5.8%), while carrying the largest run-off portfolio. 

 

4.  I can't find the transcript but in 1 conference, Brian stated that as they move people out of LAS, they still got their real estate leases in place.  There are leases that would start running off in 2017 and beyond.  Below are few transcripts I found where he repeatedly say it's going to go down below $500 million per quarter.  I think we'll get an update in 2016 what LAS non interest expense ex litigation will be in 2017.

 

Transcript from Brian's Barclay presentation

 

LAS, are in Phase 1 to get it to the $500 million a quarter, that means there's a phase 2 to actually bring it to normalized servicing

costs, which we have to keep working on.

 

You've got the LAS piece, that's got to go from 900 to 500 and beyond.

 

Transcript from Q4 2014 call

 

Brennan Hawken

Then helpful to hear about the target of around $800 million for LAS by yearend and then driving it lower in 2016. Can

you help us think about how you think about that number to zero? Because I mean, ultimately, that's given

the title, the L in the LAS, right? That's got to go to zero eventually. How should we think about that?

 

Bruce Thompson

Well we have got several and in there and so there is all the servicing expense in the company is in that unit well good

loans and bad loans, so it doesn’t go to zero but it’s got to get a lot better at this. If you start to move on to 4 million or

so units we have in first mortgage servicing and think about the annualized cost we have got to get us down

significantly may be servicing and mortgages make sense to us and so, but that’s a project that we’re working against

doing it the right way for the customer, doing it the right way for the regulatory environment and the consent orders and

all the things that have gone on as you are aware and so we just got to keep feeling out a way. So when we say 800 or

so that is the next way station on our train right here, but it’s got to go a lot further than that for the 3.5 million to 4

million the good units we have so to speak.

 

Brennan Hawken

Okay. So no indication about where that settlingout level might ultimately be even if not a win, but kind of what the

number would be?

 

Brian Moynihan

Well, I think the Bruce talked about a half billion but I am not sure that’s a great performance not overtime either. So

just assume that there is nothing more interesting than driving that number down to a normalized servicing cost than

this company.

 

Transcript from Sanford Bernstein conference May 2014

 

John McDonald - Sanford C. Bernstein & Co., LLC

And that's servicing cost that's come down and now it's 1.6 and 1.1. Ultimately you said something in the 500 million is (inaudible).

 

Brian Moynihan

 

I mean, you start taking the portfolio of loans and putting an invisible cost that isn't there, you'd say what are you doing. So, yes, we got to get down. And now the question is, for the near term – I don't want to get ahead of this – we got to get all these other things done to make sure that the business doesn't incur penalties and fines and things like that. And so, there's two aspects.

 

One is to get the implementation of all these rules completely done that everybody agrees you've done them, and everybody says that you can then keep the volatility around, the outcome of the business down. And the second is we've got to get through the backlog. So, 270,000 delinquent loans in a portfolio of 4 million and change, we're still way over the number. I mean ultimately it should be down to a couple percent of that portfolio. And that difference is where the cost is.

 

5.  My zero revenue, technology cost slashing model is just a simple model, but BAC has various levers to take down costs.  In Q3 alone, they hired 1600 sales people.  All these investments can be reversed if revenue growth is 0.  The $3B per year system spending include Merrill One platform which is now completed.  I believe that Brian can take out $2 B annually out of core expense in zero revenue growth environment. 

[Rasputin]

hehe my investment in bac is mostly via A warrants (I also have shares, leaps, and sold puts).

 

Since I will be owning BAC shares for a long time, I mainly look at the warrants/shares conversion ratio.  If BAC stock price is $20 by expiration and warrant strike price is $12.50, I'll get 0.375 share per warrant (cashless exercise). 

 

I basically want more shares, so right now the warrants/shares ratio is pretty attractive to me.  I've traded back (i sold shares, bought warrants when ratio is 0.35, sold warrants, bought shares when ratio is above 0.4) and forth and generated free shares in tax free accounts. 

 

7% per year with low chance of losses in this environment is pretty good to me.  If interest rates remain as low as they are 3 years from now, and BAC's eps continue to grind higher with consistency with good prospects for continued growth, I doubt BAC P/E would be below 12 in a calm market. 

 

[jay21]

Excellent notes. Thank you.

[gary17]

Hey Rasputin, thank you for your analysis !    I didn't know about the cashless exercise option - I will check into that.

 

So you agree with my 7% analysis ?

