Why Bank of America Stock Is a Buy Under $8

by Richard Band | August 26, 2011 12:16 pm

A big item of discussion in the market this week  — other than the resignation of the legendary Apple founder, Steve Jobs[1]  — was Berkshire Hathaway (NYSE:BRK-B[2]) providing a $5 billion capital infusion into Bank of America (NYSE:BAC[3]).

So does this buy by Warren Buffett mean that Bank of America stock is also a buy for regular investors?

Some skeptics are reading the Warren Buffett deal as a negative for BAC.  After all, CEO Brian Moynihan told the world only two weeks ago that the bank didn’t need any more capital.

But a closer reading of the terms Buffett obtained leads to a different conclusion.  Back in the fall of 2008, when the Oracle of Omaha pumped cash into Goldman Sachs (NYSE:GS[4]) and then General Electric (NYSE:GE[5]), he demanded a Mafia-style payoff.

Both GS and GE swallowed a usurious 10% coupon on the preferred stock they issued to Berkshire Hathaway.  In addition, the warrants attached to the preferred allowed Buffett to purchase GS and GE common stock at a significant discount to the prevailing market price.

In effect, both companies were signaling that Buffett had them over a barrel.  Small wonder the price of their common plummeted over the next few months, until the market indexes bottomed in March 2009.

What’s different now?  BAC agreed to pay only 6% on Berkshire’s new preferred — substantially less than the 8% or so that “straight” (non-convertible) BAC preferreds were yielding Wednesday, before the deal was announced.

Furthermore, the conversion price for the Oracle’s warrants was set at $7.14 per share, above BAC’s Wednesday close of $6.99 but slightly below the intraday trading Friday around $7.50.

So yes, Buffett got a good deal.  (He doesn’t have to pony up a dime for the common shares until he’s ready to convert his warrants.)  But it wasn’t a fire sale.

It couldn’t be — because Buffett knows, and Brian Moynihan knows, that Bank of America today doesn’t face a liquidity bind, as most of our giant financial institutions did in 2008.  As of June 30, the company held $706 billion of cash equivalents, versus only $125 billion at year-end 2008.  A “run on the bank” now is almost inconceivable.

The real question is how much the stock might be worth, once the current economic uncertainty clears up and the bank bulldozes through its mile-high garbage pile of litigation.

Assuming a 1% return on assets (typical in good times for a megabank), and full conversion of Buffett’s warrants, I figure BAC could earn $2 a share within the next three years.  Even at a paltry P/E ratio of 8, the common would fetch $16, more than double Thursday’s close.

Accordingly, I think BAC stock is a buy for speculators.  Pay up to $8 for BAC stock if you’re an aggressive investor.

Richard Band is recommending BAC as an aggressive buy for his Profitable Investing newsletter subscribers. Richard also personally owns a position in Bank of America, Berkshire Hathaway and General Electric stock.

Endnotes:
  1. Steve Jobs: http://investorplace.com/2011/08/steve-job-retires-ceo-apple-aapl/
  2. BRK-B: http://studio-5.financialcontent.com/investplace/quote?Symbol=BRK-B
  3. BAC: http://studio-5.financialcontent.com/investplace/quote?Symbol=BAC
  4. GS: http://studio-5.financialcontent.com/investplace/quote?Symbol=GS
  5. GE: http://studio-5.financialcontent.com/investplace/quote?Symbol=GE

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