Warren Buffett (Trades, Portfolio) and Berkshire Hathaway (BRK.A)(BRK.B)'s largest stock positions as of 2013 year-end are American Express Company (AXP), The Coca-Cola Company (KO), ExxonMobil Corp. (XOM) and the Goldman Sachs Group Inc. (GS). Instead of IBM (IBM) as the next in line though, Buffett reminded shareholders in his 2013 annual letter that the warrants he owns for Bank of America (BAC) make it tantamount to his fifth largest stock investment. It is also "one we value highly," he said.
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Buffett's Bank of American investment has already more than doubled. The 700 million shares his warrants entitle him to buy for $5 billion reached a value of $10.9 billion at yearend. Bank of America's share price has gained 2.47% year to date, meaning the stake's value has ticked upward to $11.17 billion as of Monday.
Dealings between Bank of America and Buffett began in August 2011, when the bank was in need of a cash infusion and a strong vote of confidence in the eyes of the public. Buffett offered both, giving his stamp of approval to the company by purchasing 50,000 shares of cumulative perpetual preferred stock valued at $100,000 per share, with a 6% annual dividend. In addition to the shares, the bank conferred the warrants to buy 700 million shares with an exercise price of $7.14 per share.
The day of the announcement, Bank of America's share price opened at $8.29 per share, after sliding roughly 38% that year.
The terms of the deal changed in February of this year. According to an SEC filing, Buffett has forfeited missed dividend payments from the bank in order to benefit its Tier 1 capital and leverage ratios. In return, Bank of America agreed to wait five years until it redeems Buffett's preferred shares, which include the 6% dividend payment and a 5% redemption premium.
Buffett has previously given high praise to Bank of America, saying at the deal's announcement, "Bank of America is a strong, well-led company, and I called Brian to tell him I wanted to invest in it. I am impressed with the profit-generating abilities of this franchise, and that they are acting aggressively to put their challenges behind them. Bank of America is focused on their customers and on serving them well. That's what customers want, and that's the company's strategy."
In recent months Bank of America has shown increasing financial strength and taken several shareholder-friendly measures. First, it announced March 26 it would raise its quarterly common stock dividend to $0.05 per share starting in second quarter 2014. This was the first dividend increase the bank announced since cutting quarterly payments from $0.68 in 2008 to $0.01 in 2009 due to the financial crisis.
Bank of America also authorized a $4.0 billion stock repurchase program, to replace its previous program set to expire on March 31, 2014.
Investor and Bank of America stockholder Bill Nygren (Trades, Portfolio) of the Oakmark Funds believes that the greater potential for payouts was partially responsible for the stock's recent rise. He said in his fourth quarter letter: "Another top performer was our largest position, Bank of America (BAC). We still think the financial services sector is attractively valued, and with Bank of America, we are pleased to see investors recognize better visibility of higher future earnings and an enhanced capacity to return excess capital to shareholders."
Both announcements came a week after Bank of America announced the results of its 2014 Dodd-Frank Act Annual Stress Test, and upon receipt of its 2014 Comprehensive Capital Analysis and Review from the Federal Reserve, which stated that it did not object to its capital plans. Five other banks, including Citigroup (C), failed the Fed's stress test in March. The tests primarily assess a financial institution's Tier 1 common ratio and leverage ratio, which in Bank of America's case was bolstered by Buffett's decision to forego missed dividend payouts.
Prior to the increase, Bank of America had a 0.2% dividend yield and 3% dividend payout ratio. Prior to the financial crisis, the bank's payout ratio hovered around the mid-40% range. Meanwhile, earnings have improved for the past three consecutive years.
In addition, the bank continued to shed entanglements left over from the financial crisis, stating on March 26 that it reached a settlement with mortgage lenders Fannie Mae and Freddie Mac to resolve all of its four lawsuits with the Federal Housing Finance Agency (FHFA) concerning residential mortgage-backed securities litigation and other legacy contract claims. The suits began in September 2011, when the FHFA alleged that Bank of America's entities falsely represented that $57.5 billion in private-label RMBS loans complied with certain standards.
Costs associated with the settlement are expected to dent first-quarter 2014 net income by about $3.7 billion pre-tax, or $0.21 per common share. The settlement was also one of the most significant troubles it still faced related to RMBS securities litigation, and means it has cleared 88% of the unpaid principal balance of the RMBS under litigation throughout all of its entities. In the fourth quarter, pretax litigation expenses for the company amounted to $2.3 billion.
In the fourth quarter, Bank of America reported revenue increases across each of its four reporting segments, with total revenue net of interest expense up 15% year over year to $21.7 billion. In addition, total nonperforming loans fell to $17.7 billion from $20.03 billion in the previous quarter, and consolidated deposit balances increased to a record $1.12 trillion.
Bank of America at $15.98 per share on Monday is still priced below its year-end book value of $20.71, and has a P/E of 17.7, compared to the industry's median 13.8, and P/S of 2.04, near a five-year high. Buffett still has seven years for the price to appreciate before the deadline to convert the warrants, which is September 2021. In his shareholder letter he said is likely to wait until the very last minute to cash out.
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This article first appeared on GuruFocus.