 

If as Eric pointed out , we should be at $22 - $24 , then the return would be much better than 7% , even without a rate rise and PE expansion. 

 

The part I get lost is if the EPS 1.7 ~ 1.8  people have been throwing around here is based on today's 11 B fully diluted share or based on the amount of shares that will have been reduced due to the repurchased -   

 

Gary

 

hehe my investment in bac is mostly via A warrants (I also have shares, leaps, and sold puts).

 

Since I will be owning BAC shares for a long time, I mainly look at the warrants/shares conversion ratio.  If BAC stock price is $20 by expiration and warrant strike price is $12.50, I'll get 0.375 share per warrant (cashless exercise). 

 

I basically want more shares, so right now the warrants/shares ratio is pretty attractive to me.  I've traded back (i sold shares, bought warrants when ratio is 0.35, sold warrants, bought shares when ratio is above 0.4) and forth and generated free shares in tax free accounts. 

 

7% per year with low chance of losses in this environment is pretty good to me.  If interest rates remain as low as they are 3 years from now, and BAC's eps continue to grind higher with consistency with good prospects for continued growth, I doubt BAC P/E would be below 12 in a calm market.

[vinod1]

Hi Rasputin,

 

Thanks for the detailed info. So servicing could have a bit of additional cost saving remaining.

 

Regarding credit costs, looking at the past 15 years or so and excluding the great recession, credit performance of WFC, BAC and JPM are pretty much in line with each other if you weight them based on their loan portfolio composition. They are all pretty good but BAC does not particularly stand out in terms of loan underwriting quality.

 

During and after the great recession, since BAC was the most impacted due to residential mortgages and home equity loans, they have tightned the most and increased reserves the most among all the big banks. As the home prices improved, they are getting the benefit of those reserve releases. So to me it does not really indicate superior underwriting, but a knee jerk reaction to their near death experience. Anyway once these reserve releases come off and new loans written after 2012/2013 become a greater fraction of the loan portfolios credit losses would tend to increase.

 

A relevant comment from WFC conf call:

 

Eric Wasserstrom - Guggenheim Securities

And if I can just do one quick follow-up on asset quality, it sounds like from your commentary the go forward expectation should be for provision to roughly equal NCOs, is that right?

 

John Shrewsberry - Chief Financial Officer

So, it's up to forecast. We've gone through five years of reserve releasing. We've been saying for a few quarters that what's going to happened, subsequently it's going to reflect loan growth, portfolio performance and general economic outcomes. Does that mean that we remain at a no release, no provision level? That's too precise to forecast. But it should, if we grow our portfolio and the new assets look like the assets that we already have that we'll begin providing for those which could become more of net outcome as we're already had a generational low in terms of charge-offs which means that credit performance can't really improve meaningful from where we are today. It's already that good.

 

 

We are at historically low levels of charge offs and provisioning at this time. To me it is not conservative to estimate such low levels out into the future. I know we are not there yet, but looking out to say 2018, I would not be comfortable penciling in $3.6 billion in credit losses on what could be about a $950 billion loan portfolio at that time.

 

I am not saying 1% is the right number going forward, but normalized I would pencil in something like 0.5% or 0.6% charge offs for BAC.

 

As to additional cost saves, I do agree that BAC probably has some additional overhead. Just not sure why they are not targetting cost saves more aggressively. Looking at WFC, JPM and USB, I just do not get the same level of focus on reducing expenses. They seem to be bit defensive trying to justify why they should have a higher efficiency ratio compared to peers. So that is why I am bit skeptical of penciling in savings in my estimates.

 

All in all, I do not think we differ all that much.

 

Vinod

 

 

[vinod1]

Hey Rasputin, thank you for your analysis !    I didn't know about the cashless exercise option - I will check into that.

 

So you agree with my 7% analysis ?

 

If as Eric pointed out , we should be at $22 - $24 , then the return would be much better than 7% , even without a rate rise and PE expansion. 

 

The part I get lost is if the EPS 1.7 ~ 1.8  people have been throwing around here is based on today's 11 B fully diluted share or based on the amount of shares that will have been reduced due to the repurchased -   

 

Gary

 

hehe my investment in bac is mostly via A warrants (I also have shares, leaps, and sold puts).

 

Since I will be owning BAC shares for a long time, I mainly look at the warrants/shares conversion ratio.  If BAC stock price is $20 by expiration and warrant strike price is $12.50, I'll get 0.375 share per warrant (cashless exercise). 

