I've been out buying several series of warrants in my Special Situations portfolio recently, and now I'm back to buy more, with my purchase of Bank of America (NYSE:BAC) warrants. The warrants offer substantial leveraged upside on the recovery of one of the nation's largest banks and the normalization of the economy and housing market in the coming years.
The business and special situation
I'm going to spend little time going through Bank of America's business. It's a well-worn path, but I do want to focus on a few general points.
As one of the nation's largest banks, Bank of America has an enviable position of being able to extract money from the economy as a whole. That's a tremendously advantaged position. The bank also effectively receives subsidies via implicit government support (i.e., too big to fail), making the bank all the more profitable. Those are huge advantages, ones that a strong financial lobby reinforces. Love it or hate it, Bank of America is profitable and will be more so as the economy normalizes. It will take an act of Congress to change the financial industry, and Congress has been unwilling to do anything, here.
The bank is cheap. Net out settlements of $6 billion last year, and the bank is trading at less than 12 times earnings. If you look at Warren Buffett's preferred investing threshold of 10 times earnings before taxes, then B of A also looks attractive. On that basis, the stock is trading at just 8.2 times. That disparity must be why Buffett continues to own the stock and warrants. It lends some comfort -- and confirmation bias -- to know Buffett is involved. But that's hardly a reason, even a small one, to own the stock.
The special situation here is the TARP warrants issued as part of the bailout of the financial system in 2008. Warrants can be particularly attractive, since long-term derivative securities tend to be mispriced, and I think that's what we have in Bank of America's January 2019 warrants with a strike price of $13.30. The warrants currently trade for around $8.20 against B of A's $17.20 stock price today, so they have about $4 per share of time value currently baked into the price.
Just like a call option, the warrants will provide leveraged upside on an increasing stock price, and with nearly five years til expiration, B of A has a lot of time to improve its operations.
The warrants have another interesting feature, a so-called anti-dilution provision that, among other things, protects warrant holders if B of A pays dividends greater than $0.01 per quarter. In effect, warrant holders get to collect that dividend via a provision that lowers the effective strike price of the warrants.
Well, guess what happened last week? The bank announced it has raised its dividend from a penny per share to a nickel, paid quarterly. That excess will soon be reflected in the warrant strike price, providing yet another tailwind. As dividends continue to increase, the warrants will get even more valuable. Other smart capital-allocation moves, such as the recently announced buybacks, will keep the stock and warrants moving in the right direction, too.
Foolish bottom line
I expect lollapalooza effects from this investment over time. Bank of America will continue increasing its profitability substantially over the next five years, allowing the stock to trade at a higher multiple. Then I'm layering warrants onto the investment case for even more leveraged upside, and dividends and buybacks help, too. So, that's why my Special Situations portfolio is adding $500 in January 2019 warrants to start, and I'll look to add to that on any significant dip.
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Jim Royal has no position in any stocks mentioned. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.