The fact that Warren Buffett invested $5 billion in Bank of America (NYSE: BAC ) doesn't mean you should own its stock as well. If anything, in fact, it's safe to assume he wouldn't have done so if it weren't for the highly favorable terms of the deal.
It's important to realize that Buffett doesn't only invest in the superb franchises that Berkshire Hathaway (NYSE: BRK-A ) (NYSE: BRK-B ) has come to be known for -- Coca-Cola and American Express serve as textbook examples. Over the years, he's made countless investments in shorter-term arbitrage positions.
"We have practiced arbitrage on an opportunistic basis for decades, and to date, our results have been quite good," Buffett wrote in his 1987 letter to shareholders. One year later, he discussed at length the arbitrage principles and success of his mentor, Benjamin Graham.
While at Graham-Newman, I made a study of its earnings from arbitrage during the entire 1926-1956 lifespan of the company. Unleveraged returns averaged 20% per year. Starting in 1956, I applied Ben Graham's arbitrage principles, first at Buffett Partnership and then Berkshire. Though I've not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%.
Of course, that Buffett engages in arbitrage doesn't in and of itself mean Berkshire's position in Bank of America qualifies as such (or, rather, as something less than an all-out investment in an outstanding business). Who's to say he doesn't view it as an exceptional franchise akin in Coca-Cola and American Express? Given his massive financial stake in the Charlotte, N.C.-based bank, he certainly wouldn't admit to this.
The answer to this question can instead be found by reading between the lines of Buffett's past writings on both banks and investments more generally. As anybody who's made their way through Buffett's shareholder letters knows, the Oracle of Omaha is not one to reserve praise.
Describing the managers of Wells Fargo, he fawned in Berkshire's 1990 letter that "we think we have obtained the best managers in the business," called the bank "superbly managed," and singled out their resolve to "vigorously" attack costs and to allow their abilities -- not their egos -- to determine the direction of the business.
Regarding Berkshire's original $40 million investment in First Empire State Bank (which went on to become M&T Bank), Buffett noted that, "Normally I would think a purchase of this size too small for Berkshire, but I have enormous respect for Bob Wilmers, CEO of First Empire [now chairman and CEO of M&T Bank], and like being his partner on any scale."
And discussing Berkshire's former wholly owned subsidiary Illinois National Bank and Trust:
With Eugene Abegg running the operation, the exceptional has become the commonplace. Year after year he continues to run one of the most profitable banks in the United States, while paying maximum interest rates to depositors, operating with unusual levels of liquidity, and maintaining a superior level of loan quality.
Meanwhile, here's what he had to say about Bank of America three years ago upon announcing Berkshire's $5 billion position in it:
At Bank of America, some huge mistakes were made by prior management. Brian Moynihan has made excellent progress in cleaning those up, though the completion of that process will take a number of years. Concurrently, he is nurturing a huge and attractive underlying business that will endure long after today's problems are forgotten.
Now, just to be clear, it's not that Bank of America doesn't have good qualities. It's just that the nation's second largest bank by assets is in an entirely different league than Berkshire's other bank holdings. While Wells Fargo and M&T Bank are the captains of the varsity team, Bank of America is a junior varsity journeyman.
On a more tangible basis, furthermore, it's critical to recognize how different Berkshire's stake in Bank of America is from these other lenders. Buffett went headlong into Wells Fargo, Illinois National, and M&T Bank (as well as U.S. Bancorp) by buying their common stock outright. With Bank of America, by contrast, Berkshire's original stake consisted of cumulative preferred stock, which all but guarantees a 6% dividend and is entitled to preferential treatment in the event of liquidation.
Indeed, even though Berkshire has effectively become Bank of America's largest holder of common stock, one could argue that this position was a mere afterthought -- to Bank of America at least. It stems from warrants on 700 million shares of stock that were essentially thrown in with the preferred stock to sweeten the pot in exchange for Buffett's vote of confidence at a time when things were looking particularly grim for the bank.
Finally, it simply can't be denied that Bank of America doesn't fit the profile of the type of bank, or company for that matter, Buffett typically seeks out. The main problem? Its costs are some of the highest in the country, sporting an efficiency ratio that would make even the most brazen bank executive blush.
My point here isn't to pile on Bank of America at a time when it's reeling from yet another round of self-inflicted wounds. It's rather simply to provide context for Buffett's interest in the bank. While you can expect him to continue "talking his book" by defending the bank, as he recently did at Berkshire's annual meeting, you're making a mistake if you interpret such talk as a ringing endorsement.
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