 

I basically want more shares, so right now the warrants/shares ratio is pretty attractive to me.  I've traded back (i sold shares, bought warrants when ratio is 0.35, sold warrants, bought shares when ratio is above 0.4) and forth and generated free shares in tax free accounts. 

 

7% per year with low chance of losses in this environment is pretty good to me.  If interest rates remain as low as they are 3 years from now, and BAC's eps continue to grind higher with consistency with good prospects for continued growth, I doubt BAC P/E would be below 12 in a calm market.

 

If you think BAC warrants are attractive, I would recommend looking at JPM warrants also.

 

Vinod

[vinod1]

I think BAC is attractive but the attractiveness is not due to market overlooking the underlying earnings power anymore.

 

Future returns to me seem to be more from a combination of an earnings multiple re-rating upwards and a modest growth in earnings. The combination produces a 12% to 15% returns over the next few years.

 

If so, then a few other banks are also on the same boat and BAC does not look to be an outlier anymore.

 

I might just be stating something very obvious, but that I how I am viewing it.

 

Vinod

[Capitalist World]

My spreadsheet on all the TARP warrants currently rates WFC and JPM wts as the best risk reward to time premium and leverage.  Special note too to HIG BAC wts are middle of the pack.  don't forget to look at Div paid and div growth above TARP  threshold which will adjust strike price downward.

[Rasputin]

Hi Vinod,

 

I think BAC post Moynihan is a completely different beast.  The culture has completely morphed to a culture that's very risk averse.  So past 15 years may not represent the future. 

 

This is one example how risk adverse they are: Merrill fired at least 2 Barron top 100 advisors recently who have been in business for 30+ years because they're not 100% compliant.

 

http://advisorhubinc.com/tag/merrill-lynch/

 

I wouldn't be surprised if BAC charge off ratio 5 years from now is lowest among the US trillionaires. 

 

The fed seems to agree that BAC has the least risky loan portfolio among the US trillionaires.  Those loan losses the fed projected during the 5 quarter stressed period ignores current reserves.  Current reserves are only taken into account in the projected provisions. 

 

From DFAST 2015

 

Loan losses are estimated separately for different categories of loans, based on the type of obligor (e.g., consumer or commercial and industrial), collateral (e.g., residential real estate, commercial real estate), loan structure (e.g., revolving credit lines), and accounting treatment (accrual or fair value). These categories generally follow the classifications of the Consolidated Financial Statements for Holding Companies (FR Y-9C) regulatory report, though some loss projections are made for more granular loan categories.  Two general approaches are taken to model losses on the accrual loan portfolio.

 

In the first approach, the models estimate expected losses under the macroeco-nomic scenario. These models generally involve projections of the probability of default, loss given default, and exposure at default for each loan or segment of loans in the portfolio, given conditions in the scenario.

 

In the second approach, the models capture the historical behavior of net charge-offs relative to changes in macroeconomic and financial market variables.  Accrual loan losses are projected using detailed loan information, including borrower characteristics, collateral characteristics, characteristics of the loans or credit facilities, amounts outstanding and yet to be

drawn down (for credit lines), payment history, and current payment status.  Data are collected on individual loans or credit facilities for wholesale loan, domestic retail credit card,

and residential mortgage portfolios. For other domestic and international retail loans, the data are collected based on segments of the portfolio (e.g. segments defined by borrower credit score, geographic location, and loan-to-value (LTV) ratio).

 

I'm going to show the 2015 fed projected loan losses and provisions (this is where current reserves is taken into account) for BAC, WFC, JPM under severely adverse scenario during the 5 quarter stressed period.

 

              Fed projected loan losses (% of total loan)        Provisions

 

BAC          45.7 (4.9%)                                                          49.1

WFC          48.8 (5.8%)                                                          56.4

JPM          49.7 (6.4%)                                                            55.5

 

 

I would be ecstatic if total loan portfolio ends up around $950 Billion with credit costs of $5-$6 Billion by end 2018.  I think we'll see higher than $1.72 eps in that scenario.

 

As far as expenses, in the Bloomberg interview after earnings call. he talked about bringing efficiency ratio from 65 to 60, 2.5% through cost cut, and 2.5% through revenue growth (faster if interest rates rise, longer if grinding via loan and fees growth). 

