The Real Challenge for Bank of America

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One thing is for sure: There is no shortage of challenges for Bank of America  (NYSE: BAC  ) right now.

The bank has mammoth legal challenges that will continue to threaten its bottom line for the near future. It competes in a cutthroat business that puts it head to head with similarly entrenched giants like Wells Fargo  (NYSE: WFC  ) and JPMorgan. Regulators could continue tightening down on the banking business and hacking away at potential profits. And the list goes on.

Some of these will be ongoing long-term challenges. Competition, for instance, isn't going away. Others are shorter term. The legal headaches the bank is facing will hurt, but they'll largely play out over the next few years.

All of these challenges, however, are overshadowed by a much larger issue: Bank of America's need for a clear, durable competitive advantage.

This will ring particularly true for fans of Warren Buffett, who has long emphasized the need for this sort of defense against competitive pressures. In his 1995 letter to Berkshire Hathaway  (NYSE: BRK-A  ) (NYSE: BRK-B  ) investors he wrote: "In business, I look for economic castles protected by unbreachable 'moats.'"

As it stands now, B of A just doesn't have this. It has the makings of some potential moats -- its size, for instance. The vision of CEO Brian Moynihan also has the bank targeting such moats -- like leveraging its diversified businesses to cross sell to customers and make relationships more lucrative and stickier. But the Bank of America of today is so focused on addressing near-term challenges that it's not making fast headway on this long-term must. And that shouldn't come as a shock -- creating a truly worthwhile competitive moat isn't something that happens overnight and is made even tougher when it has to compete with major cost-cutting efforts.

The question could be asked why Buffett would have invested heavily in Bank of America if it lacked this key Buffett-investment ingredient. The answer lies in the nature of Buffett's investment. The $5 billion he invested in B of A came in the form of preferred stock that pays 6% per year. As a result, he gets a handy return on a big investment in a bank that won't go out of business. We're talking "too big to fail" here, after all.

Meanwhile, the deal also included a huge number of warrants that give Buffett the option to make Berkshire a major equity investor. At the time of the deal, Moynihan said the investment was a "strong endorsement in our vision and our strategy" by Buffett. Vision and strategy are well and good, but in B of A's case, they're a bet on the future. Buffett's deal allows him to see whether Moynihan's vision and strategy work out, and then truly buy into B of A. Or not.

This, of course, contrasts with Buffett's investment in Wells Fargo. Wells has been in Berkshire's portfolio for decades, and Buffett has been actively adding to it in recent years -- it's now Berkshire's top stock holding. The economic moat at Wells is obvious; the company has a clear, established vision and corporate culture that guides the business and has led to outstanding results over a long period of time. Or, as CFO Tim Sloan recently put it:

At Wells Fargo everything we do starts with our vision -- to satisfy all our customers' financial needs and to help them succeed financially. We believe this consistent vision is a key differentiator for Wells Fargo and is one of the reasons that we have been successful for many different economic cycles and many different interest rate environments.

From my perspective, Bank of America's stock is an attractive investment right now. But that attractiveness stems from the fact that it's a bank on the path to recovery that's priced at a compelling discount. This, I believe, will deliver solid gains in the coming years. However, truly outstanding long-term results will only accrue if the bank is able to reengineer itself so it has a serious, durable competitive moat. 

As Phil Fisher -- one of Buffett's key influences -- put it in Common Stocks and Uncommon Profits:

The reason why the growth stocks do so much better is that they seem to show gains in value in the hundreds of per cent each decade. In contrast, it is an unusual bargain that is as much as 50 per cent undervalued. The cumulative effect of this simple arithmetic should be obvious.

For now, investors can lean on the fact that B of A may still be considerably undervalued. But as time passes and -- ideally -- that valuation rises, they'll want to carefully watch whether the bank is able to transform into a company that is worth holding for for the true long term.

Digging deeper on Bank of America
Bank of America's stock doubled in 2012. Is there more yet to come? With significant challenges still ahead, it's critical to have a solid understanding of this megabank before adding it to your portfolio. In The Motley Fool's premium research report on B of A, analysts Anand Chokkavelu, CFA, and Matt Koppenheffer, Financials bureau chief, lift the veil on the bank's operations, including detailing three reasons to buy and three reasons to sell. Click here now to claim your copy.


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