Risk on! Stocks rallied sharply on the first trading of the year on the back of a bare-bones agreement to address the fiscal cliff, with the Dow Jones Industrial Average (^DJI 0.06%) and the broader S&P 500 (^GSPC -0.22%) gaining 2.4% and 2.5%, respectively. Conversely, the VIX (^VIX -1.15%), a measure of investors' expectations for stock volatility over the next 30 days, fell to its lowest level since Sept. 24 (and much below its long-term historical average) -- which merits some raised eyebrows if one considers how little the deal on the fiscal cliff actually achieved and how much lawmakers still need to work through.
Buffett's Bank of America bonanza
Berkshire Hathaway's (BRK.B 0.54%) Class A shares rose 16.8% in 2012, beating the S&P 500, which returned 16% including reinvested dividends. (Berkshire doesn't pay a dividend.) Berkshire's price-to-book value multiple increased by just 1% over the period; on that basis, the bulk of share price gains are attributable to an increase in the conglomerate's book value. One contributor to a higher book value: Berkshire's Bank of America bonanza.
In September 2011, Buffett invested $5 billion in Bank of America (BAC 1.53%) preferred shares with a 6% annual dividend to bolster investor confidence in the lender. However, the dividend return now pales in comparison with the enormous gains on warrants Berkshire received as part of the transaction. The warrants enable Berkshire to purchase 700 million shares of B of A at an exercise price $7.14 per share at any time until Sept. 1, 2021.
At the end of 2011, with the bank's stock trading at less than $6, those warrants were underwater. The stock better than doubled in 2012; had he exercised his warrants on Monday, Buffett would have realized an immediate gain of $3.1 billion. Using a Black-Scholes model and assuming annualized volatility of 35% for B of A shares, I value the warrants at $4.1 billion -- a nice sweetener on Buffett's $5 billion investment.
At last year's Berkshire annual meeting, Buffett downplayed the contribution of similarly structured investments in Goldman Sachs and General Electric that he made in 2008 in a total amount of $8 billion, arguing that "the values in Berkshire that have been accumulated by some special security transaction are really just peanuts compared to buying businesses like Geico, or Iscar or BNSF. It's not a key to Berkshire's future." These investments may be "peanuts" to Buffett, but for the average dart-throwing monkey, they're the stuff of dreams.
Editor's note: A previous version of this article gave the incorrect number of Bank of America stocks Berkshire Hathaway can purchase.