 

http://www.bloomberg.com/news/videos/2015-10-14/how-can-bank-of-america-drive-better-efficiency-

 

I'll be happy if we see $1.72 in 2018 :)  I think the stock price will start with a 2

 

 

 

[Rasputin]

Hi Gary,

 

If you say exercise price is $13 and stock price is $20, then yeah from $5.60 today, we'll get roughly 6.6% annualized return.  I do think exercise price will be close to $12.50 by expiration.  If that scenario occurs, we'll get 9.4% annualized return.  Not bad at all if 10 yr treasury is at 2%. 

 

My $1.72 is based on 10.85 b diluted shares oustanding in 2018, taking into account repurchases. 

 

Vinod,

 

I do own WFC and JPM tarp warrants too.  I think JPM will have more headwind vs BAC going forward in terms of y/y eps growth due to the preferred shares they have to issue this year and maybe more next year if their stressed tier 1 leverage ratio remains too low for their capital return program (they had to revise their capital request due to stressed tier 1 leverage ratio hitting below 4%). 

 

WFC might have to issue more long term debt vs BAC to meet TLAC requirement.  At the end of 2014, BAC had $253 B long term debt, while WFC had $167 B. 

 

All the US trillionaires seem cheap - very reasonably valued.  I own them all with bac complex being my largest holding.  I see Lou Simpson continues to add to WFC at these prices earlier this year. 

 

Thank you all for the great discussion!

[gary17]

Thanks Rasputin

I like your assessment of 9% ~ return --- I believe this is WITHOUT any rate increases ! 

[vinod1]

Hi Rasputin,

 

I am long BAC, JPM and WFC as well. Except for the last couple of days BAC warrants were pretty expensive so I hold the stock directly. WFC is a core long term holding so hold it as stock as well.

 

My own expectation of BAC is about $1.8 EPS in 2018.

 

Not to belabor the point about charge offs where our differences between our estimates are not all that significant but here is the charge off data for the last 30 years for all US banks. I do agree that BAC was more conservative in the recent past than other banks.

 

Vinod

[sswan11]

 

 

By SARAH MAX

October 17, 2015

Enlarge Image

 

“People will sometimes criticize Markel and say they’re just a Berkshire wannabe. My response: ‘Who wouldn’t want to be like Berkshire?’ ” — Chris Davis Photo: Jordan Hollender for Barron’s

Seven years after the collapse of Lehman Brothers tipped off a global financial crisis, investors are still leery of financial stocks, which as a group have yet to fully recover. “Whenever there is uncertainty, investors’ knee-jerk reaction is to sell financials,” says Chris Davis, chairman of Davis Advisors.

 

Yet, he thinks the opportunities in financials are as compelling today as they were in 1991, when he launched the $830 million Davis Financial fund (ticker: RPFGX). Despite record profitability, improving market share, and the prospect of higher interest rates, he says, high-quality financials are trading at significant discounts, relative to their historical levels. “Many of the companies we own not only survived the financial crisis, they have actually grown,” says Davis.

 

Of course, Davis has long had an affinity for financials. His grandfather, Shelby Cullom Davis, made a name for himself, and a fortune, investing in banks and insurers, beginning in the 1940s. In 1969, Davis’s father, also named Shelby, founded an advisory firm based on these principles and launched what is now the $14.3 billion Davis New York Venture fund (NYVTX). While the fund, which Chris Davis co-manages, is diversified across all sectors, more than a third of its assets are invested in—you guessed it—financial services.

 

In 2007, Davis took himself off the Davis Financial fund’s management team to focus on running the firm’s larger strategies. The hiatus ended in 2013, when he retook the helm and asked Ken Feinberg, his partner of 15 years, to step down after several years of significant underperformance on both funds. Davis promptly pared the fund’s nonfinancial holdings. It ended 2014 up 13% for the year, and has bested 64% of its peers and the broader market so far this year.

 

Portfolio manager Chris Davis explains to Jack Otter that investors often have trouble separating price and value, and says that oil stocks and big financial companies might be the place to invest now.

 

Davis, 50, recently spoke with Barron’s about why the diverse and misunderstood financial sector still holds long-term promise.

 

Barron's : Where are financials in their recovery?

 

Davis: It’s important to start by saying that financials aren’t just a single group. They are lumped together, and yet they have huge differences in business models. Some have credit risk, some have interest-rate risk, some have real- estate exposure, some have consumer or capital-market exposure, some are domestic and some are global, and so on.

 

That said, I look at the period of the early ’90s, when I launched the Davis Financial fund, and think we’re in a very similar environment now. We’re through the crisis. The companies are well off their lows. There are fewer competitors. The models have been proven. The management teams have been proven. Yet nobody much likes them. The result is that they’re trading at as wide a discount to the S&P as they’ve traded at in the past 20 or 30 years.

 

Will they ever get the multiples they deserve?

 

What’s wonderful is that they don’t need to. In a way, their destiny is in their hands. They’ve generally built capital to where it needs to be from a regulatory point of view; they are, on average, generating between 7% and 9% of their market cap per year in distributable cash. If multiples don’t grow, then what you’re going to see is steep increases in dividends over the next five years and a reduction in the shares outstanding.

 

Meanwhile, the companies we own are generating terrific earnings today even with low interest rates, but sooner or later, if and when interest rates go up, their earnings will go up sharply.

 

Have you ever had doubts about the sector?

 

Actually, the time that was the most unsettling was 2006, 2007, and 2008 because our relative performance had fallen. We were getting beaten by these home finance funds or leveraged financial funds. The further you went out on the risk curve, the more leverage you had, the better you did.

 

An analogy that my grandfather used to use was: “If you’re building a ship to sail across the ocean, build it very light and, if the weather’s good, you will win the race. But if the weather’s bad, you won’t survive the race.” It’s about finding that balance.

 

Even though all the stocks did lousy after the financial crisis, it was clear that the high-quality companies would survive. In the case of Wells Fargo [WFC], instead of a run on the bank, there was a run to the bank. Depositors were lined up to put their money in.

 

What do you look for in a financial company?

 

A defining characteristic of most financial companies is that culture is an advantage. Yet it doesn’t show up in a financial statement. There was very little difference in the business model of Wells Fargo and Bank of America [bAC] for 10 years. Same geographies, roughly the same products, roughly the same returns. Yet you go through the financial crisis, and one is down 60% or 70%, and the other one has record profits a few years later. The difference is culture.

 

Enlarge Image

 

What do you mean by culture?

 

In a financial company of any kind, your earnings are based on a huge number of estimates, from what percentage of your loans will go bad to what percentage of your premiums will pay off. The most dramatic example is in insurance. Say you have an event that you think will occur once every 100 years, but you price it as if it will occur once every 200 years. You’re going to look good for a long time, in all likelihood, but eventually that will take the company down.

 

By accounting choices, reserve practices, past credit losses, and disclosure practices, you can build a pretty good mosaic about the culture of an organization. When you look through our portfolio, it’s companies like Wells Fargo and JPMorgan Chase [JPM] that have that culture.

 

JPMorgan has had its share of controversy. Why do you like it?

 

If I had to boil it down, I would say it’s a company that is generating 8% to 9% of its market cap per year in distributable cash, and [CEO] Jamie Dimon may be the greatest financial executive of my time. He has been characterized as deeply hated and mistrusted, and yet he has behaved with transparency, integrity, and relentless focus.

 

We bought a lot of our positions in JPMorgan during the London Whale crisis. People viewed that as a disaster. I viewed it as so reassuring because of the way the company handled it. They got the information out. They took responsibility at the top. They ended up losing a couple of months’ worth of earnings on what had been a major event. That was to me a very, very good sign of culture.

 

They also do as good a job as any company in terms of global scale, using their size as an advantage and executing—and yet they trade at 10 times earnings.

 

How do you categorize your overall portfolio?

 

People will often say, “Oh well, there’s retail banks and commercial banks and property-casualties.” I categorize them a little differently: There are financials where scale is a huge advantage. There are financials where brand is a huge advantage. There are financials where capital allocation is the key advantage, and then there are companies where their global footprint is a huge advantage.

 

In scale, Wells Fargo and JPMorgan have been gaining share through acquisitions. There is also Bank of New York Mellon [bK], which is not just a bank but a global processing center. If you think of the financial markets as a city, Bank of New York runs the utilities, the infrastructure.

 

What about brands?

 

This is an area where you can buy what I call growth stocks in disguise. Companies where their return on equity, their growth characteristics, everything really looks like a consumer brand company. Think of Visa [V], Moody’s [MCO], McGraw Hill Financial [MHFI], Charles Schwab [sCHW], and American Express [AXP].

 

American Express stock is down nearly 20% this year…

 

The change in AmEx’s relationship with Costco Wholesale [COST] was disappointing, but it also shows discipline. [AmEx had an exclusive deal with the retailer—it didn’t accept any other cards—that will end in 2016.] They could have kept that account if they had wanted. Their view was it was not economic. I should say that we also own a lot of Costco in our other funds. Of all of the stocks I just listed, the cheapest, and the one that we would add to today, is AmEx. Its return on equity has been above 20% every year but three of the past 15 years.

 

What about capital allocation?

 

Markel [MKL] is a little specialty insurance company based in Richmond[Virginia]. It was run for several generations by the Markel family. They built their record originally doing specialized insurance like summer camps or doctors that had been sued for malpractice. They since grew their insurance operations to where they really are a specialty leader in many categories around the world. In addition to being great underwriters with a conservative culture and a long record of reserves, they have also been great investors.

 

The investment portfolio has been run very well for many years by Tom Gayner, someone I admire. They buy strange things like dredging companies, or pickle- slicing companies, and they own the whole business, sort of like a small Berkshire Hathaway [bRK.A], which is another longtime holding. People will sometimes criticize them and, say they’re just a Berkshire wannabe. My response: “Who wouldn’t want to be like Berkshire?”

 

What fits in the global bucket?

 

We’ve always viewed financial services as a very natural global business because risk and credit now move with the key strokes. But you have very few true global leaders. Goldman Sachs Group [GS] and Julius Baer Gruppe [bAER] in Switzerland are both global leaders in what they do. But the one that stands out for me is Ace [ACE], which is based in Switzerland but has operations all over the world.

 

It isn’t a coincidence that it’s run by somebody named Greenberg. Hank Greenberg built AIG [AIG] and his son Evan has had quite a huge role in building Ace. They’ve announced recently that they’re buying Chubb [CB], and although they’re paying full price, I think that Chubb is a unique franchise in insurance. [Earlier this month, the deal got the green light from the Federal Trade Commission.]

 

What are the biggest threats to financials?

 

The biggest risk is a deep recession with interest rates where they are today. Typically, financials that have credit exposure have these two sides: When credit losses are bad and the economy is slowing, the Federal Reserve cuts interest rates, spreads widen, the banks have more money to fill the reserve holes, and life goes on.

 

If you start with rates very low, you don’t have that cushion. I would be reluctant to take a lot of credit risk. That’s one of the reasons we stick with companies that have been much more disciplined lenders than other large banks.

 

Thanks, Chris.

 

 

 

[karthikpm]

http://www.wsj.com/articles/big-banks-to-americas-companies-we-dont-want-your-cash-1445161083

[gary17]

Wow - nice jobs report -  the market certainly seems to think the interest rate will be lifted in December.

 

if they do finally do so; the media can now finally focus on the pace and the extent of rate rise LOL   

[ERICOPOLY]

Stock is now basically no longer discounted at 10x earnings, with rate hike priced in.  10% a year still isn't terrible, but anything more than that is now based upon P/E expansion beyond 10x.

[PLynchJr]

True...but I think mild multiple expansion over time (11x to 12x) is very possible.

 

BTW...I love that this stock is still so volatile.  I'm sitting on a 23% gain in a month.

[gary17]

my personal view is big banks in the US , with all the regulatory mechanisms in place, should be valued at 15x P/E.  but i'll believe it when i see it ! 

 

10% un leveraged; if you use margin or buy warrants could get more than 10% I think !

[CorpRaider]

That was sort of my thought process last time I updated.  Looking at ~10% with static valuation multiples; leverage it ~2.6x  - cost of leverage, when costs were reasonable.

[ERICOPOLY]

Driven, entirely, by will China drag down the US along with it... or won't it.  And it only takes 1 month of jobs data to have the conclusive answer on the attendant rate hike speculation.  Viva Las Vegas.

 

[gary17]

macro economics is so overrated LOL!!!!!!

[ourkid8]

http://www.usatoday.com/story/money/2015/11/09/global-banks-still-too-big-fail-financial-stability-board-12-trillion/75459110/

 

We need an activist in BAC to advocate for a split-up of the bank, just like he is advocating for AIG...  *hint hint Icahn*

[benchmark]

Looking at Jan 18 BAC put option, bid at $0.79. If you sell put, you are pocketing the premium, and BAC has to go down 30% for you to not make money. Given the upcoming rate increase, is the buyer of the contract really that pessimistic?